India Equity Insight by Boston Company Asset Management
Content
August 2013
Uncovering Opportunities in Indian Equities
Author
Andrea M. Clark, CFA
Portfolio Strategist
Introduction
Home to the world’s second-largest population, India is a complicated market. Its tremendous need for infrastructure and its rising disposable income – particularly in rural areas – should drive substantial economic expansion. Yet, India has a history of falling short of its seemingly obvious potential. Its democratically elected government is often sidetracked by partisan politics, becoming an obstacle rather than an executor of reform. As a result, the country has struggled to eliminate bottlenecks in everything from power generation to formalized consumer retail, causing India’s output gap to widen. However, India has often rewarded investors willing to look past its flaws. Right now, we believe there is opportunity in Indian equities, based on the following factors: I ndia is in the early stages of economic development, years behind China in terms of infrastructure investment. I t has a large young population, which should support long-term consumer demand and overall economic expansion. I t is known for its expertise in business services, software and generic-pharmaceutical development, making it a global outsourcing center. Its equity market is diversified, liquid and well regulated. However, there is ongoing debate about India’s ability to advance its economy and reward equity investors. The bear case centers on structural problems that require serious, yet often politically contentious, policy changes and reform measures. India’s fragmented government almost ensures a slower path to development compared to the quick, targeted solutions sought by most investors. Yet we have observed a shift in government action that gives us confidence in India’s ability to move beyond its current weakness. The debate will surely continue, and India’s performance will probably stumble before gaining traction, but the negatives already appear to be reflected in current stock prices, and long-term opportunities remain robust. In this paper, we will outline the challenges facing India and the ways in which they could be surmounted.
Co-Author
Dheeraj Wadhwani
Senior Analyst BNY Mellon India
Challenge: A Fiscal Deficit
India’s fiscal condition has been shaped by inefficient spending. Contributing to a persistent government budget shortfall has been the proliferation of well-intended social-welfare programs, many of which are unproductive and often inadvertently benefit more prosperous citizens. For example, the country’s expensive diesel-fuel subsidy does little to help the poor, who are not
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
Uncovering Opportunities in Indian Equities major fuel consumers. Revenue collection is another trouble spot, as tax revenue is vulnerable to India’s slowing economic growth and to the informal sector, which is made up of businesses running “off the books.” Meanwhile, the central government’s gross fiscal deficit as a percentage of gross domestic product surged in the wake of the 2008 global financial crisis, climbing from 2.5% in 2007-08 to 5.9% in 2011-12. It is not unusual for governments to run a deficit when funding longerterm growth, but India’s remains high relative to other emerging markets, is the product of inefficiency, and exposes the government to higher funding costs when combined with the current account deficit.
Exhibit 1: A Troubling Deficit
4.0
Central Gov't Structural Balance % of GDP
Central Gov't Fiscal Deficit% of GDP
India - Requires tax reform and spending efficiency
2.0 0.0 -2.0 -4.0 -6.0 -8.0 -10.0 -12.0
2004 Brazil 2005 2006 China 2007 2008 India 2009 2010 Indonesia 2011 2012 2013E 2014E 2015E Turkey
South Africa
Source: International Monetary Fund
A portion of India’s fiscal deficit can be attributed to the global financial crisis. Indian officials – like many other government policy makers – responded to the sharp contraction in global economic expansion through a stimulus package that included across-the-board tax cuts and increased expenditures to revive struggling sectors. The government also hiked public-sector wages and responded to rising oil prices with the aforementioned fuel subsidies. High fuel prices have impeded more accommodative monetary policy, hindered consumption and stoked inflation, which has remained stubbornly high, as illustrated in Exhibit 2. In the wake of this, the gross domestic savings rate declined from a peak of 36.8% in 2007-08 to 31.8% in 2012-13.
Exhibit 2: Inflation Is Set to Fall With Commodity Prices
14 12 10 8 6 4 2 0 -2 2007 2008
Brazil
Inflation - Average Consumer Price Change %
2009
China
2010
India
2011
2012
Indonesia
2013
South Africa
2014
2015
Turkey
Source: International Monetary Fund
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Uncovering Opportunities in Indian Equities Recent economic weakness has forced officials to expeditiously tackle spending efficiency and tax collection. (See Sidebar 1) Government spending has been cut sharply, and the deficit and debt have already declined as a result. (Exhibit 3) A new Direct Benefit Transfer Program was set up to establish a framework that promotes social welfare without draining revenues, targeting those most in need, while streamlining an unwieldy number of programs. It is expected to boost overall consumption by providing tangible cash versus subsidized pricing. Meanwhile, elimination of the costly diesel-fuel subsidy and reform of the tax system have been discussed. On the revenue side, the government is planning to introduce a national and state-level goods and services tax, with goals of broadening the tax base, reducing complexity and increasing transparency. In addition, the Direct Tax Code will be simplified, with a higher “tax-free” threshold to cover more low-income individuals. There have been encouraging signs of the government’s willingness to monetize state-owned assets, with potential divestments including stakes in Oil India and power generator NTPC. While this could create a near-term overhang in shares slated for sale, the government tends to create a favorable backdrop to ensure deal success. This could include progress on coal-pricing reform and power-sector restructuring. In the long term, cash in the government’s coffers will lower debt dependency while supporting more efficient social programs.
