Profit from India’s great leap forward

India is brimming with potential, and reforms are transforming the country. Smart investors should buy in now, says Matthew Partridge. Here, he tips the best shares to profit.

India has held the title of next emerging economic superpower' for about two decades. The country is always seen as brimming full of potential it just hasn't quite realised it yet.

It's not that India hasn't made any progress at all. It's now the third-largest economy in the world, if you take purchasing power into account no mean feat. But it continues to lag its big Asian rival, China. While the average Chinese citizen has an income of $8,387, according to International Monetary Fund (IMF) estimates, India's GDP is only $3,663 per head.

This comparatively poor performance is partly down to politics. India is a democracy, which is often cited as its advantage over China. But Indian politics is also rife with corruption and the structure of the political system allows special interest groups to hold undue sway.

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These two factors have combined to block essential economic reforms and prevent the government from investing in the key infrastructure essential to India's future success. It also means that foreign investment remains heavily restricted. Those who do invest in the country complain that even simple projects take years to be agreed, and frequently leave for more business-friendly climes.

As a result, India scores badly on many internationally recognised measures of competitiveness. Transparency International, a corruption watchdog, ranks India's public sector 94th in the world on a list of 172 nations in terms of openness. That's tied with Colombia and Mongolia, while China is in 80th place.

The Index of Economic Freedom produced by the Heritage Foundation, a think tank, rates India as "mostly unfree", alongside the likes of Pakistan and Tanzania. Some even argue that India provides proof that democracy does not always aid economic growth.

But there are signs that India's youthful population, especially its well-educated middle-class, is no longer prepared to tolerate the bad old ways. Anti-corruption campaigners are popular: zero rupee' protests (where public servants soliciting bribes are given zero rupee' notes) are on the rise. This has forced the government to take action, such as passing new anti-corruption laws.

India is also opening up to foreign investment and improving its infrastructure. Forward-looking state governments, such as that of the western state of Gujarat, are pushing ahead with reforms designed to encourage the private sector to build roads, distribution networks and power plants. This could be a big boost to the economy the IMF reckons growth could rise by 2% a year if infrastructure was improved. It's also a great investment opportunity.

Powering up India

One of the main challenges is to upgrade India's power supply. Last year, a prolonged blackout saw roughly half of the country left without power for several days. As well as the day-to-day disruption to people's lives, it caused economic chaos, with business forced to shut down, trains grinding to a halt and miners trapped underground.

Government officials claimed it was a one-off: unusually high temperatures and a drought saw power demand from both urban and rural areas spike. They also blamed three states for drawing more than the allocated supplies.

But as Wendy Stephenson of Indian energy company CW Renewable Energy, noted at a recent Duncan Lawrie roundtable, around 350 million Indians (of a population of 1.3 billion) still have no access to electricity. Even those who do suffer regular outages. This can only get worse.

Increased urbanisation will see energy demand rise by 8% a year, well above the current output growth rate. India's power-generation industry has missed every single official target for adding capacity since 1951. This means that homes and businesses face being forced to rely ever more heavily on their already ubiquitous private generators.

So why the chaotic power system? It stems from the fact that the state has always had a large role in the sector. Around two-thirds of India's electricity comes from coal. India has plenty of coal. But the main mining company, state-owned Coal India, has a very poor reputation. NTPC, one of the largest power companies, has accused Coal India of tossing poor-quality coal, and even rocks and boulders, into its deliveries to meet targets.

These failings mean that power plants are routinely forced to pay a premium to import foreign coal, despite the easily accessed reserves sitting on their doorstep.

Government interference isn't just limited to the energy supply. Many of the power companies are also state-run, and energy prices are tightly capped in many regions. This means there is no profit incentive to supply extra power to the market, and it also means that some existing plants run at a loss.

On top of this, the government owns a majority stake in Power Grid Corporation of India, which distributes half the power produced in the country. While the company claims that its reliability is in line with international norms, it was bitterly criticised in the aftermath of last year's major outage.

