EXECUTIVE SUMMARY - BY PRAS INDRAKUMAR
A Prosperous Economy in Waiting
India’s favourable demographics, given its vast and youthful population, provide a stark contrast to several nations who have a growing burden from an ageing population. With the pro-active, pro-business Modi Government winning the right to Government in May 2014 (having a significant majority in the lower-house), opportunity now knocks at the door for India if economic policy and a reform agenda can address the existing bottlenecks to unlock an even stronger GDP growth rate.However, India is not without its economic problems, as witnessed during lean years of 2010-2013 where rising inflation, capital account issues as investors withdrew money and policy paralysis due to a bureaucracy and significant red tape, led to poor investment returns.
The future looks brighter with economic tailwinds such as youthful demographics and a significant infrastructure opportunity waiting to be capitalised upon, given the appropriate reforms.The Modi Government, since elected in May 2014 has focused particularly on India’s external perception. For years India has suffered from poor external perception, particularly on ease of doing business within the country. There was swift realisation by the Government that India needed global participation given the significant private sector investment in infrastructure required to increase efficiency, clear bottlenecks and reduce the burden on local banks (thus far the lender for infrastructure projects).
Strong Economic Growth provide Tailwinds for Key Sectors
India’s economy has shifted from an agrarian focus to services based economy over the past 50 years, skipping a stronger contribution from manufacturing along the way. The services sector has grown strongly, with its share of GDP over 60%, a level more akin to a developed economy. Within services there have been sectors growing at a pace well in excess of GDP growth due to macroeconomic tailwinds (Banks), favourable demographics (Retail/Automobiles) and competitive advantages (Pharma) relative to the rest of the world.The next steps for India are to revisit manufacturing as a key growth sector, given its ability to create jobs and increase foreign investment in India through its competitive advantages. Once more jobs are created and the middle class in India grows it will be able to leverage its positive demographic landscape.
The agriculture sector remains highly relevant given the significant contribution of food prices to the economy’s inflation rate. Technology, monsoon patterns and land rights have a large impact on agriculture’s contribution to economic growth.We have highlighted the growth potential of Automobiles, Banks, Pharmaceutical and Retail as four sectors growing well above the rate of GDP growth. The best way to participate in these sectors is through the stock market. However, market capitalization based benchmarks for foreign investors do not have significant representation.
The Development of India’s Capital Markets
One of the most direct ways to benefit from India’s exciting growth trajectory is its equity market. There are close to 5,500 listed companies, with over 2,000 being readily trade-able. The significant breadth of the equity markets, in conjunction with an aspiring culture spurning many entrepreneurs, provides investors with the requisite landscape to access companies growing well above the general level of GDP growth.Equity markets in India have been operational since the 19th Century, with long-term investors generally experiencing strong appreciation. However, equity markets over time have had their fair share of issues relating to scams, frauds and regulatory change over time as they evolve from a nascent stage towards the structure and efficiency of a more developed market.Today, Indian equity markets with a T+2 settlement timeframe is more efficient in their function compared to many of their developed counterparts. With a liquid equity and derivatives market, growing number of stockbrokers and increasing participation from both foreign and local investors, the level of market efficiency continues to improve.
Despite the volatility which accompanies a developing equity market, substantial returns have been achieved by long-term foreign investors. In fact over rolling 7-year periods, Indian equities have outperformed broad emerging markets benchmarks on 78% of occasions.We also discuss some of the key drivers and outlook for equity markets as the Government continues on its reform path, with a growing majority in parliament. We anticipate that as foreign perception and sentiment towards India and its equity market improve, investors will seek increasing participation. As the level of local equity ownership rises from a very low level (below 5%), it is likely that the markets will continue their steep ascent.Finally, in this section we also highlight some of the corporate success stories to date, providing some insight into the breadth of opportunities which exist.
Indian Mutual Fund Industry and Other Asset Classes
As equity markets have developed significantly, so has the Mutual Fund Industry since the launch of the first fund in the 1960’s. During the 1990’s many more players entered the market as the industry went through a swift acceleration from its nascent stage. With a low level of education on investing for the future and a lack of appropriate, long-term investment vehicles, Mutual Funds have suffered from short-term competitive pressures.However, asset management companies have shown the ability to achieve sustainably strong alpha across their product set over time. In fact according to a BNP report “while it is estimated that barely 30% of active funds manage to outperform their benchmark over a five year horizon1, in India the situation is actually the opposite. Based on publically available information, 67% of local Indian equity mutual funds outperformed their benchmark over three years and an impressive 75% of funds managed to outperform over five years”.