India’s Fiscal Deficit Reform Direct Benefit Transfer: This aims to transfer benefits and subsidies directly to those living below the poverty line. The government’s ambitious plan to directly transfer cash subsidies on cooking gas to consumers’ bank accounts recently launched in 18 districts. Widening Service Tax Base: A service tax is levied on most services provided in India. The actual collection of service tax in 2011-12 grew about 37% from the 2010-11 level, as the government expanded the number of industries in the tax base. Introduction of Value-Added Tax: VAT has been implemented across the states and was a major step in increasing tax revenue.
At a Glance:
Exhibit 3: Declining Debt Levels
India Government Debt to GDP Trend
90 80 70 Gov't Debt/GDP % 60 50 40 30 20 10 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Government of India, Planning Commission of India
Challenge: Current Account Deficit
For the fourth quarter of 2012, India posted its highest-ever current account deficit of $32.6 billion, representing 6.7% of GDP , which pressured both currency and equity markets. This was driven by a combination of high energy prices and aggressive gold buying. India relies heavily on imported oil and gas, and it has a seemingly insatiable appetite for gold, for both cultural reasons and as a store of value. However, India is not alone in its current account quandary, as noted in Exhibit 4.
Unified Goods and Service Tax: The central government is working with state officials to establish a unified Goods and Service Tax (GST) that will reform the complicated indirect tax system that actually hindered interstate trade. Although the GST will not be implemented fully until 2015, central and state governments have made solid progress in solving issues related to individual state compensation. Direct Tax Code Reform: This is intended to broaden the corporate base, reduce administrative costs and promote retirement savings.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
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Uncovering Opportunities in Indian Equities
Exhibit 4: A Slight Improvement in Current Account Deficit
15.0 10.0 5.0 0.0 ‐5.0 ‐10.0 ‐15.0 2007
Brazil
Current Account Deficit
India - Improving, not the worst
2008
2009
China
2010
India
2011
Indonesia
2012
2013
South Africa
2014
Turkey
2015
Source: International Monetary Fund
The recent stabilization of energy and gold prices, as demonstrated in Exhibit 5, should take some pressure off the expanding deficit.
Exhibit 5: Signs of Stabilization in Commodities
140 120 100 80 60 40 20 0 Feb-09 Feb-10 Feb-11 Feb-12 May-09 May-10 May-11 Nov-08 Nov-09 Nov-10 Nov-11 Feb-13 May-13 May-12 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Nov-12
Crude Oil Brent ($/bbl)
2,000 1,800 1,600 1,400 1,200 1,000
NY Gold ($/ozt)
Oil prices stabilizing ‐ positive for CA
800 600 400 200 0 Aug-08 Aug-09 Aug-10
Gold prices falling ‐ positive for CA
Aug-11
May-09
May-10
May-11
May-12
Aug-12
Source: FactSet
The only caveat is currency. (See Exhibit 6.) Like most unpegged emerging-market currencies, the Indian rupee has declined as the imminent reversal of easy-money policies encroaches on the carry trade. A weaker rupee could negate the improvement in import prices and frustrate the Reserve Bank of India’s ability to lower interest rates. This is a factor to watch as the year progresses.
Exhibit 6: Currency Watch
60 55 50 45 40 35
Aug-07 Sep-04 Sep-09 Oct-06
US Dollar / Indian Rupee
US Dollar/Indian Rupee
May-06 May-11 Aug-12 Oct-11 Mar-07 Dec-05 Dec-10 Feb-05 Feb-10 Nov-03 Nov-08 Mar-12 Jun-08 Jun-03 Apr-04 Apr-09 Jul-05 Jul-10 Jan-08 Jan-13
30
Source: FactSet No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
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4
May-13
Feb-09
Feb-10
Feb-11
Feb-12
Nov-08
Nov-09
Nov-10
Nov-11
Nov-12
Feb-13
Uncovering Opportunities in Indian Equities
Challenge: Poor Infrastructure
India’s deficient infrastructure is another root cause of economic underachievement. Anyone who has driven around the country can observe the need for better roads. Its power sector is prone to shortages, and key projects have been delayed by government bureaucracy. That said, India has made progress in modernizing transportation and communication. For example, paving on many rural roads, as exemplified in Exhibit 7, has made transportation substantially more efficient.
