A tale of Indian equities – still a long way to go
“The long-term case for investing in India is a no-brainer. India’s many attractions have been well chronicled, but they can’t be emphasized enough: a tradition of democracy, respect for the rule of law and widespread fluency in English. These qualities are not easy to find in emerging markets and they give India a huge advantage in the global marketplace…
…If you are willing to be patient, it is one of the most compelling investment destinations the world has to offer.” – Forbes International Investment Report, July 2006
India – the world’s largest democracy with a population of one billion plus people- is one of the world’s fastest growing & most dynamic economies, and fast becoming a very significant player of the global economy. Three engines namely Consumption supported by a positive demography, rising incomes, and growing aspirations; Outsourcing supported by skilled workforce and India’s competitiveness; and Investment supported by improved commitment towards infrastructure development and strong industry capex under-way have kept Indian economy growing at healthy 7-8% in last few years and likely to do so in future also. Environment is also conductive for growth with entrepreneurial culture & strong private enterprises, well-established legal & institutional framework in place, strong educational base, and facilitating governments. Indian economy is also more resilient due to its domestic driven economic growth and less influenced by global economic cycles as reflected the fact that in last 25 years, India’s GDP growth has seen only a single year of contraction.
Reflecting the economic fundamentals, the SENSEX – India’s benchmark equity index– has risen more than 4.5 times since 2001 and has delivered a compounded annual return of more than 17% over last 25 years. Though at more than 20 times trailing twelve months earnings the market seems to be reasonably valued, the structural bull market is very much alive and it may slow but unlikely to reverse prematurely. Indian equities – as an asset class is still an attractive investment destination due to long-term growth prospects, globally competitive & aspiring enterprises, superior corporate performance, emerging sectors and expanding market breadth.
Fundamentals are place for sustainable economic growth
Qualities – not easy to find everywhere
Indian growth story is not a one-time phenomenon. Rather it is more sustainable with long-term growth drivers in place [See box item Fundamentals are place for sustainable economic growth]
and these strengths are not easy to find in all emerging markets. India is a world’s largest democratic country with presence of diverse, liberal and vibrant democracy – free elections, independent democratic institutions / regulatory frameworks, truly independent media, albeit slow but well-established judicial system and secular politics. India’s leadership is also very diverse and proactive – facilitator for growth. In fact secular and diverse nature of Indian leadership can be judged by the fact that Prime Minister Dr Manmohan Singh is a Sikh Phd Economist, President Dr A P J Abdul Kalam is a Muslim rocket scientist, President of ruling party Mrs. Sonia Gandhi is a foreign borne national and Finance Minister Mr. P Chidambaram is a Hindu Harvard MBA. India is also becoming an important and strategic ally on international politics due to its rising economic powers in Asia, vibrant democracy, nuclear power, etc – ratified by recent historic nuclear deal between India and USA.
Private sector – flourishing in an entrepreneurial culture – is another strength India has. Ranging from large well established, large firms of both old and new economy to upcoming medium and small sized firms of emerging sectors – these private enterprises & domestic entrepreneurship have contributed significantly to India’s recent success unlike China where FDI driven export led model and politically driven investment model has contributed to the growth.
In fact according to a study by JP Morgan, due to thriving private enterprises, listed Indian firms deliver a higher return on equity (RoE) than comparable companies in Hong Kong, Singapore, Korea, Taiwan, Japan and Malaysia or Hong Kong-listed Chinese firms. Remarkably, Indian firms combine high RoEs with Asia’s lowest debt-to-equity ratios. Though India has large number of sizeable public sector enterprises from various manufacturing sectors, the success of private enterprise is truly remarkable in services sector – particularly in the area of information technology – with truly world class companies like Infosys, TCS, Wirpo, etc. Indian companies have also made their present felt globally with many
companies becoming globally cost competitive, acquiring companies globally, gearing for global size and becoming global sourcing hub.
Right demography is also a driving force behind India’s recent success and if handled properly can be a source of sustainable long-term growth. India is a young nation with ~ 54 percent of population is less than 25 year old and whose middle class, which is greater than Europe, has created a vast domestic market. India’s educational system is also reasonably adequate (With few world class institutes like India Institute of Technologies and India Institute of Managements to be proud about) creating skilled workforce. In fact compare to China who has only 1.5 million college graduates India has 3 million graduates. IMD’s competitiveness yearbook 2003 showed that on availability of skilled labor on a scale of 1 to 10 (1=low; 10= High), India scored 7.2 just behind score of USA (7.3) and Singapore (7.4) compare to China whose score was much lower at 4.3.
