Is now the time to unlock India’s potential?
India has lagged behind rallies in Brazil and Russia in 2016, delivering returns of 6.7% compared with 9.74% for the broader MSCI Emerging Markets Index.
One of the reasons behind the rebound in emerging markets is the rally in value stocks which were badly hit by the collapse in commodity and oil prices. As Brazil and Russia stabilised, India, meanwhile slipped back as the initial elation of a new prime minister, Narendra Modi, gave way to the reality that the much needed changes wouldn’t take shape immediately.
However, two years on, it seems India could now be on the brink of change, which could open up more opportunities for investors.
The introduction of the Goods and Services Tax Bill, essentially a VAT bill, sees India move towards a unified economic zone and away from a patchwork of inconsistent state taxes; its financial inclusion policy means 99% of the population now has access to a bank account, up from the 50% a year ago; and the government’s move to curb corruption has seen the nation allow foreign direct investment. Its GDP is expected to rise to 7.5% in 2017, up from the 7.3% in 2015.
Kunal Desai, manager of the Neptune India fund, says these factors should trigger a period of significant earnings growth for Indian companies.
He also says the stability of Modi’s pro-reform government should lead to a drop in India’s ‘political risk premium’ relative to its emerging market peers.
“With the valuation mismatch between developed and emerging markets at close to record levels, this new political risk dynamic could see a shift in global asset allocation, encouraging greater flows into India,” he says.
For investors looking to access the country, the question is whether to go down the pure play route or gain exposure through a general emerging markets fund to minimise risk. Below we outline the case for each route.
Global emerging market funds have low allocation to India
Desai says that global emerging market equity funds tend to allocate less than 10% to India on average meaning there’s a strong case for increasing India exposure via a dedicated fund in order to benefit from the country’s expected growth.
According to latest data from FE Trustnet, the average allocation to India of 70 global emerging market funds for sale in the UK stands at 11.67%.
At the lower end of the scale, the UBS Emerging Markets Equity Income fund includes India in its top 10 geographical allocation holdings, but it only had 3.3% invested in the country as at 30 September.
In comparison, the Newton Global Emerging Markets fund invests a greater proportion in India with 30.5% held in the country as at 31 October, showing there can be large variations in allocation across different funds.
Emerging market funds tend to focus on large-cap India
While some emerging market funds do offer greater exposure to India, they tend to focus on large-caps, missing out on returns and growth of small and mid-cap companies.
Desai says his fund is overweight small and mid cap, currently investing 30% of the fund in stocks with a market-cap less than £5bn.
This allows him to find under-researched opportunities further down the market-cap spectrum, meaning less portfolio overlap between a pure fund and other popular global emerging market funds.
Further, mid-caps are trading at a 29% discount to large caps, showing “there is superior value at the smaller end of the market”.
He gives the example of Blue Star, a top 10 holding in the Neptune India fund, which is rapidly increasing its share in the air conditioning market.
“The company has a fully integrated business model of a manufacturer, contractor and after sales service provider and this has enabled it to offer an end-to-end solution which separates it from competitors. We have been very impressed with the management team whilst the stock trades at a discount to its larger peers.”
Benefit from future returns and diversification
Desai says that an India fund can help from a portfolio construction point of view as Indian equities have a low correlation to both developed markets and global emerging markets.
“While Indian equities are traditionally seen as a risky asset class, introducing the Neptune India fund to an emerging market portfolio can actually reduce volatility,” he says.
“For example, a 50/50 split between the M&G Emerging Markets fund and the Neptune India fund has been considerably less volatile over the past three years than the two funds in isolation, precisely because the correlation is so low. It has also considerably boosted performance.”
‘Pure play India is attractive but it’s risky’
While the reforms referenced above look positive, Adrian Lowcock, investment director at Architas, points out there is still a long way to go before they are complete. He also notes there are risks when investing in any emerging market.
He says one of the biggest risks investors should be aware of is India’s politics as Modi seems to have the support and backing to make fundamental changes, but he is the key person so his removal or restriction in office could limit such reforms.
Lowcock also lists corruption and red tape as being of concern to potential investors. Modi’s policies seem to be taking shape, but there could be a ‘fight back’ by those who oppose the changes.
While much of India’s transformation is internal, Lowcock says global shock or slowdown will have a knock-on effect to stock markets as investors become risk averse.
He says: “For most investors a pure India play is risky. For an experienced active investor, I would say India offers an attractive pure play, but you need to monitor performance. India is attractive now and could remain so for many years, however investors don’t tend to switch funds and India can easily be replaced by another emerging market as markets rise and fall and the outlook for different countries change. For example, the Trump result has changed the outlook for a number of emerging market countries significantly.”
For investors looking to tap into the India theme and complement their existing portfolios, Lowcock says they may want to offset the exposure with more defensive, income-orientated stocks, such as UK equity income stocks which are less vulnerable to political upset and slowdown in economic growth.
He says that emerging markets should only form a small part of a portfolio. “For a low risk investor I would suggest getting exposure through a diversified EM fund with perhaps 5% in emerging markets. A similar approach would be appropriate for a moderate risk investor but slightly more exposure, say 7%. A higher risk investor could hold 10%. And any India exposure should form a small part of your broader emerging markets exposure, say 2% of the portfolio,” he says.
Fund ideas include Fidelity Emerging Markets which has about 14% invested in India and provides investors with a diversified exposure to emerging markets.
Lowcock says: “Manager Nick Price has a well-established process and is focused on investing in companies with superior growth potential, sustainable profitability and a consistent track record over time. The fund has a bias towards large companies but is able to deviate from the benchmark.”
He also picks Jupiter India as the manager, Avinash Vazirani, looks for companies whose growth prospects have been overlooked by the market and it typically includes between 80 and 100 companies.
“His process is mainly driven by detailed company research but he is aware of broader economic developments and themes in India, taking account of how these may impact companies. Target companies typically have solid balance sheets and robust and sustainable business models,” he says.
The fund has traditionally had a healthy weighting to small and medium-sized companies so Lowcock cautions this fund should be considered riskier and may not suit all investors.