Exhibit 7: A Smoother Road Ahead
India Road Expansion
3,200,000 2,700,000 2,200,000 1,700,000 1,200,000 700,000 200,000 1951 1961 1971 1981 1991 2001 2011
Total length of the road (In Miles)
Source: Government of India, Ministry of Road
100 90 80 70 60 50 40 30 20
Growth (%)
Foreign Investors Show Optimism on India
The United Nations Conference on Trade and Development’s World Investment Report 2012 highlighted India as the third most attractive location for foreign direct investment (FDI) for 2012-14. The 2011 survey of the Japan Bank for International Cooperation ranked India as the second most promising country for overseas business operations in the medium term. Ernst & Young’s 2012 Attractiveness survey listed India as the fourth global destination for FDI in terms of the number of FDI projects. The 2012 A.T. Kearney confidence Index rates India second in terms of future prospect for FDI inflows.
Mobile-phone penetration has grown steadily, as shown in Exhibit 8, often circumventing India’s inadequate fixed-line network in several areas across the country. The use of mobile phones has had an especially positive impact on rural economic development, where communication has bolstered productivity.
Exhibit 8: Explosive Mobile Growth
India Mobile Cellular Subscriptions (per 100 people) 90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13
India Mobile Cellular Subscriptions
(till Dec 2012)
Source: Government of India, Department of Telecommunications
But more investment is still needed. With government finances stretched, officials have announced several reforms aimed at boosting capital investment. India has typically been wary of outside investors, limiting foreign ownership in various industries, although many multinationals are eager to invest in the country. (See Sidebar 2.) However, the recent growth slowdown has led the government to relax foreign investment limits in several sectors, including multi-brand retail, aviation and power generation.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
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Uncovering Opportunities in Indian Equities The government has also established a Cabinet Committee on Investment (CCI) to expedite key infrastructure projects that have been bogged down in the approval process coordinated by state officials and central government ministers. The CCI will also fast-track oil and gas exploration approvals as India attempts to boost local production. Fuel-price liberalization is critical and will go a long way toward broadening private-sector participation in energy production. Although lower subsidies and market pricing will not benefit all sectors – for example, miners will face higher diesel prices – more rational consumption, lower overall global prices thanks to increased supply, and transparency should support longer-term equilibrium. Until India’s energy market has greater visibility — i.e., less government control — oil and gas investment will be hamstrung by weak profits. India’s power sector has also been riddled with operational problems and financial losses. To increase power-sector investment and long-term viability, the central government has restructured the debt of the state power distributors, raised tariffs to make power purchase agreements more profitable, and is exploring ways to alleviate local coal shortages. This ambitious agenda should set the stage for sustainable electricity output.
Challenge: Margin Deterioration
Historically, Indian companies delivered margins that were superior to other emerging-market companies. This was probably unsustainable, as several Indian industries, such as telecom service providers, were earning more than their peers in other countries because of higher relative prices. That has changed with increased competition and government policy initiatives working to normalize customer prices. Plus, many other emerging-market countries are industry-heavy, such as Russia in Energy, which can distort aggregate profitability factors. Nonetheless, input cost pressure and weak demand have caused margins to decline. And margins at India’s stateowned banks have declined, as recent economic weakness caused nonperforming loans to pick up in designated mandatory lending segments. All of these issues have contributed to a convergence in India’s return on equity relative to other emerging markets, as seen in Exhibit 9. Yet, India’s profit margins remain above the MSCI Emerging Markets Index average, and following a few years of aggressive earnings downgrades, earnings expectations have become more realistic.
Exhibit 9: Some ROE Convergence
25.0 23.0 21.0 19.0 17.0 15.0 13.0 11.0 9.0 7.0 5.0
Oct-06 Oct-07 Jun-06 Jun-07 Feb-07 Feb-08
MSCI India ROE Oct-08 Oct-09 Jun-08 Jun-09 Jun-10 Feb-09 Feb-10
MSCI EM ROE Oct-10 Oct-11 Jun-11 Feb-11 Feb-12 Jun-12 Oct-12 Feb-13
Source: MSCI, FactSet
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
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Uncovering Opportunities in Indian Equities Valuations have also become more compelling, as evidenced by Exhibit 10. When considering the government’s sizable reform agenda, Indian equities have become increasingly more attractive for the long-term investor.