India is set to be the world’s ‘youngest’ nation by 2010 and will be the only large country to have favourable demographics – the only large country where the earning population is more than those dependent. A recent study by J M Morgan Stanley says “Favourable demographics, along with structural reforms and globalisation will drive the country to a sustained +8 per cent economic growth. The economic impact of India’s demographic trends should improve further as the age-dependency ratio falls to 55 per cent by 2010 and to 52 per cent by 2015 from an estimated 60 per cent at present. The favourable demographics would also push India’s aggregate savings to over 33-35 per cent of GDP over the next five years, from the past three years’ average of 28.6 per cent. This increase in savings and, correspondingly, the investment-to-GDP ratio to above 35 per cent should ensure a shift in India’s growth to a sustained rate of +8 per cent.”
Economy running on three growth engines
India’s economy has grown phenomenally in last few years and also likely to achieve a strong growth in current year resulting an expected average growth rate of more than 8 percent in a four year period FY2003-07. Two engines namely Domestic consumption -supported by a positive demography, rising incomes, and growing aspirations and Outsourcing -supported by skilled workforce and India’s competitiveness has kept momentum strong so far while the third engine, Investment -supported by improved commitment towards infrastructure development and strong industry capex under-way has just changed gears and likely to gather pace in coming years. With GDP of ~ USD 750 billion, India is 10th largest economy in the world at market exchange rate and 4th largest economy in the world in terms of purchasing power parity. Even by the most conservative growth forecast India will be among the top five economies by 2025. Resilience is another hallmark of Indian economy – in last 25 years, India’s GDP growth has seen only a single year of contraction. Breakdown of India’s GDP is also comparable to developed countries – 50 percent from services, and remaining from industry & agriculture. It is a domestically driven economy with much less reliance on exports compare to other Asian countries. In past, India has very well survived oil shocks for FY1973-75, FY1980-82 and FY1991-92 and is also fairly resilient to agriculture shocks as industry and services accounts for 77 percent of GDP.
The first growth engine, domestic consumption is fueled by factors like: Young and Aspiring population; Growing urbanization due to urban oriented employment opportunities; Rising incomes both in urban areas due to robust industry and service sector and in rural areas due to firm global and domestic agro-commodity prices. And at ~ 65 percentage of GDP, domestic consumption, by no means, is excessive compare to countries like USA. Compare to their counterpart Indian owns lowest number of consumer goods and with one billion plus population aspire to have higher standards of living supported by rising incomes- domestic consumption is likely to be much stronger in times to come.
The second growth engine, outsourcing is also running well & to some extent supporting recent consumption boom. India boasts a few internationally competitive industries on which global markets are relying. India’s low cost highly skilled English-speaking labor has been the force behind the engine. The most renowned success story in this space is IT services and software exports. India has already captured 75 percent of worldwide outsourcing market of IT services. India’s low cost highly skilled English-speaking labor has been the force behind the engine. Another success story is pharmaceutical industry supplying high quality low cost generics to the world. India is also budding as an outsourcing hub for manufacturing industries like auto, auto components, textiles, engineering and financial services. Indian outsourcing is not only about labor arbitrage. Support from huge & growing domestic market and vast availability of knowledge-managerial- entrepreneur base makes India a strategic place in global supply chain.
The third engine, investment in infrastructure and new capacities, now holds the key for driving the next phase of economic growth. This engine has just changed gears and likely to gather pace in coming years. Indian industries are beginning to exhaust capacities on the back of three years strong growth with capacity utilization of key industries running above 90 percent. After extracting capacities through consolidation, de-bottlenecking, restructuring, Indian industries are now on capacity expansion binge. As per the Center for Monitoring Indian Economy, the outstanding investment in new capacities as on April 2006 was at whopping Rs 28 trillion (~ USD 600 billion) out of which projects under implementation were accounting for Rs 8 trillion (~ USD 175 billion). This time capex of Indian industries is will supported by strong cash flows, relatively low level of debt to equity, and strong performance of equity market year-on-year. Infrastructure is another area that is likely to drive investment growth. It is the fact that infrastructure India in general is not up to the mark comparable to its Asian counterparts. After recognizing the fact that proper infrastructure is must for sustainable economic growth, Indian governments have improved their commitments for infrastructure development through various measures. As per estimates, in India, Investment in various infrastructures like roads, railways, ports, power, telecom, housing, oil & gas, water distribution, etc is likely to be over Rs 14 trillion during FY07-12 period. India will be the ‘country under construction” in years to come.