This is expected to continue going forward, as the Indian equity market landscape remains highly conducive to alpha generation given its significant breadth, high level of new listings and lack of depth of brokerage coverage outside the top 200 stocks.With local education in tier 2 cities (and below) being high on agenda given Government directive, the mutual fund industry continues to search for more avenues to stable, longer term capital. Over the last 10 years there have been some high profile casualties with global asset managers pulling the plug on India asset management operations (Fidelity, ING, Alliance Bernstein and Deutsche) given the difficulties faced.
Survivors of the industry have stable and well performed investment teams with a strong investment process and distribution capability.In this section we look closely at the Indian equity mutual fund industry with further scrutiny on the logic for outperformance. Our attribution analysis illustrates that most mutual funds deliver strong outperformance through stock selection, whereas sector allocation has been more an outcome of their stock selection. Funds have been more volatile in their pursuit of value-add in this category.Next our report turns its attention to the Indian Debt Mutual Fund Industry, providing insight into investing in local fixed income markets.
Given the restrictions, quotas, taxation and regulation involved with this asset class, it is can certainly be classified as complex. However, Indian fixed income appears a lucrative investment at this stage with falling inflation, slowing global growth, a stabilising currency and an improving economy (from a credit perspective).
In our view, this is possibly a less volatile way to play the improvement of the Indian economy, particularly given very low yields and worsening sovereign credit ratings elsewhere in the world.The Alternative Asset Industry is relatively more nascent in India, but is going through significant development as some investors seek greater breadth in accessing the strongly growing economy. There is an increasing number of vehicles providing exposure to asset classes such as Private Equity, Investment Trusts focused on REITs and Infrastructure, Hedge Funds and Gold/Commodities.
Insights into Indian Equity Mutual Funds
Our analysis provides insights into which style factors have outperformed in Indian equity markets over the past 20 years. Whilst, these factors don’t always outperform in the short-term, over time they have provided impetus for outperformance. Several mutual fund managers consider these factors at some stage as part of their overall portfolio construction and stock selection.Generally, we find that most investment processes focus on deep analysis into stock selection to gain an insightful advantage over the general investor.
Given the focus on stock selection, most styles are an output of stock selection and the current environment, rather than a puritan, disciplined application.A period-by-period analysis also allows deeper understanding of the type of environment in which outperformance is likely to occur. In the context of Indian markets, outperformance is more likely when mid and small caps are prospering, particularly given the ability of local managers to identify strong growth companies at an early stage, rather than after they have been discovered by investors generally or become significant benchmark constituents.Over the past 20 years, the industry has evolved from a nascent stage where stock selection drove risk attribution in portfolios.
However, the industry has evolved to focus more on risk management, portfolio construction and building appropriate exposure across its product set.We summarise the section by providing our take on the optimal way to gain exposure to India’s growth through its equity markets. Investors need to be conscious of their exposure vehicle which can leverage the market breadth on offer, stock selection skills of local managers and due diligence of portfolio overlays combined with best-of breed manager selection.
Securities Markets
While investors can appreciate the opportunity that an economy like India presents in terms of investment returns, it is important to understand the functioning of the local securities markets to maximize its benefits. In developing markets like India there are often regulatory nuances, which may not be commonplace in a developed market, depending on the level of “openness”.Investing in India’s capital markets is often considered concurrently with the “headaches” of dealing with local market regulation and red tape. In fact, several businesses consider and/or incorporate the additional cost of cutting through the red tape.
The Modi Government has been focused on increasing transparency and achieving global standards in terms of efficiency through a transparent legal and regulatory framework and a regulator, which is motivated to enable rather than restrict.The result is that setting up an account to buy Indian equities is now much faster than the previous experience of a 6-12 month time period.
Investment Avenues
There are various investment avenues to consider when seeking exposure. The Government and SEBI have sought to simplify many of the investment routes and the associated complexity. Whilst there remain some restrictions such as the level of foreign ownership in certain companies, there is now increasing clarity of what is required to invest with clarity in Indian equity markets.In 2014 regulations were changed to consolidate the routes required to be a direct investor in local Indian equities. A Foreign Portfolio Investor license consolidates the prior requirements into simple and transparent categories of differentiation.
Foreign Portfolio Investors (FPI)
The report articulates the eligibility requirements for an FPI across asset classes.We also consider other instruments utilized by foreign investors to gain exposure such as P-Notes, ADR’s and GDR’s. We also consider the foreign currency implications of investing in India. This is a pertinent for foreign investors as they have to consider the volatility of the Indian Rupee and whether they should hedge it’s movements against their home currency. Investing in a developing market like India, presents an opportunity to participate in the currency of a high GDP growth market.Finally, we have also provided information on taxation without being prescriptive given differential consequences in the hands of the investor.
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