Exhibit 10: Attractive Valuations
25.0 23.0 21.0 19.0 17.0 15.0 13.0 11.0 9.0 7.0 5.0 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 MSCI India Price/Earnings Average -1 STD +1 STD
7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 MSCI India Price/Book Average -1 STD +1 STD
Source: MSCI, IBES, FactSet
Conclusion: India’s Exceptional Potential Often Overlooked
The noise surrounding India’s current economic flaws often overshadows its future prospects. Some of the country’s key advantages are listed here: I ndia boasts a large, working-age population that will drive expansion through personal consumption. Unlike China and many developed nations, India is not grappling with an aging demographic that will need substantial social support.
Exhibit 11: India’s Sizable Young Population Should Drive Domestic Growth
50 45 40 35 30 25 20 15 10 5 0 India
Source: World Bank
Young Population % of Working Age Total
Brazil
China
Russia
Germany
Japan
United States
Penetration levels for goods and services remain quite low, and demand is building.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
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Uncovering Opportunities in Indian Equities
Exhibit 12: India’s Auto Penetration Shows Potential for Long-Term Consumption
500 400 Passenger car
(per 1000 people)
300 200 100 0
0 Brazil 10,000 China 20,000 30,000 40,000 50,000 GDP per capita ($US) Korea India Japan Germany United States
Source: World Bank, as of 2011
Urbanization will drive demand for housing, transportation and connectivity. R ural wages are growing, thanks to government programs like the rural employment guarantee scheme, improved infrastructure, and mobile communications. The refinement and continuation of these programs aimed at assisting lower-income individuals will help to promote middle-class development and sustainable expansion. I ndia is a vibrant democracy with a well-respected, independent central bank, securities regulator and a deep, diversified equity market. Elections often spark investor caution — and a national election is approaching in 2014 — but the various parties that form India’s coalition government appear to be working together to pass palatable reforms aimed at improving the country’s performance. The country is also working on various trade agreements to boost export activity. ith India’s GDP hitting a five-year low, it is easy to simply look elsewhere for growth, but that W would be short-sighted. India’s future growth potential is set to rebound from depressed levels, according to forecasts from the International Monetary Fund, as seen in Exhibit 13.
Exhibit 13: GDP Growth Ahead
12 10 8 6 4 2 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: International Monetary Fund
India GDP Growth % set to rebound from a decade low
Equity markets tend to be leading economic indicators, and today’s valuations appear to have discounted any type of economic or earnings recovery. For long-term investors, the time to buy India looks to be close at hand.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
www.thebostoncompany.com
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Uncovering Opportunities in Indian Equities
About the Author
Andrea M. Clark, CFA
Portfolio Strategist Andrea is a Portfolio Strategist for The Boston Company’s Non-US and Emerging Markets investment disciplines, responsible for communicating the teams’ strategies to clients, prospective clients and consultants. Previously at the firm, Andrea was an analyst on the Non-US Value Team. Prior to joining The Boston Company, she was a Vice President at Standish Mellon Asset Management, where she was responsible for equity product management, development and positioning. Before that, Andrea was a Vice President of Institutional Product Management at Pioneer Investment Management Inc. During her career, Andrea also worked for Putnam Investments in several business groups, including Portfolio Analysis and Marketing. Andrea received a BS and an MBA from Suffolk University. She holds the Chartered Financial Analyst designation and is a member of the CFA Institute and the Boston Security Analysts Society.
Co-Author
Dheeraj Wadhwani
Senior Analyst Dheeraj is a Senior Analyst at BNY Mellon India, working closely with the Distribution Support Group at The Boston Company. In this role, Dheeraj develops and maintains product information on third-party consultant databases for marketing The Boston Company’s institutional investment products. Previously, Dheeraj was an Analyst at Credit Point Services (India), part of Rage Frameworks Inc., where he was responsible for performance measurement of portfolios for international wealth-management clients. Before that, he served as a Research Analyst at India Co. Venture, a private-equity firm, where he screened and researched Indian companies. Dheeraj earned a Bachelor of Commerce in Accounts and Finance from M.J.P . Rohilkhand University and an M.S. in Finance from ICFAI University.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
www.thebostoncompany.com
9
Disclosure
Any statements of opinion constitute only current opinions of The Boston Company Asset Management, LLC (TBCAM), which are subject to change and which TBCAM does not undertake to update. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. This publication or any portion thereof may not be copied or distributed without prior written approval from TBCAM. Statements are correct as of the date of the material only. This document may not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or not authorised. The information in this publication is for general information only and is not intended to provide specific investment advice or recommendations for any purchase or sale of any specific security. Some information contained herein has been obtained from third party sources that are believed to be reliable, but the information has not been independently verified by TBCAM. TBCAM makes no representations as to the accuracy or the completeness of such information. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
For more information on the market perspectives of The Boston Company Asset Management, please visit our website at http://www.thebostoncompany.com/literature/views-and-insights.html
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
Uncovering Opportunities in Indian Equities
