In 1492, Italian explorer Christopher Columbus set sail to discover India. He missed his mark, however, landing in America instead. The rest, as they say, is history—with the exception that more than 500 years later India is still worthy of discovery for many Western investors.

Portfolio Manager and Director of International Research David Nadel discusses:

An Introduction to India

In 1492, Italian explorer Christopher Columbus set sail to discover India. He missed his mark, however, landing in America instead. The rest, as they say, is history—with the exception that more than 500 years later India is still worthy of discovery for many Western investors.

India is the world’s largest democracy and Asia’s third-largest economy. With its rapidly growing middle class, India is also the world’s third-largest economy measured by purchasing power parity, and with a median age of just 25 years old, it will also soon have a fifth of the world’s working-age population.1 India’s median age is 10 years younger than the U.S.’s and nine years younger than China’s.2 This demographic dividend sets the stage for growth.

Gross Domestic Product, 2012 by Purchasing Power Parity (millions of international dollars)3

 India

My Royce colleague George Wyper and I recently visited the country to meet with 14 local companies to try and unearth some promising investments. This was our second visit together in three years, and my third in total. Investors’ attitudes toward India tend to alternate between extremes of worship and despair. We think a calmer middle ground is warranted for this market (any many others.

As of December 31, 2013, India is the fifth largest country allocation of the Royce International Smaller-Companies Fund (click for a prospectus). Let’s discover why we are somewhat more bullish than most.

India is the world’s largest democracy, Asia’s third-largest-economy, and the world’s third-largest economy measured by purchasing power parity.

Royce International Smaller-Companies Fund’s Portfolio Country Breakdown as of 12/31/13

Countries % of Net Assets (Subject to Change)*
Japan 12.8
United Kingdom 12.5
Hong Kong 10.4
France 9.3
India 5.1

*Securities are categorized by the country of their headquarters

India and the BRICs: Unloved, Underinvested

Over the past decade, the emerging markets (EM) have been responsible for the bulk of real GDP growth globally and now collectively account for more than half of the global economy. Yet the BRIC stock markets (Brazil, Russia, India, China) have dramatically underperformed global equities for nearly three straight years. And within the Indian market, there has been an epic level of bifurcation between large- and small-caps. While the S&P BSE Sensex Index of India’s 30-largest companies recently touched an all-time high on January 23, 2014, Royce’s market-cap range as represented by the S&P BSE Small Cap Index was trading at press time some 55% below its 2008 high. Given this yawning gap in performance, we see the greatest opportunity and valuation cushion among India’s small-caps.

While investors hoping to gain EM (emerging markets) exposure have bid up the prices of large-cap multi-national corporations (MNCs) based in the U.S. and Europe, they have curtailed direct investment in EM companies. Foreign Direct Investment (FDI) for India contracted 30% in 2012 over 2011, returning to 2010’s level of $25 billion, and has contracted still further in 2013, while investment by Indian corporations has likewise slowed for more than a year.4

For bottom-up stock pickers like Royce, we like that most of the Indian smid-cap companies with which we met are managed as much for returns as they are for growth, an unusual calculus in the emerging markets.

Yet even as most investors are running away, our investment view on India is cautiously optimistic. Its current account deficit has improved to just 1.2% of GDP, and its unemployment rate (4.7%) and even budget deficit (5.3% of GDP)a have likewise shrunk to manageable levels.5 More importantly, for bottom-up stock-pickers like Royce, we like that most of the Indian smid-cap companies with which we met are managed as much for returns (return on capital, return on equity) as they are for growth, an unusual calculus in the EM. Corporate India has generated the highest ROE (return on equity) among the BRIC economies, and among the highest ROE in all of Asia.6

Fastest Growing Middle Class

India’s middle class is the fastest growing among the BRIC countries, and has expanded by 35% in the past decade.7 At current rates of growth, India in just eight years will have as many households with disposable income of $10,000+ as the U.S. or the eurozone.8 By 2030, India is expected to have more members of the middle class than any other country, including the entire EU.9 Put another way, India’s middle class is expected to outnumber the entire U.S. population by sometime before 2025.10

Shares of Global Middle Class Consumption, 2000-205011

Comparisons of India’s economic miracle to China’s are inevitable for westerners, who have even coined the phrase “Chindia” to combine the two powerhouses. However, the face of economic growth is quite different in the two countries. For one, India is not a command economy but rather a democracy with a much smaller government. State-owned enterprises (SOEs) comprise only 14% of India‘s market cap versus 73% of China’s.12 Government services are spartan, at just 15% of GDP.13 The government’s revenue-collection capacity is limited, with only 3% of Indian citizens paying income tax.14 India’s business leadership is more independent of government than is China’s, and Indians have excelled at industries that do not require heavy government support, such as pharmaceutical manufacture and information technology.b Half of the world’s FDA-approved pharmaceutical facilities are in India. IT services behemoth Infosys was famously founded with $250 and today commands a market cap of $30 billion.c

India is more service based while China is more manufacturing based15
GDP by Industry (%)

India’s development has been largely fueled by a game of rural catchup, in our view creating a potentially more sustainable growth model over the longer term.

The second, and more important, difference versus China is the composition of that middle-class growth. In contrast to China, where the middle class expansion has been driven disproportionately from cities (arguably creating an unstable socioeconomic divide between cities and the country-side), India’s development has been largely fueled by a game of rural catchup, in our view creating a potentially more sustainable growth model over the longer term.d While urban India is still wealthier than its countryside—the 100 biggest cities account for 43% of GDP with just 16% of the country’s population—its rural economy is advancing more rapidly.16

India’s “Rural Revolution”

India’s “rural revolution” can be traced to a number of sources, including government policy. Whereas farming comprised nearly two-thirds of rural employment in 2000, now it is closer to 40%, replaced by more stable and less seasonal jobs in various services.17 Annual growth in rural wages rose at an annual growth rate of 16% in seven years, almost double the pace of inflation during this period.18 Rural land is now used for a broader range of purposes beyond farming, even as farming yields themselves have improved. Accordingly, land values have advanced five to 10

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