Move over China - Indian investments have the real potential

Overseas money is flooding into India. But this is just the first wave. The real India boom has barely begun. So what is the best way to invest in a country set to become the next global economic powerhouse?

Overseas money is flooding into India. But this is just the first wave. The real Indian investment boom has barely begun.

Canny investors have always been aware of India's potential, especially after its liberalisation in the 1990s, but now that the Bombay stockmarket is surging to new highs on a weekly basis and overseas money is flooding in, it seems that the investment world has finally woken up to the charms of the subcontinent. Its GDP growth at 8% is second only to China, twice as fast as that of the US, and four times ahead of the eurozone.

Indian investments: advantages over China

With over a billion people each, both Asian giants have enormous reservoirs of labour and consumption. But while centralised and authoritarian China may have got ahead in the short-term by its ability to make unilateral investment decisions, India's stable history of democracy and property rights could prove to be the fundamental advantage that allows the country to leap ahead of China in the long term.

A second factor likely to drive future Indian investment growth is internationally competitive higher education in everything from business management and science to information technology (IT). So far, outsourcing has only attracted a tiny portion of the educated talent of India's mammoth professional class. Consider this: Indian universities churn out some 350,000 engineering students annually while the US will have more sports therapy graduates than engineering ones this year. Such high numbers of qualified workers will help India push further ahead in research and development (R&D) and innovation in many fields. Indeed, as many as 230 multinationals have arrived in India since 2001 in order to set up research centres. These include General Electric, Microsoft and Daimler Chrysler.

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A third Indian asset is demographics. While China has a strong labour force, its one-child policy could lead to the European problem: a small working population struggling to support a growing number of pensioners. But half India's population which is set to surpass that of China in about 40 years' time is under the age of 25 and fiercely hungry to work. That's a labour force that can't be beaten. And that's why what we have seen so far in terms of outsourcing call-centres is only the beginning. That first wave is going to be followed by further waves of higher-paying jobs in law, business services, and medicine.

When that happens, watch the real Indian investment boom explode. Indians are huge savers they hold onto around 28% of everything they make, compared to 2% in the US and the expansion and enrichment of the professional classes will mean consumer spending on housing, healthcare, cars, and food, with money pouring into investment. Manufacturing, already a huge part of the economy, will expand. IT infrastructure already sophisticated will keep advancing further.

Internet and cable have already penetrated remote rural areas. Local governments, in Karnataka and Hyderabad, for example, are teaming up with companies such as Microsoft to provide computers and technical training down to the village level. Indians staff are not only employed in the more humdrum aspects of IT, but are increasingly involved at its creative core.

Indian engineers fill R&D departments in innumerable international firms. Of 186 of the world's largest corporations, 70% of new R&D centres over the next three years will be in India or China.

India's medical system is being tapped by the West as well. Not only are readings of x-rays, billing and routine work being outsourced, but increasingly medical tourists are putting Indian hospitals and clinics on their radar for high-quality, inexpensive care.

Indian lawyers and accountants are taking care of business through the internet for American firms on the other side of the globe, 11 hours away. As technology advances, this is becoming easier and quicker. The price comparisons between the West and India make outsourcing too compelling for firms to ignore. From Lloyds TSB's account-enquiry call centre to the National Health Service's medical testing, businesses are moving to India.

Investment in Indian infrastructure: roads revolution under way

But there are aspects of Indian infrastructure that, admittedly, do have their problems. And transportation is one of them. In the past, this made foreign companies loath to set up even in large, relatively developed cities, such as Bangalore.

Potholed roads and poor layout meant traffic congestion and delays in delivery. In the 1990s, India was spending barely a tenth of the 18 billions pounds that China spent on its roads. Eighty per cent of Indian goods moved on antiquated highways that made up only 2% of its entire road network. Now all that is changing.

A roads revolution is behind the propulsion of annual growth past 8%. The 3,650-mile Golden Quadrilateral' highway project, the largest infrastructure project since Independence in 1947, will create a diamond of expressways linking Delhi with the country's three other largest cities: Mumbai, Chennai and Calcutta. On schedule to be completed this year and within its £4bn budget, the project is just the start of more than £35bn of future road projects.