The government has taken several steps to boost production. Firstly, it has tried to reorganise the mining sector. Three years ago, it sold a small stake in Coal India, and now plans to outsource operations of its mines to private firms. Coal India has also gone on a buying spree, pledging to spend $6.5bn on buying mines in Africa, South America and Australia.

India's Competition Commission has also criticised Coal India, claiming that it is abusing its monopoly, which could see the company broken up and fully privatised.

As well as changing the structure of the coal industry, New Delhi has made a big effort to encourage private investment in other energy sources, setting a target of raising $300bn in new investment, especially in renewable energy.

As part of this initiative, it aims to increase the proportion of energy coming from wind power by 150% in the next seven years. It has waived foreign-investment barriers (including tariffs on equipment), and offered low-cost loans and tax breaks.

Finally, India is trying to find a bigger role for nuclear power. But rather than just use conventional uranium-based technology, it has focused on the less well-known thorium.

Thorium, which we've covered occasionally in the past at MoneyWeek, is less radioactive than uranium, and so generates less waste and reduces the risk of an accident. It is also naturally abundant in India, which will cuts costs and help improve the country's trade balance. A site for the first plant has been identified, with construction due to begin next year.

Upgrading the transport network

India's deficient power network isn't its only infrastructure problem. The Indian economy is also held back by the state of the roads. Paved highways that are usable in all-weather conditions, throughout the year, account for a tiny fraction of the network. Yet the alternatives are so dire that traffic still crams onto this tiny sliver of reliable road, leading to awful congestion, especially around cities.

This affects all areas of the economy, notes Pinakin Patel of JP Morgan Asset Management. Although India is virtually self-sufficient in food, for example, that food often can't get to the store or the market quickly enough, and it rots. Overall, "there's no doubt that the Indian consumer wants to spend, but they have to be given the opportunity" to do so. This means usable infrastructure "is critical to getting a consumption-driven economy".

The traditional solution to congestion has been for the government simply to build more roads. However, the results of this strategy have been poor. Companies involved in past contracts have complained of huge delays in getting paid, while local and state governments retort that the work is substandard and sometimes not even finished. As a result, even finished roads rapidly become cracked and potholed and end up requiring constant repairs.

So the government has decided it's time for a new approach: a partnership' model. Instead of getting paid upfront, or upon completion, companies are being offered the right to earn back their investment by charging tolls. In some cases, firms even pay the government.

The most obvious benefit is that this approach allows more roads to be built without public spending rising. More importantly, the fact that revenues will be dependent on the number of people using them and paying tolls to do so, gives firms an incentive to produce good quality, well-maintained roads.

While this model is relatively new, it is catching on quickly. Accountants PriceWaterhouseCoopers estimates that roads now account for over half of all Indian public-private partnership deals.

India's ports need major upgrades too. Almost all (95%) of India's trade by volume, and 70% by value, passes through its ports. However, this sector has many problems. Labour relations are poor, connections to the road and rail network are lacking, and a low proportion of goods is shipped in containers (the most efficient way to transport goods).

As with much of Indian infrastructure, the core problem is that state-run companies historically controlled almost all of the traffic going through the ports, and have done a bad job of it. But this too is changing.

The removal of barriers to entry means that, within the next few years, private operators are on track to overtake their state-run rivals in terms of traffic handled. Many of the new private ports come with state-of-the-art technology allowing the loading and unloading of cargo to be largely mechanised, cutting costs and the risk of labour disputes.

And with global trade starting to grow again, there is still a huge opportunity here. The volume of cargo passing through Indian ports is growing by around 10% a year, according to the research company ICR. Existing ports are nearly full, with average capacity usage of 85%.

Port operator APM Terminals suggests that, given the size of India's economy, total traffic should be up to 12 times bigger. While such a huge expansion is unlikely to take place, it firmly believes that a further $20bn of investment will be needed by the end of the decade, or it will continue to act as a major drag on economic growth.