Equity market infrastructure is in place
As far as equities are concerned, India has one of the best market infrastructures in place comparable to that of developed world. It has two national level exchanges namely Bombay Stock Exchange (the oldest stock exchange in Asia) and National Stock Exchange. They have modern trading and settlement systems in place – all the trading is electronic and online whereas settlement system is on rolling T+2 basis and also electronic with more than 70% outstanding shares are held electronically. An independent regulatory body Security and Exchange Board of India (SEBI), formed in line with SEC of USA, governs market conduct. Policy initiatives by SEBI has lead to consistent improvement in corporate governance and studies rate India third in Asia behind Singapore and Hong Kong on overall country ratings on corporate governance. Introduction of modern index and stock options and futures in July 2000 has also seen India develop into one of the most vibrant and liquid derivatives markets in Asia.
The depth and breadth of Indian equity market is also very impressive. With more than 5000 listed companies India has second highest number of listed companies in the world. Indian exchanges are
amongst the five largest stock exchanges in the world in terms of number of transactions. The listed companies represent variety of sectors with large number of companies in each sector. With emergence of new sectors like real estate, retail, etc diversity has increased over a time and will continue to increase in future with increased fund raising through public offering of equity route by large public sector undertakings and private sector companies of all size. Tax regime is also very conductive with no tax for dividend & long-term capital gain and marginal 10% tax for short-term capital gain.
A recent study by McKinsey & company also rank well India in comparison to mature markets (G7 countries) on various equity market benchmarks like size of equity market as a percentage of GDP, equity market yearly turnover as a percentage of total market capitalization, commission of equity trades and percentage of total market capitalization of top 10 companies. A table below shows a comparison.
[Table] Equity market benchmarks (year 2004)
|icriteria||India||China1||Korea||U.S||Mature market bench mark|
|size of equity market as a pe percentage of GDP||56%||17%||63%||139||G7 country average at 93% GDP|
|Equity market yearly turturnnover as a percentage of tottotal market capitalization||88||362||169||127||Liquid but not speculative|
|commission on equity t trades2 sis points||5||50||16||5-15||No more than 25 basis points|
|Percentage of total market capitalization in top 10 companies||36%||14%||41%||15%||Top 10 companies account for less than 30% of total market cap|
|Overall assessment||Meets 50% of overall bench-mark||Does not meet bench-mark||Meets 50% of overall bench-mark||Meets the bench-mark|
1– Adjusted for non-tradable equity, 2 – Estimate
Source: McKinsey Global Institute analysis
Evolving equity ownership structure: Institutional depth to increase, under exposure of household savings to correct
A brief look at equity ownership structure in India suggests that more than 50 percent is still hold by promoters and insiders while holding of both Indian public and institutional investors is pegged in the range of 15 to 20 percent for each. Government as a promoter l holds 20-22 percent through equities of public sector undertakings (PSUs) but with planned fund raising by select PSUs through IPO route in next one or two years is likely to see government holding declining over a period. Despite record fund flows into India by foreign institutional investor (FII) in last couple of years due to less restrictive investment environment and huge investment potential, FII holdings of Indian equities at aggregate 8-10 percent level is not excessive relative to other Asian markets and a result of increased asset allocation by global fund managers to emerging markets like India. FII holding is still concentrated in large caps and that again in to few sectors like banking and technology. This leaves an immense scope for continued FII flows in India into emerging sectors, upcoming companies, and potential large cap public sector listings.
Though holding of domestic institutional investors in Indian equities is relatively low, the scenario is likely to change in future with environment facilitating growth of domestic institutions. With opening of the mutual fund market to private players including foreign companies in 1993, the competitive mutual fund sector has evolved significantly in India and is today much more mature then in past thanks to better awareness, wide distribution, self regulatory framework in place, innovative products, availability of requisite skill set, and entry of foreign players. Since 1993, share of UTI – the former monopoly fund – has fallen to less then 15% today and the mutual fund market has grown at ~ 10 percent annually to reach at asset under management (AUM) of ~ USD 50 billion. Though AUM as a percentage of GDP at 6.5 percent is still low compare to 25 percent in Korea and 40 percent in Brazil, with widening distribution and better awareness among households this ratio is most likely to increase provide more institutional depth the market.