The arrival of bigger, better roads has had an "immediate, visible effect" because of the size of the untapped market. There may be only 7.5 million cars on the road, but there are 40 million Indians who can afford to buy one. And auto manufacturers, foreign and domestic, have not been slow to take notice. No wonder that sales of Ford cars in the country are rising at more than 30% a year. Indeed, Indians are becoming so well off that the first ever Rolls-Royce Phantom sold in India last year for £500,000.

Local production is ramping up as well, with India's biggest motor manufacturer, Maruti (majority owned by Japan's Suzuki), leading the charge. Figures from the Society of Indian Automobile Manufacturers show India's vehicle production jumping 13% last year, while its auto-components firms have also joined the outsourcing boom. Kamal Nath, India's trade minister, recently pointed out that General Motors was losing workers in Detroit that it was recruiting in India.

Indian investment: political climate improving

Investors have another reason to cheer. The political climate, which has in the past been a major source of unease for investors, seems to have become more favourable to foreign investment. While it is the right-wing Bharatiya Janata Party (BJP) that is most associated with economic liberalisation, the xenophobia and strident religious chauvinism it exhibited when in power made investors more than a little uneasy.

From that perspective, the Congress party's return to power was encouraging, even though it was originally under Congress that India's bureaucratic regulators became notorious as the "License Raj". The new government chose reformist Cambridge-educated economist Manmohan Singh to be its prime minister, helping to reassure investors that economic growth will have a top priority in Delhi.

And so far, the markets seem to have no doubts that the government will stick to this plan. In the first four months of 2006, $17bn in foreign money was invested in Asia in total, according to Citigroup, ten times more than in the same period last year. US investors are at the vanguard of this move, having poured $68bn into international mutual funds this year more than twice the amount allocated to US funds, says Deborah Brewster in the FT, with a good proportion of this money going into India. And it's not just the US other Asian countries that have already had their boom see India as the future. According to HSBC, up to two-thirds of the $6.5bn of foreign net flows into Indian equities since last August have come from Japanese buyers.

All these positive trends and floods of foreign money are showing up in the bonanza that is the Bombay Stock Exchange Sensex, India's flagship stock-market index. In the last three years, it has rocketed nearly 300% and shows no sign of stopping yet. Already this year it's up by 33%, putting it on a par with China's SSE Composite benchmark and far outstripping the measly 1.3% the UK's FTSE 100 has returned since January.

How to invest in India

Indian Property

Marc Faber believes that even after recent price rises, Asian property is the "most attractive asset class in the world". And within Asia, India is the latest "hot spot", following last year's relaxation of the rules on overseas investment in property, according to Investors Chronicle. The market is currently worth an estimated $12bn, and analysts think it could reach $90 bn in a decade. For example, despite its huge size, India only has 35m sq ft of office space in the whole country around "one-third" of the amount found in London.

The first two UK-quoted Indian property firms are Trinity Capital and Eredene Capital. Trinity has raised £250m for investment in Indian property. It is expected to be fully invested within 18 months and will be geared by around 60%, giving a total investment of £400m.

Alastair King's Eredene Capital cash shell has raised £57m for investment in Indian office space, retail and residential projects. King expects to announce a deal every one or two months, investing in cities in India with populations of 500,000 to 1 million. This could be the start of a "deluge" of high-risk, emerging-market property companies joining Aim. However, investors should wait until companies such as Trinity and Eredene can boast meaningful track records.

India Funds

The least risky route into the country is through funds. There are an increasing number that invest solely in India, although the overall market is still fairly small. Best known is the JP Morgan Indian Investment Trust, up 80% over the last year and 419% over the last three years. Co-run by Rukhshad Shroff in Hong Kong with Ted Pulling in London, the fund launched in 1994 and has now grown to £311m. It holds around 50 stocks, among the biggest of which are Bharat Heavy Electricals, Infosys Technologies and Larsen & Toubro. The annual management fee is 1.2%.

