More Than Modi, The Case For India’s Equities by Matthews Asia
In May 2014, India’s prime minister Narendra Modi and the Bharatiya Janata Party (BJP) won a landslide electoral victory, securing the first absolute majority in a general election in 30 years. Since then, investors have been inundated with optimistic analyses of Modi’s pro-business attitude, his policy announcements and optimistic rhetoric on India’s demographics and its economic future.
In April this year, the International Monetary Fund’s World Economic Outlook showed that India is set to overtake China as the fastest growing major emerging market, with a forecast of 7.5% GDP growth in 2015 to China’s 6.8%. The impression of renewed momentum in the economy after several disappointing years is reawakening interest from many international investors. Foreign institutions put almost US$6 billion into Indian stocks in the first three months of 2015, compared to around US$16 billion in the entire of the previous year.
Yet this upbeat narrative is misleading in many ways. There are compelling reasons to invest in India, but recent developments in the economy are not among them. While the vision that Modi has for India is positive, expectations have run far ahead of execution. India continues to suffer from economic and political barriers to progress.
But focusing on macroeconomics is to misunderstand the main drivers of equity returns in India. Successful investing in this market is not about anticipating twists and turns in the economy, but about finding quality companies that can thrive regardless of what comes. It’s all about the micro rather than the macro.
A Challenging Environment
Macroeconomics in India have never been comforting. Inflation is often high, with CPI averaging around 8% per year over the last three years and reaching double-digit levels on a number of occasions in the past according to the IMF. The Indian rupee has edged lower in recent years, with the S&P Indian Rupee Index—which replicates the performance of the rupee versus the U.S. dollar—down approximately 11% as of June 2015, since its peak in July 2011.
The twin deficits—a persistent, large budget deficit and current account deficit—are frequent cause for concern. It’s no surprise that when markets began worrying about the impact of the end of the U.S. Federal Reserve’s quantitative easing program on emerging markets, India was classed as one of Morgan Stanley’s “fragile five” that seemed especially vulnerable.
Inconsistent and excessive regulation adds to the problems. India’s economy is held back by a tangle of overcomplicated, poorly implemented laws, a legacy of its history as a “planned economy” for much of the time between independence and the 1990s. One recent example of inconsistent regulation is the Minimum Alternative Tax (MAT)—a form of corporate taxation hitherto not traditionally applied to foreign investment funds in India. Many funds are now fielding demands from Indian tax authorities to pay retrospective MAT charges. These demands, currently being challenged by large funds and fund tax groups, have led to uncertainty for some investor groups and these claims could have repercussions on equity market flows.
There have, however, been some policy improvements over the last two decades. Reforms in the early 1990s liberalized the outputs of the economy, sweeping away licenses and quotas that restricted which companies could produce which goods and in what quantities.
However, policymakers insufficiently liberalized the rules governing inputs such as land and labor markets, which remain restricted by red tape. Only by freeing businesses from this red tape and introducing simpler, more effective laws can India’s potential be realized.
The previous government had made little progress in this direction and had clearly run out of momentum in the last years of its term. But hopes have been high that Modi’s administration would have more success; Modi was formerly chief minister of the state of Gujarat, where he was widely credited with helping to accelerate growth and development.
Thus far, the new government has taken only modest steps in this direction. Modi has been held back by the fact that, while he enjoys a sizeable majority in the Lower House of Parliament, the BJP and its allies remain in the minority in the Upper House. Consequently, Modi has been forced to rely on ordinances—short-term executive orders issued by his cabinet and rubber-stamped by the largely symbolic office of the president—to push through temporary changes, while he attempts to build support to pass new laws through both houses of Parliament.
Hence, the Modi government has yet to go as far in shaking up India’s bureaucracy as many supporters and investors are expecting. While the government deserves a high grade on their intentions, and may yet deliver positive results, long-term policy progress has underwhelmed the hype so far.
From the Macro to the Micro
At the corporate level, India has been mixed when it comes to corporate governance. Problems can occur when chief executives are fighting boards, or boards are at odds with shareholders. These issues are often the product of a lack of strategic clarity. There are also corporate governance challenges specific to India, such as the prevalence of family-run listed companies—67.4% of listed businesses according to the Credit Suisse Emerging Market Research Institute, Asian Family Businesses Report (2011). While family influence at the boardroom level has potential benefits-such as long-term decision-making and a propensity for high dividend payout ratios-there are also potential conflicts of interest when it comes to succession planning.
Business leaders should be free to drive their companies forward, but exercise that freedom within a framework of effective accountability. As bottom-up, fundamental investors, we seek to build positions in companies where good governance and incentive systems are in place, and there is a strategic framework that most shareholders agree with. The rights and equitable treatment of shareholders, a culture of disclosure and transparency, and a track record of boardroom accountability are hallmarks of a company that can withstand India’s macro headwinds, and develop into a successful long-term portfolio holding.
Against this political and corporate governance backdrop, India may seem a challenging destination for investors, especially given that the market rallied strongly during 2014 in the belief that Modi will deliver. For the year, the Sensex benchmark of large-cap stocks on the Bombay Stock Exchange was up by 30%. On the face of it, a great deal of good economic news is already being priced in and there is a clear risk of disappointment. Yet if we delve into the India corporate sector, the investment case becomes much more compelling for bottom-up stock picking investors. Paradoxically, this is in part due to the same economic and political headaches that can make India appear so challenging to top-down investors.
Because India represents such a difficult environment in which to do business, successful companies must adapt and evolve in response to these restrictions. We believe this helps to create well-run, flexible and efficient companies that are of an extremely high quality.
The best Indian firms are not just good by emerging market standards-they are on a par with anything else in the world. Many foreign investors will be familiar with this in the context of India’s information technology and business process-outsourcing firms, which are highly successful globally. But the same is true of many other firms, both large and small, that are little-known outside the country.
At Matthews Asia, we look for companies that are not afraid to act independently-smart management, product range exclusivity, and low cost basis are typical characteristics of our holdings. We also seek out management teams with long-term strategies, where research and development levels—relative to sales—are high and rising. Pricing power can be key to consistent growth, as are structural tailwinds-one theme we are following is the rise of private banking across the country. However, a compelling narrative is no substitute for in-depth research. In the course of our due diligence, we often discover companies with limited analyst coverage—meaning that relatively little of the growth opportunity is priced in to current valuations. Our goal is to identify these mispriced equities in good businesses and hold them for a long enough time to allow the growth prospects to kick in and the market to recognize this. Especially in emerging markets such as India, managers are increasingly trading companies rather than investing in them. We believe one needs to adopt at least a 5-year holding period in order to consistently benefit from the confluence of bottom-up and top-down drivers of returns.
We often find high-quality investment ideas in the mid- and small-cap segments of the market. While quality companies can be found in mega- and large-cap range, the exceptional price discovery opportunities we look for are harder to come by.
Avoiding Policy Risks
We believe that a bottom-up approach is more likely to result in positive returns than the macro- and policy-focused approach taken by many investors. As an example of the risk of focusing too much on the big picture, it’s worth considering the infrastructure sector. This has been a popular top-down theme with many foreign and domestic investors, but is one that we have generally chosen to avoid.
This may seem perverse, since it’s widely acknowledged that poor infrastructure is a major bottleneck for India’s growth. Many investors argue that firms which can help to fill that gap should be able to reap considerable rewards from doing so. Yet, in practice, there have been many problems with this reasoning. The history of infrastructure development in other economies during industrialization provides plenty of cautionary tales to support this view. For example, Britain’s canal mania in the early 1800s and railway mania in the mid-1800s gifted the country with excellent infrastructure that helped to accelerate development-but many of the developers went bankrupt due to a glut of competing projects.
The second issue is that infrastructure projects are often heavily dependent on government policy and official favor. This creates noticeable incentives for corruption. There are obvious business risks posed by this-for example, the company may fall from favor or suffer in a change of government.
More subtly, however, the reality is that companies whose business model is founded in dubious dealings are unlikely to treat minority shareholders fairly. Instead, the promoters of these types of businesses will often endeavor to keep the benefits for themselves and pass the costs onto other shareholders. Rather than focus on infrastructure or thematic investments, we tend to focus on quality companies that can control their own destinies and benefit from rising consumption that is secular and profitable.
Is India Too Expensive?
Whether investors choose to focus on the macro or the micro, the big question now is whether the strong Modi-driven rally has meant they’ve missed the opportunity to invest. After all, at first glance, India appears to be a relatively expensive market. The MSCI India index traded on a price/earnings ratio of 19.83 at the end of May 2015, and a price/book ratio of 3.2. The figure for the MSCI Emerging Markets index was 14.5 and 1.59, respectively. This may seem to give weight to the idea that optimism about the Modi government has pushed up valuations to a point where the performance of the market will be highly dependent on whether they will deliver. As we’ve seen, there is reason to be cautious about whether this will happen, suggesting that the market may be vulnerable to disappointment.
However, India has generally been a relatively expensive market compared to the rest of the emerging universe (see chart 1). This reflects the higher quality of the India corporate sector as a whole. What’s more, in our view, the market is becoming increasingly selective on valuations: good companies have been rewarded with stronger valuations, while weaker ones have been de-rated.
The strength of the run-up means that there is some risk that the market may underperform in the short term, unless the government is able to pick up the pace of implementation. However, short-term volatility in returns has always been in the nature of the Indian market. As chart 2 shows, historically there has been a high probability of negative returns over a one-year period, but over longer periods investors have earned attractive returns, almost irrespective of when they choose to enter the market. In other words, your holding period is generally more important than your market timing acumen when it comes to investing in India.
A Bright Future
We believe that India will thrive over the long term, regardless of political developments in the short term. Despite the significant barriers to business that the Indian economy poses, the corporate sector is full of entrepreneurial, innovative companies.
For all its issues, the Indian economy has been a secular and resilient growth story. And the electoral victory of a pro-reform government has given some hope that at the very least the country won’t go reverse gear on the reforms front.
India remains a country where much can be achieved over the next decade to improve people’s standard of living, spending power and productivity. It is one of the few high-growth regions that investors can get access to via an established equity market. The demographics in India are particularly favorable, and entrepreneurship of the young should be one of the biggest drivers of returns over the long term. And most importantly, the stock market provides a potentially rich set of entrepreneurial opportunities to access this resilient underlying growth without being affected by macroeconomic conditions.