Author
Andrea M. Clark, CFA
Portfolio Strategist
Introduction
Home to the world’s second-largest population, India is a complicated market. Its tremendous need for infrastructure and its rising disposable income – particularly in rural areas – should drive substantial economic expansion. Yet, India has a history of falling short of its seemingly obvious potential. Its democratically elected government is often sidetracked by partisan politics, becoming an obstacle rather than an executor of reform. As a result, the country has struggled to eliminate bottlenecks in everything from power generation to formalized consumer retail, causing India’s output gap to widen. However, India has often rewarded investors willing to look past its flaws. Right now, we believe there is opportunity in Indian equities, based on the following factors: I ndia is in the early stages of economic development, years behind China in terms of infrastructure investment. I t has a large young population, which should support long-term consumer demand and overall economic expansion. I t is known for its expertise in business services, software and generic-pharmaceutical development, making it a global outsourcing center. Its equity market is diversified, liquid and well regulated. However, there is ongoing debate about India’s ability to advance its economy and reward equity investors. The bear case centers on structural problems that require serious, yet often politically contentious, policy changes and reform measures. India’s fragmented government almost ensures a slower path to development compared to the quick, targeted solutions sought by most investors. Yet we have observed a shift in government action that gives us confidence in India’s ability to move beyond its current weakness. The debate will surely continue, and India’s performance will probably stumble before gaining traction, but the negatives already appear to be reflected in current stock prices, and long-term opportunities remain robust. In this paper, we will outline the challenges facing India and the ways in which they could be surmounted.
Co-Author
Dheeraj Wadhwani
Senior Analyst BNY Mellon India
Challenge: A Fiscal Deficit
India’s fiscal condition has been shaped by inefficient spending. Contributing to a persistent government budget shortfall has been the proliferation of well-intended social-welfare programs, many of which are unproductive and often inadvertently benefit more prosperous citizens. For example, the country’s expensive diesel-fuel subsidy does little to help the poor, who are not
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
Uncovering Opportunities in Indian Equities major fuel consumers. Revenue collection is another trouble spot, as tax revenue is vulnerable to India’s slowing economic growth and to the informal sector, which is made up of businesses running “off the books.” Meanwhile, the central government’s gross fiscal deficit as a percentage of gross domestic product surged in the wake of the 2008 global financial crisis, climbing from 2.5% in 2007-08 to 5.9% in 2011-12. It is not unusual for governments to run a deficit when funding longerterm growth, but India’s remains high relative to other emerging markets, is the product of inefficiency, and exposes the government to higher funding costs when combined with the current account deficit.
Exhibit 1: A Troubling Deficit
4.0
Central Gov't Structural Balance % of GDP
Central Gov't Fiscal Deficit% of GDP
India - Requires tax reform and spending efficiency
2.0 0.0 -2.0 -4.0 -6.0 -8.0 -10.0 -12.0
2004 Brazil 2005 2006 China 2007 2008 India 2009 2010 Indonesia 2011 2012 2013E 2014E 2015E Turkey
South Africa
Source: International Monetary Fund
A portion of India’s fiscal deficit can be attributed to the global financial crisis. Indian officials – like many other government policy makers – responded to the sharp contraction in global economic expansion through a stimulus package that included across-the-board tax cuts and increased expenditures to revive struggling sectors. The government also hiked public-sector wages and responded to rising oil prices with the aforementioned fuel subsidies. High fuel prices have impeded more accommodative monetary policy, hindered consumption and stoked inflation, which has remained stubbornly high, as illustrated in Exhibit 2. In the wake of this, the gross domestic savings rate declined from a peak of 36.8% in 2007-08 to 31.8% in 2012-13.
Exhibit 2: Inflation Is Set to Fall With Commodity Prices
14 12 10 8 6 4 2 0 -2 2007 2008
Brazil
Inflation - Average Consumer Price Change %
2009
China
2010
India
2011
2012
Indonesia
2013
South Africa
2014
2015
Turkey
Source: International Monetary Fund
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
www.thebostoncompany.com
2
Uncovering Opportunities in Indian Equities Recent economic weakness has forced officials to expeditiously tackle spending efficiency and tax collection. (See Sidebar 1) Government spending has been cut sharply, and the deficit and debt have already declined as a result. (Exhibit 3) A new Direct Benefit Transfer Program was set up to establish a framework that promotes social welfare without draining revenues, targeting those most in need, while streamlining an unwieldy number of programs. It is expected to boost overall consumption by providing tangible cash versus subsidized pricing. Meanwhile, elimination of the costly diesel-fuel subsidy and reform of the tax system have been discussed. On the revenue side, the government is planning to introduce a national and state-level goods and services tax, with goals of broadening the tax base, reducing complexity and increasing transparency. In addition, the Direct Tax Code will be simplified, with a higher “tax-free” threshold to cover more low-income individuals. There have been encouraging signs of the government’s willingness to monetize state-owned assets, with potential divestments including stakes in Oil India and power generator NTPC. While this could create a near-term overhang in shares slated for sale, the government tends to create a favorable backdrop to ensure deal success. This could include progress on coal-pricing reform and power-sector restructuring. In the long term, cash in the government’s coffers will lower debt dependency while supporting more efficient social programs.