Of course, spanking new ports are of little use if you can't transport goods once they're in the country. The Indian railway network is one of the largest in the world. However, it is still largely trapped in the pre-independence era, plagued by low speeds and long journey times.

India's rail minister Pawan Kumar Bansal thinks that, to bring the freight network, let alone passenger transport, up to the required standard there will need to be an extra $30bn in investment. As with roads, he believes that the private sector should be involved "to the maximum extent possible". We look at the companies set to profit below.

Barriers to entry

Up until recently it was almost impossible for most British private investors to buy Indian shares directly. The only foreigners allowed to participate in the market were those with enough Indian ancestry to be classed as non-resident Indians. However, the Indian government has started to loosen the rules.

At the start of last year, the Indian government opened up the markets to allow any qualified foreign investor, which includes any EU, US, Canadian or Australian citizen, to buy into mutual funds. This was rapidly broadened to include individual shares.

But even with the recent changes, investors still have to open a brokerage account, a non-interest-bearing rupee bank account, and get an income tax number from the tax authorities. The amount of any one company that foreign investors can own is also limited to 5% (although this is unlikely to affect small investors).

Kotak Mahindra Group, which offers banking and trading services, estimates that complying with these steps will take the average investor about a month. In short, unless you're very keen to invest direct, we'd stick to funds or stocks available on more accessible exchanges.

The investments to buy into now

Two India funds that are worth investigating in this area are Infrastructure India (LSE: IIP) and Eredene Capital (LSE: ERE).

Infrastructure India operates five main projects. Three are in the renewable-energy sector: two hydropower plants and a wind farm in southwest India that supplies the booming city of Bangalore. However, it also has a substantial stake in a central Indian toll road and full ownership of a port container company, which has operations in both Bangalore and Chennai.

While it recently reported an operating loss, the fund currently trades at under half its net asset value. That discount makes it look like an attractive long-term bet for patient investors.

Eredene, meanwhile, trades at a narrower discount, of only a quarter of the value of its assets. However, research group Equity Development thinks investors are likely to see the benefits of this mispricing in the near future, as it is gradually selling off its investments to return cash to shareholders.

Eredene's portfolio is mainly focused on transport (ports) and distribution. This includes a small stake in Ocean Sparkle, which owns the biggest fleet of harbour tugs (used to help ships dock). It also has a controlling stake in a Mumbai real-estate firm, Matheran Realty.

If you're more interested in individual stocks, then one company to investigate in India's energy sector is Greenko Group (LSE: GKO). The group is involved in several renewable energy projects, including biomass, hydropower and wind. The total capacity of the plants it runs has grown from 189 megawatts (MW) to 785MW in the past year at full output, that's enough to provide roughly a third of the power consumed by Mumbai's 11-million-strong population.

Management's long-term goal is to increase capacity to 3,000MW, and it has received an injection of £100m in funds from a Singaporean sovereign wealth fund to do so. Revenue is expected to more than double from €37m in 2012 to €85.7m in 2014. Although it's on a price/earnings (p/e) ratio of 31, Greenko is growing rapidly and still trades below its book value.

Great Eastern Energy Corporation Limited (LSE: GEEC) also looks promising. It generates electricity by extracting and collecting methane gas from coal beds. This unconventional energy has been described as the "next shale gas". Since India has the fifth-largest supplies of coal in the world, this could be one way to close the gap between supply and demand. Great Eastern has only recently moved into profitability, but its p/e ratio falls to just 4.9 by 2014.

You can buy into both energy and transport through conglomerate Reliance Infrastructure (LSE: RIFA). Not only is it India's largest power utility, with a monopoly on delivering energy to Mumbai's booming suburbs, but it is also involved in building roads, railway lines and energy pipelines.

One of its major concessions, a rail link from New Delhi's airport to its main metro station, has now restarted and should be running at full speed by the end of the year. It may also get extra revenue from plans to build a large office block in Hyderabad. Overall, it looks good value, trading at only 8.7 times 2013 earnings.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri