Imagine war-torn Angola in the late nineties. The chairman of a promising Indian pharmaceutical firm is driving down a dusty backroad near the capital. His car is overtaken by a gang of masked gunmen in SUVs. They rifle through his luggage and find a small amount of money. They sit there for a while underneath the unrelenting African sun debating what to do. Our chairman waits nervously for his fate to be determined. The robbers make a split second decision to take the money and leave as abruptly as they showed up.
Why was our distinguished chairman in Angola? He is an enterprising entrepreneur and he believes the following: “The more dangerous the country, the more attractive the prospects; the more unsafe its streets, the less competition we encountered.” Entrepreneurs take risks and are richly rewarded for their endeavors if they are successful. The overarching truth about wealth in a capitalistic society is that it rightfully accrues to business owners, who sacrifice their capital, time and even their safety without any guarantee of receiving a return. However, you don’t need to be an entrepreneur to benefit from the wealth creation generated by successful businesses. Publicly traded equities provide you with an opportunity to be a part owner in a business. Our daring chairman is none other than C.C. Parthipaan of Caplin Point Laboratories, who wrote about his escapades in a recent annual report. Although his story is dramatic, he’s not alone in terms of his entrepreneurial spirit. As I wrote in an earlier article, doing business in India is getting easier but definitely not easy. Successful Indian management teams must deal with red tape and complex environments. As a result, many Indian companies are able to succeed in other frontier markets because their business model and management have been proven in the domestic market. As a global investor, you want to be a part owner in the many well-run and entrepreneurial companies trading in India.
Why Should NRI’s Invest in Indian Equities?
India is now the fastest growing major economy in the world. With an estimated GDP growth rate of 7.5% in 2018, it has now surpassed China as one of the fastest growing emerging markets. Furthermore, according to Morgan Stanley equity strategist Ridham Desai, the Indian equity market is the best performing market globally over the past two decades. As a US-based NRI, you definitely want exposure to this fast growing market of over 1.2 bn people. Unless you have your own business that can exploit this burgeoning middle class, the only viable alternative is partial ownership in successful Indian companies via the equity market.
The chart below shows the performance of the world’s major equity markets since January 2000. We can see clearly that the Indian market has been the best performer by a wide margin. In addition, the graph is charted in USD terms which means the depreciation of the Indian Rupee over the same period is factored into the analysis. The result is not surprising since equity markets always follow earnings growth. Strong GDP growth has translated into excellent revenue growth which ultimately leads to earnings growth. Naturally, you might be thinking to yourself that past performance is no guarantee of future performance. However, there is a high probability that GDP growth accelerates as India’s Prime Minister Narendra Modi has vowed to ease the burden of doing business in India and to remove “red tape.” As the multitude of reforms takes effect there is a high likelihood that GDP growth will improve over the course of the current decade.
How Can America Based NRIs Invest in Indian Equities?
U.S. citizens and U.S. permanent residents have a limited number of options when deciding to invest in Indian equities. Due to FATCA (Foreign Account Tax Compliance Act), there are now severe penalties associated with the failure to adequately disclose foreign investments held outside the U.S. Additionally, all foreign investments funds are categorized as PFIC (Passive Foreign Investment Companies). Thus foreign mutual funds, hedge funds, and even insurance products are classified as PFIC. The tax treatment for PFICs is extremely disadvantageous relative to U.S. domiciled investments. Not to mention the complexity of the reporting requirements. If you ever want to see your tax preparer break out into a cold sweat simply mention the fact that you’re thinking about investing in a foreign mutual fund. Without going into the gory detail, it’s safe to assume that for the vast majority of U.S. investors foreign investment funds are not a viable option. Thus, the only remaining options are U.S. based funds that invest in foreign markets. However, most emerging market funds are broadly diversified across various countries and would only have a limited exposure to India. For those looking for direct Indian equity exposure, the only options are India focused mutual funds, ETFs and private investment funds.
Why Invest in a Private Investment Fund vs a Mutual Fund?
Contrary to popular belief most mutual fund managers don’t underperform their benchmarks due to a lack of stock-picking skills. The true cause of underperformance is a toxic combination of closet indexing and over-diversification. Numerous studies have shown the closer that a mutual fund manager hews to his benchmark the higher the probability that he underperforms. If you look at performance net of fees it’s virtually impossible for a “closet indexing” mutual fund manager to outperform. Many mutual fund managers are afraid to take concentrated bets because their incentives are misaligned with that of their investors. The portfolio managers understand that there is no significant reward for outperforming their benchmark. However, they will definitely lose assets if they underperform their benchmark. Thus, the average mutual fund manager will stick close to his benchmark because the penalty for underperformance is severe. Fund managers who run private long-only investment funds or hedge funds are not as constrained as mutual fund managers and have incentives that are better aligned with those of their investors. Most fund managers who run private investment partnerships have a significant portion of their net worth invested in the partnership. Both Warren Buffett and Charlie Munger ran private investment partnerships before building Berkshire Hathaway. Fund managers who run private investment funds can run more concentrated portfolios, that have the potential to outperform their respective benchmarks. If you’re an accredited or qualified investor a private investment fund that focuses on investing in India may be the ideal way to gain exposure to Indian equities.
Aren’t Private Investment Funds More Expensive than Traditional Mutual Funds?
Superficially, it may appear that private investment funds charge higher fees but it may not necessarily be true. The majority of mutual funds charge either a front-end or back-end load fee. Which means you’ll be charged a (front-end) fee when entering the fund or a (back-end) fee when exiting the fund. These fees can range anywhere from 1% to 5% of the total amount you’ve invested. For example, if a mutual fund charges a front-end load fee of 5% and an annual management fee of 1.5% you’re already down 6.5% on your initial investment within the first year. Most private investment partnerships don’t charge load fees and their management fees are competitive with mutual funds. Some investment partnerships charge performance fees but they’re only charged if the manager hits certain return benchmarks that are specified in the private offering documents. The combination of high fees and poor investment performance make the average mutual fund a drain on your wealth. Thus, a private investment fund may be a better solution for your wealth generation needs.
In summary, you want to be a part owner in a business run by enterprising and experienced entrepreneurs. In addition, you should have exposure to the Indian equity market. India’s strong GDP growth has translated into superior equity market performance over the past twenty years. You can gain exposure to the Indian equity market through an India focused mutual fund or ETF. However, a private investment fund may be a better vehicle due to the ability of the fund manager to hold a concentrated portfolio of companies. Finally, private investment funds are not necessarily more expensive in comparison to mutual funds.
Our adventurous chairman, Mr. C.C. Parthipaan, has not only built inroads into Africa but also Central and South America. Caplin Point Labs is now preparing to enter the US generic market as its geographical growth continues. There are many other similar stories of global expansion within the Indian small-cap and mid-cap space. As a global investor, you definitely want exposure to these well-run and rapidly growing publicly traded companies.
To learn more about our focused investment approach investing in high-quality Indian companies visit us at Ashva Capital Management LLC.