From the April 2012 issue of Investment Advisor • Subscribe!

March 26, 2012

India at the Crossroads

So far, India’s potential has been largely unrealized as investors avoid the country due to limitations imposed by its government. Is it time for investors to come back to India, or is there still more to do?

Beyond the exoticism and mystique that’s always been associated with India lies one of the greatest emerging market growth stories of recent times, one to which, until fairly recently, it seemed there could be no end.

But then one day, the glowing narratives that had toasted India’s high growth potential and its impressive GDP rate, the stories that had exalted the enormous investment opportunity India offered, changed. Rather than marvel at India, commentators and observers began to question the sustainability of its growth, particularly when placed against a backdrop of soaring inflation and a serious fiscal deficit.

As much as India, like any other emerging market, was a victim of the fall in demand that resulted from Europe’s problems and the rise in commodity prices that was a consequence of the global financial crisis, increased frustration with what’s inherent to the Indian model has led to increased investor disenchantment. More and more foreign investors have been taking their money out of India, seeing better opportunity in other emerging markets or even elsewhere in the world. The dramatic fall in foreign investment meant that India became one of the worst performing emerging stock markets in 2011.

While increased government spending and domestic consumption have made up for the decline in foreign investments in the short term, it’s clear that India cannot achieve broader and sustained economic growth without foreign investment. The Indian government is reportedly aware of that, but what is it going to take to get investors to buy back into the India story? What are the sticking points that have led many foreign investors to change course and shift their view? What does India need to do in order to get investors to commit for the long haul, and what’s the best way for investors to go forward in a country that undeniably still offers great investment potential?

Politics and Policy

For foreign investors, India has been one of the hardest countries to invest in. While it’s only natural for a sovereign nation to protect its own best interests before it throws the doors open too wide to the interests of others, many feel the Indian door has been one of the toughest to open. They would like to see it opened wider, with measures that would make it easier for investors to access the Indian market, which would benefit the country by meeting the great needs it has for private sector funding (both foreign direct investment and foreign institutional investment) in various sectors of the economy.

Investors who want to continue to invest in India, who believe that there is potential there, feel they cannot do so unless the government takes some serious action on the reform front by putting in place measures that really do seek to encourage foreign investment over government spending and domestic protectionism.

The logistical difficulties of investing in India have caused many foreign investors to pull away from the country, particularly when they compare India to other emerging market nations like Brazil and Indonesia, where investing from overseas is easier.

“We’ve viewed India from afar without directly investing there because of the trading limitations that we have faced,” says Jonathon Brodsky, managing director at Advisory Research in Chicago. “We view any country where the processes to trade and the transactional and frictional costs are negative as unattractive. Compared to other emerging markets, we view India as unattractive because of the many limitations that the government imposes, which makes investing there an onerous process.”

Despite India’s great need for foreign investment, the government has up till now taken very small steps to enable it, says Robert Davy, deputy head of global emerging markets at Schroders in London. This is particularly frustrating to foreign investors and one of the main reasons, he says, why they withdrew so dramatically from the Indian stock market in 2011.

Of course, investors are still very keen on the India growth story, which is why any small measure taken by the government does help in improving sentiment, Davy says. The Indian government, for example, recently passed legislation that would make it easier for foreign investors to invest directly in the Indian equity market, in the hopes of attracting more investors and lifting the market from its 2011 low. This resulted in a rise, as investors are still very keen on India and are waiting for steps like this. “But this is also an example of a small change that won’t make a very big difference in the long run, because there are still so many hurdles that foreign investors need to clear,” Davy says.

In the long term, he says, only a sustained commitment to reform and a clear-cut economic agenda by the Indian government can help keep foreign investment coming in.

That said, the enthusiasm over India’s potential has evidently lent itself to great investment fervor, Brodsky says, and this resulted in periods of time when stocks were very much overvalued. Even today, Brodsky has not seen the inefficiencies in pricing that would make investing in Indian equities a worthwhile venture for a value investor like himself, which is why he is still in favor of investing in the country indirectly through Indian ADRs listed in places like London, Hong Kong and Singapore—a path that is less cumbersome yet affords some of the gains to be had from the Indian growth story.

“As an active manager, I stay away from places where I see limitations,” he says. “I would have to find a really incredible opportunity to overcome those limitations, and I haven’t found it yet in India.”

Investing in India would be much more attractive and worthwhile for Brodsky if the Indian government seriously committed to reform and showed that commitment in measures that would make it easier for foreign investors to invest in India. Removing the stringent restrictions India currently imposes on foreign direct investment, for instance, would be a huge help, Brodsky says, and would provide a great deal of encouragement and incentive to foreign institutional investors. It’s a step he’s hoping the government will take shortly.

“As India matures and becomes more integrated with the rest of the world, I do think that the government is looking more and more at things from our perspective and realizing that you have to view a market holistically and compare it to other markets,” he says.

Infrastructure—Or Lack Thereof

There is no way that economic growth, no matter how robust it may be, can be sustained without a country having in place solid infrastructure. Infrastructure—or the lack thereof—has been the bane of India’s existence for years and one of the main reasons why economic growth forecasts have taken such a hit and investors have shied away from the country. Improper infrastructure, and what many view as a half-hearted commitment from the Indian government to implement the reforms needed to encourage investments in infrastructure, is one of the biggest sticking points for investors.