India’s Fiscal Deficit Reform Direct Benefit Transfer: This aims to transfer benefits and subsidies directly to those living below the poverty line. The government’s ambitious plan to directly transfer cash subsidies on cooking gas to consumers’ bank accounts recently launched in 18 districts. Widening Service Tax Base: A service tax is levied on most services provided in India. The actual collection of service tax in 2011-12 grew about 37% from the 2010-11 level, as the government expanded the number of industries in the tax base. Introduction of Value-Added Tax: VAT has been implemented across the states and was a major step in increasing tax revenue.
At a Glance:
Exhibit 3: Declining Debt Levels
India Government Debt to GDP Trend
90 80 70 Gov't Debt/GDP % 60 50 40 30 20 10 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Government of India, Planning Commission of India
Challenge: Current Account Deficit
For the fourth quarter of 2012, India posted its highest-ever current account deficit of $32.6 billion, representing 6.7% of GDP , which pressured both currency and equity markets. This was driven by a combination of high energy prices and aggressive gold buying. India relies heavily on imported oil and gas, and it has a seemingly insatiable appetite for gold, for both cultural reasons and as a store of value. However, India is not alone in its current account quandary, as noted in Exhibit 4.
Unified Goods and Service Tax: The central government is working with state officials to establish a unified Goods and Service Tax (GST) that will reform the complicated indirect tax system that actually hindered interstate trade. Although the GST will not be implemented fully until 2015, central and state governments have made solid progress in solving issues related to individual state compensation. Direct Tax Code Reform: This is intended to broaden the corporate base, reduce administrative costs and promote retirement savings.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
www.thebostoncompany.com
3
Uncovering Opportunities in Indian Equities
Exhibit 4: A Slight Improvement in Current Account Deficit
15.0 10.0 5.0 0.0 ‐5.0 ‐10.0 ‐15.0 2007
Brazil
Current Account Deficit
India - Improving, not the worst
2008
2009
China
2010
India
2011
Indonesia
2012
2013
South Africa
2014
Turkey
2015
Source: International Monetary Fund
The recent stabilization of energy and gold prices, as demonstrated in Exhibit 5, should take some pressure off the expanding deficit.
Exhibit 5: Signs of Stabilization in Commodities
140 120 100 80 60 40 20 0 Feb-09 Feb-10 Feb-11 Feb-12 May-09 May-10 May-11 Nov-08 Nov-09 Nov-10 Nov-11 Feb-13 May-13 May-12 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Nov-12
Crude Oil Brent ($/bbl)
2,000 1,800 1,600 1,400 1,200 1,000
NY Gold ($/ozt)
Oil prices stabilizing ‐ positive for CA
800 600 400 200 0 Aug-08 Aug-09 Aug-10
Gold prices falling ‐ positive for CA
Aug-11
May-09
May-10
May-11
May-12
Aug-12
Source: FactSet
The only caveat is currency. (See Exhibit 6.) Like most unpegged emerging-market currencies, the Indian rupee has declined as the imminent reversal of easy-money policies encroaches on the carry trade. A weaker rupee could negate the improvement in import prices and frustrate the Reserve Bank of India’s ability to lower interest rates. This is a factor to watch as the year progresses.
Exhibit 6: Currency Watch
60 55 50 45 40 35
Aug-07 Sep-04 Sep-09 Oct-06
US Dollar / Indian Rupee
US Dollar/Indian Rupee
May-06 May-11 Aug-12 Oct-11 Mar-07 Dec-05 Dec-10 Feb-05 Feb-10 Nov-03 Nov-08 Mar-12 Jun-08 Jun-03 Apr-04 Apr-09 Jul-05 Jul-10 Jan-08 Jan-13
30
Source: FactSet No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
www.thebostoncompany.com
4
May-13
Feb-09
Feb-10
Feb-11
Feb-12
Nov-08
Nov-09
Nov-10
Nov-11
Nov-12
Feb-13
Uncovering Opportunities in Indian Equities
Challenge: Poor Infrastructure
India’s deficient infrastructure is another root cause of economic underachievement. Anyone who has driven around the country can observe the need for better roads. Its power sector is prone to shortages, and key projects have been delayed by government bureaucracy. That said, India has made progress in modernizing transportation and communication. For example, paving on many rural roads, as exemplified in Exhibit 7, has made transportation substantially more efficient.