Insurance will be another sector that is likely to see more participation in Indian equity market. Insurance is an approximately USD 10 billion (premiums) industry in India and opening of the sector to private companies in 2000 has made it more competitive and evolving. With better awareness, wider distribution, increased penetration, innovative products and participation by foreign player, the insurance sector in future is likely to see growth patterns shown by the mutual fund industry in a last decade. Though equity investment is restricted at 15 percent of assets of insurance companies in India, the likely allocation to equity is still going to be very significant over a period as the growth of insurance sector is India is inevitable where 80 percent of population in without any insurance coverage and the life insurance market is only 13 percent of GDP compare to 23 percent in Korea and 33% in USA. Increased penetration of provident and pension funds (covering just 13 percent of work force of organized sector), less restricted environment on asset holdings and more allocation to equities (within prescribed limits) by funds in search of better returns are also likely to see significant participation by Indian pension and provident funds in equities in times to come.
A study shows that allocation to equities in Indian household financial assets has fallen significantly from ~23 percent in FY92 & ~ 14 percent in FY94 to less than 3 percent in FY05. This underexposure in inevitably likely to be corrected in future due to search for better return and availability of more products. Allocation of household savings to equities may not necessarily increase through direct participation by India public into equities but will increase through participation in IPOs, mutual funds, insurance & pension products, portfolio management services, etc. Assuming an annual growth rate of savings at 16-17 percent and equity exposure of 10 percent of household savings, additional USD 50 billion plus is likely to come into Indian equities market by FY12.
Recent correction and gradual bounce back
Reflecting the economic fundamentals, the SENSEX – India’s benchmark equity index– has risen more than 4.5 times since 2001 and has delivered a compounded annual return of more than 17% over last 25 years. In line with other emerging markets and asset classes, Indian equities corrected from +12600 level of SENSEX in May 2006 to 8800 level just within a month’s period due to concerns like rising interest rates, looming inflation, decreasing prospects of US economy, etc and have become volatile since then. There are certain other reasons apart from these concerns, which lead to a correction. During the run up of SENSEX towards 12,000 plus mark, certain excesses were built in markets like increased leverage positions by retail & margin traders, IPOs at hefty prices, real estate stocks & their hyper valuations, significant run ups in not so fundamentally strong micro & small caps, etc. And during the correction, this exuberance is reasonably corrected. However, strong growth outlook for Indian economy in coming years despite some monetary tightening by RBI & not so benign inflation, improved sentiment towards emerging markets and revived fund flows to Indian equities has resulted into gradual recoveries of Indian equities and SENSEX is back to around 12000 level at present.
At 12000 level, SENSEX is quoting at 17-18 x FY07E earning and 15 x FY08E earnings. This valuation is definitely not cheap to aggressively buy in to uncertainty. Global imbalances created by US consumption binge and Chinese production & investment binge are well acknowledged by many leading economists world over and long due for a correction. Inflation threat is still looming first due to rise energy and metal commodity prices and now due to rise in wage inflation and prices of agro commodities. The path to currency adjustments world over is still full of many complexities. Amidst these uncertainties, favorable scenario for India will be slowing US economy – due to slowing consumption growth & cooling housing market in US, benign inflation and interest rate outlook, and softening commodity prices. In this scenario, which is slowly shaping up, a re-rating of Indian equities is possible due to India’s more certain & balanced growth and less vulnerability to US slowdown and if this happens, SENSEX may touch level of 15000-16000 level in one years time frame.
We have to remember the facts that the correction and consolidation are part and parcel of bull markets and a four-letter word “Risk” is always associated with equities.
Though India’s strong economic growth and superlative corporate performance are likely to continue keeping the intrinsic structural bull market very much alive, there are certain risks that might spoil the party again in near to intermediate term. If US & world growth remain robust, factors like prolonged bull-run in commodities, resurface of inflation threat, and further monetary tightening might weigh on the economic performance and corporate earnings. On other hand, a prolonged global economic slowdown might affect the performance of some of India’s global outsourcing sectors. In a more uncertain world economic scenario, a lack of global risk appetite might continue to hurt foreign institutional flows to Indian equities. Slower economic reforms & infrastructure development and large current account deficits are some of the internal factors that might weigh on overall economic growth. Right demography might work as a double edge sword if in future Indian economy fails to provide employment opportunities to growing young population.
Overall, India is an excellent long-term story. Its homegrown entrepreneurs are confident, governments is pro-growth, albeit at slow pace, demography has huge potential, its diplomacy is more strategic, infrastructure is improving, and growth is more balanced. The structural bull market is very much alive… It may slow… but it is unlikely to reverse prematurely