The Fidelity India Focus Unit Trust, launched in 2004 and managed by Sandeep Kothari, is also up 80% over the last year. Smaller than the JP Morgan fund at £63m, it holds from 60 to 80 stocks. The initial charge is 3.5% and the annual charge is 1.5%.

Other popular funds in the sector include the HSBC Indian Equity fund and Aberdeen Asset Management's India Opportunities Fund.

What the analysts say about Indian investments

In the wake of this sort of stellar performance, there are many who believe the Indian market is currently overvalued. The market p/e ratio is currently around 20 times, which means India is the most expensive market in Asia, apart from Japan. And it is more expensive than the Dow or FTSE 100. Brokers including Citigroup, Merrill Lynch and Morgan Stanley have recently issued cautionary notes on its short-term direction. Of course, consensus is always a dangerous thing, but most professional investors are keen to wait for weakness before buying in.

Emerging markets investment guru Mark Mobius, who manages Templeton's Emerging Markets trust, feels that India has become "a little expensive", according to Ellen Kelleher in the FT. However, he does say that liquidity there is likely to remain "frothy", due to the continuing boom in initial public offerings and buying coming into the market from hedge funds, pushing stocks up further in the next few months.

Others are more positive. Portfolio manager Bharat Shah at investment boutique Absolute Capital believes that prospects for growth in India are still "strong", according to Investment Adviser. Local knowledge is key, he says, and those who point to Indian stocks being fully valued are guilty of focusing on the "very largest stocks" on the Indian exchange. With some 6,500 quoted companies in India below the heavily capitalised top end of the market, there are companies trading on "very attractive valuations".

Marc Faber, aka Dr. Doom, is in agreement. He is "positively euphoric" about Asia's prospects, worrying less about an Asian bubble than the "terrifying prospect" of further asset inflation in the United States, according to William Barnes in the FT. And while he is bullish on Asia in general, he is keen on India in particular. Valuations are not generally as compelling as they were a couple of years ago, he says, yet anyone hoping to make "serious money" should be focusing their attentions on India.

Top Indian investments: three stock tips

The first companies that come to mind in India are all IT, software and outsourcing services. But these are often overvalued and it is well worth looking beyond them. Since the market was opened up a decade or so ago, India has become an important centre for vehicle production, with foreign partnerships such as Maruti, Suzuki, and Hero Honda dominating the industry. Tata Motors (TTM:NYSE) is the country's largest and the world's eighth-largest car manufacturer in the world, exporting vehicles to 70 countries globally. Vehicle sales in India grew at a double-digit rate in 2004, and a high single-digit pace in 2005. Growth of this sort is driving Tata's revenues forward at speed, and its high market share (it has 62% of India's truck and bus sector) ensures that it is benefiting fully from the trend. In a recent report, broker HSBC points to lower tax rates on small cars and overloading restrictions on commercial vehicles as being positives and rates the stock overweight'. Currently priced at $19.60 on the NYSE, the shares trade on a forward price/earnings ratio of 19 times and are yielding 1.5%.

HSBC also has an overweight' rating on Hindustan Lever (HLVR IN). HLL is India's leading home and personal-care company, majority owned by Anglo-Dutch Unilever. It prospered in the 1990s due to the 15% per annum growth in its market. In 2002, however, growth rates slowed, with consumers trading down as competitors such as P&G cut prices. But it has divested 15 businesses as part of its new growth strategy and with the portfolio restructuring now complete, 2006 should see a "significant turnaround". Priced at INR273, its prospective price/ earnings (p/e) ratio is 34, putting it on a reasonable price/ earnings to growth (PEG) ratio of 1.76. It also has a yield of 2.4% and is rated buy or overweight by UBS, JP Morgan and CLSA.

HDFC (Housing Development and Finance Corporation) Bank (HDB:NYSE) is India's second-largest bank. Increasing home-ownership is a long-term trend in India and HDFC directly benefits from the enormous demand for home loans. The bank's total loans have been growing at a 50% clip over the past couple of years, according to HDFC has seen impressive growth and is opening new branches at a rate of 100 a year and moving into new areas, such as insurances. Currently trading on the NYSE at a price of $59.18, the shares trade on an estimated p/e ratio of 30, giving it a PEG of just 1.07.