Exhibit 7: A Smoother Road Ahead
India Road Expansion
3,200,000 2,700,000 2,200,000 1,700,000 1,200,000 700,000 200,000 1951 1961 1971 1981 1991 2001 2011
Total length of the road (In Miles)
Source: Government of India, Ministry of Road
100 90 80 70 60 50 40 30 20
Growth (%)
Foreign Investors Show Optimism on India
The United Nations Conference on Trade and Development’s World Investment Report 2012 highlighted India as the third most attractive location for foreign direct investment (FDI) for 2012-14. The 2011 survey of the Japan Bank for International Cooperation ranked India as the second most promising country for overseas business operations in the medium term. Ernst & Young’s 2012 Attractiveness survey listed India as the fourth global destination for FDI in terms of the number of FDI projects. The 2012 A.T. Kearney confidence Index rates India second in terms of future prospect for FDI inflows.
Mobile-phone penetration has grown steadily, as shown in Exhibit 8, often circumventing India’s inadequate fixed-line network in several areas across the country. The use of mobile phones has had an especially positive impact on rural economic development, where communication has bolstered productivity.
Exhibit 8: Explosive Mobile Growth
India Mobile Cellular Subscriptions (per 100 people) 90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13
India Mobile Cellular Subscriptions
(till Dec 2012)
Source: Government of India, Department of Telecommunications
But more investment is still needed. With government finances stretched, officials have announced several reforms aimed at boosting capital investment. India has typically been wary of outside investors, limiting foreign ownership in various industries, although many multinationals are eager to invest in the country. (See Sidebar 2.) However, the recent growth slowdown has led the government to relax foreign investment limits in several sectors, including multi-brand retail, aviation and power generation.
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Uncovering Opportunities in Indian Equities The government has also established a Cabinet Committee on Investment (CCI) to expedite key infrastructure projects that have been bogged down in the approval process coordinated by state officials and central government ministers. The CCI will also fast-track oil and gas exploration approvals as India attempts to boost local production. Fuel-price liberalization is critical and will go a long way toward broadening private-sector participation in energy production. Although lower subsidies and market pricing will not benefit all sectors – for example, miners will face higher diesel prices – more rational consumption, lower overall global prices thanks to increased supply, and transparency should support longer-term equilibrium. Until India’s energy market has greater visibility — i.e., less government control — oil and gas investment will be hamstrung by weak profits. India’s power sector has also been riddled with operational problems and financial losses. To increase power-sector investment and long-term viability, the central government has restructured the debt of the state power distributors, raised tariffs to make power purchase agreements more profitable, and is exploring ways to alleviate local coal shortages. This ambitious agenda should set the stage for sustainable electricity output.
Challenge: Margin Deterioration
Historically, Indian companies delivered margins that were superior to other emerging-market companies. This was probably unsustainable, as several Indian industries, such as telecom service providers, were earning more than their peers in other countries because of higher relative prices. That has changed with increased competition and government policy initiatives working to normalize customer prices. Plus, many other emerging-market countries are industry-heavy, such as Russia in Energy, which can distort aggregate profitability factors. Nonetheless, input cost pressure and weak demand have caused margins to decline. And margins at India’s stateowned banks have declined, as recent economic weakness caused nonperforming loans to pick up in designated mandatory lending segments. All of these issues have contributed to a convergence in India’s return on equity relative to other emerging markets, as seen in Exhibit 9. Yet, India’s profit margins remain above the MSCI Emerging Markets Index average, and following a few years of aggressive earnings downgrades, earnings expectations have become more realistic.
Exhibit 9: Some ROE Convergence
25.0 23.0 21.0 19.0 17.0 15.0 13.0 11.0 9.0 7.0 5.0
Oct-06 Oct-07 Jun-06 Jun-07 Feb-07 Feb-08
MSCI India ROE Oct-08 Oct-09 Jun-08 Jun-09 Jun-10 Feb-09 Feb-10
MSCI EM ROE Oct-10 Oct-11 Jun-11 Feb-11 Feb-12 Jun-12 Oct-12 Feb-13
Source: MSCI, FactSet
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Uncovering Opportunities in Indian Equities Valuations have also become more compelling, as evidenced by Exhibit 10. When considering the government’s sizable reform agenda, Indian equities have become increasingly more attractive for the long-term investor.