For Joel Wells, co-portfolio manager of the Alpine Emerging Markets Real Estate Fund (AEMEX), infrastructure is India’s “central nervous system.” Without a proper infrastructure in place, India’s growth story won’t make a lot of sense and would get to a point from which it could go no farther.

“In other emerging markets, you’ve seen infrastructure develop in tandem with or even leading growth in other areas of the economy, but in India, the lack of a plan on the infrastructure side has been a significant dampener on the growth trajectory,” Wells says. “India’s infrastructure needs are huge. We’re talking about a need across the board for roads, highways, ports, airports, energy and more.”

While there have always been plans on the table for infrastructure development, Wells would like to see a clear-cut commitment from the Indian government toward enabling investment into infrastructure. The cost of doing business in India becomes extremely high “if you don’t have good roads, if you don’t have power and so on,” he says. The more the government can get behind infrastructure initiatives and put in place the proper policy, the more investors will feel encouraged to put their money in India, and economic growth will be supported as it should be.

A firm commitment to infrastructure is key to the continued attraction of India as an investment destination, and sentiment toward the country would greatly improve if the proper measures were put in place. Nevertheless, investors are still unsure about how infrastructure development will fare, as it’s been a sore point vis-à-vis India for years.

As much as projects in sectors like power, highways and roads may get approval and even get off the ground, bringing them to fruition and ensuring they are viable in the long term is an even greater problem, says Davy.

“A few years ago, a lot of investments in the power sector got approval, but many of them have run into problems because they didn’t have the coal required to run the power stations,” he says. “Or, if coal was imported, the plant was not economically viable. A lot of people get enthusiastic about infrastructure projects, but then it seems that profitability is miscalculated, and problems always seem to arise later on.”

In the absence of more widespread and reliable infrastructure, the viability and growth prospects of many businesses comes into question. Businesses, for instance, that operate inside spaces built by companies like Ascendas, a leading provider of business space solutions in Asia, don’t need to face shortages of power and water, but what happens if they need to move outside those boundaries? What about businesses that are outside such enclaves to begin with?

“Moving outside the gates of designated business spaces means that those businesses can’t be guaranteed modern world infrastructure, so there’s a huge risk to investing in companies that are outside of the gates,” Brodsky says.

Clearly, proper infrastructure would make India’s long-term growth sustainable, particularly as some believe it has the potential to one day replace China as the world’s low-cost manufacturing economy. But making that happen will mean a holistic, end-to-end commitment to infrastructure, one that’s properly planned and executed from start to finish.

Real World Investment Strategies and Careful Stock Selection Can Work

Should investors stay away from India because of the current impasse? As they wait for broader, more lasting changes, what should they be doing?

Sanjeev Kumar, director and group CEO at Delamore & Owl in London, knows that the long-term India story does offer great potential, but he feels the best approach at this juncture is to look for opportunities where they might not be so obvious and where they might be less subject to the greater forces of policy and politics.

“If you want to get involved in the real Indian economy, then you have to understand that there are actually layers of economies in India. You need to go beyond the obvious and look for growth below the surface and even past the problems,” Kumar says. “It’s important not to paint Brand India with the same broad brush.”

Kumar believes in committing capital to “real economy businesses” in various sectors. As opposed to buying equities—which Kumar feels have been mostly overvalued in India and, even today, after a fallback, continue to trade at a premium—the Delamore Group’s India strategy is focused on taking equity positions in these “real economy” companies and providing skills and expertise to management so that they’re equipped to grow the business more. Take infrastructure, the Big, Bad Wolf that’s holding India hostage: While waiting for the kind of commitment from above that would shape infrastructure for the future, Kumar looks for opportunities in industries that service infrastructure assets, that provide the “secondary level of servicing” that’s so necessary to keep infrastructure projects viable.

“There are smart guys operating those kinds of companies, and we feel that we’d be investing in good ventures if we commit the capital and take on equity positions,” he says. “There are pockets of India where the growth is not visible, but in the second and third tiers of the economy, there is a lot of growth to be generated.”

The aviation sector is another “below the surface” play that Delamore likes. While Indian airline companies are struggling for a number of reasons including industry saturation and the high cost of fuel, there is a serious need for companies in the leasing and servicing side of the business, Kumar says. These are the growth areas within the overall industry, he says.

For Sunil Asnani, co-manager of the Matthews India Fund (MINDX), the sectoral approach that so many investors have favored toward a country like India is definitely a no-no. He believes it’s best for investors with a long-term view to stick to careful stock selection. Rather than embracing India en masse or eschewing India entirely, Asnani thinks it’s important to look inside sectors and sift through the good and bad companies.

“In our strategy, we have found a lot of opportunities in small- and mid-cap stocks, and there’s a huge range of companies with attractive pricing to choose from,” he says.

In India, investors have either loved or hated entire sectors. Retail, for instance, was viewed as having one of the greatest growth potentials because retail penetration in India is still relatively low. Yet for many retail companies, returns were fairly low, Asnani says, and although sales may have grown, they did not necessarily create value for all companies.

“Being able to find companies within a particular sector that make money is important,” Asnani says. “The market does seem to be discriminating between the good and bad companies that you’d find in a particular sector, and I would say that to find the best opportunities, you have to take a longer-term view and perform company-specific, bottom-up analysis.”

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