Exhibit 10: Attractive Valuations
25.0 23.0 21.0 19.0 17.0 15.0 13.0 11.0 9.0 7.0 5.0 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 MSCI India Price/Earnings Average -1 STD +1 STD
7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 MSCI India Price/Book Average -1 STD +1 STD
Source: MSCI, IBES, FactSet
Conclusion: India’s Exceptional Potential Often Overlooked
The noise surrounding India’s current economic flaws often overshadows its future prospects. Some of the country’s key advantages are listed here: I ndia boasts a large, working-age population that will drive expansion through personal consumption. Unlike China and many developed nations, India is not grappling with an aging demographic that will need substantial social support.
Exhibit 11: India’s Sizable Young Population Should Drive Domestic Growth
50 45 40 35 30 25 20 15 10 5 0 India
Source: World Bank
Young Population % of Working Age Total
Brazil
China
Russia
Germany
Japan
United States
Penetration levels for goods and services remain quite low, and demand is building.
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Uncovering Opportunities in Indian Equities
Exhibit 12: India’s Auto Penetration Shows Potential for Long-Term Consumption
500 400 Passenger car
(per 1000 people)
300 200 100 0
0 Brazil 10,000 China 20,000 30,000 40,000 50,000 GDP per capita ($US) Korea India Japan Germany United States
Source: World Bank, as of 2011
Urbanization will drive demand for housing, transportation and connectivity. R ural wages are growing, thanks to government programs like the rural employment guarantee scheme, improved infrastructure, and mobile communications. The refinement and continuation of these programs aimed at assisting lower-income individuals will help to promote middle-class development and sustainable expansion. I ndia is a vibrant democracy with a well-respected, independent central bank, securities regulator and a deep, diversified equity market. Elections often spark investor caution — and a national election is approaching in 2014 — but the various parties that form India’s coalition government appear to be working together to pass palatable reforms aimed at improving the country’s performance. The country is also working on various trade agreements to boost export activity. ith India’s GDP hitting a five-year low, it is easy to simply look elsewhere for growth, but that W would be short-sighted. India’s future growth potential is set to rebound from depressed levels, according to forecasts from the International Monetary Fund, as seen in Exhibit 13.
Exhibit 13: GDP Growth Ahead
12 10 8 6 4 2 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: International Monetary Fund
India GDP Growth % set to rebound from a decade low
Equity markets tend to be leading economic indicators, and today’s valuations appear to have discounted any type of economic or earnings recovery. For long-term investors, the time to buy India looks to be close at hand.
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Uncovering Opportunities in Indian Equities
About the Author
Andrea M. Clark, CFA
Portfolio Strategist Andrea is a Portfolio Strategist for The Boston Company’s Non-US and Emerging Markets investment disciplines, responsible for communicating the teams’ strategies to clients, prospective clients and consultants. Previously at the firm, Andrea was an analyst on the Non-US Value Team. Prior to joining The Boston Company, she was a Vice President at Standish Mellon Asset Management, where she was responsible for equity product management, development and positioning. Before that, Andrea was a Vice President of Institutional Product Management at Pioneer Investment Management Inc. During her career, Andrea also worked for Putnam Investments in several business groups, including Portfolio Analysis and Marketing. Andrea received a BS and an MBA from Suffolk University. She holds the Chartered Financial Analyst designation and is a member of the CFA Institute and the Boston Security Analysts Society.
Co-Author
Dheeraj Wadhwani
Senior Analyst Dheeraj is a Senior Analyst at BNY Mellon India, working closely with the Distribution Support Group at The Boston Company. In this role, Dheeraj develops and maintains product information on third-party consultant databases for marketing The Boston Company’s institutional investment products. Previously, Dheeraj was an Analyst at Credit Point Services (India), part of Rage Frameworks Inc., where he was responsible for performance measurement of portfolios for international wealth-management clients. Before that, he served as a Research Analyst at India Co. Venture, a private-equity firm, where he screened and researched Indian companies. Dheeraj earned a Bachelor of Commerce in Accounts and Finance from M.J.P . Rohilkhand University and an M.S. in Finance from ICFAI University.
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Disclosure
Any statements of opinion constitute only current opinions of The Boston Company Asset Management, LLC (TBCAM), which are subject to change and which TBCAM does not undertake to update. Due to, among other things, the volatile nature of the markets and the investment areas discussed herein, they may only be suitable for certain investors. This publication or any portion thereof may not be copied or distributed without prior written approval from TBCAM. Statements are correct as of the date of the material only. This document may not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or not authorised. The information in this publication is for general information only and is not intended to provide specific investment advice or recommendations for any purchase or sale of any specific security. Some information contained herein has been obtained from third party sources that are believed to be reliable, but the information has not been independently verified by TBCAM. TBCAM makes no representations as to the accuracy or the completeness of such information. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
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No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
