Yes, we have all heard that India’s growth story is going to be a standout relative to the rest of the developed or emerging economies. So, what is the best way to invest in the India growth story? With equity markets globally at all-time highs, of course we are having the passive vs active debate, with passive all the rage at present. It’s all about cheap fees and poor active manager performance isn’t it?
Having spent the last month in India it is easy to understand why there is significant opportunity to select well-managed, strong tailwind and moat businesses in India to deliver compounded returns well ahead of nominal GDP growth of 10%. All while the index continues to look expensive to foreign investors compared to other global opportunities.
In fact, the Nifty index fails to represent the earnings growth potential of India, given its exposure to many large cap companies that derive revenue offshore. It is also a heavily concentrated index, in particular financials (as high as 40%), and thus not a true representation of Indian growth.
In an equity market like India’s, active management has dominated over the long-term, given a high level of market inefficiency, significant number of IPO’s and under-researched companies and substantial dispersion between strong and poor corporate governance.
However, most of us suffer from something called “recency bias”. In calendar year 2018, 5 mega-cap stocks dominated the performance of Indian indices; Reliance Industries, Tata Consulting Services, HDFC Bank, Infosys and ITC. This was driven by the following factors:
- Risk-off sentiment towards Emerging Markets and India given rising oil prices, trade wars and a weakening currency
- A reclassification by the Indian market regulator of what is a small cap, mid cap and large cap stock, which led several mutual funds to purchase large cap stocks which were underweight
- A focus on large, liquid, quality and earnings certainty, irrespective of company valuations
So strong was the dispersion that the Nifty (top 50 stocks by market cap) rose 2.9%, while the remaining 45 stocks fell 4.6% over calendar year 2018. Today when we discuss India’s valuations, we identify it as an expensive market despite its growth potential. Not necessarily if you look beneath the top 5, which dominate close to 40% of the weight of the constituents of the Index.
Why is our play on India’s growth via predominantly five stocks, which are either expensive stocks (HDFC Bank/ITC) or playing growth overseas rather than India i.e. technology stocks sourcing close to 95% of their revenue offshore (TCS and Infosys)?
Our analysis shows that both structurally and cyclically, we are at the worst time to invest passively in Indian equities. Is filling out an application form for an actively managed fund, which takes 30 mins, really an impediment when you are talking about approximately 4% compounded additional returns over 10 years? Assuming nominal GDP forecasts (7% + 4%) and an additional 4% per annum for active returns, and the differential investment return is 121% over 10 years.
Corporate profit to GDP has dropped drastically over the last 10 years. This is driven by weaker earnings for certain capital goods and heavy industry businesses as well as the provisioning against Non Performing Loans of banks.
Being selective on stocks is far better than being passively invested in a historic representation of capitalization. For example, India’s top 50 companies by market cap, represented by the Nifty includes a significant component of capital heavy industries like Power, Construction, Metals, Telecom, Real Estate and Oil & Gas. These industries haven’t earned their cost of capital over the last decade and make up one third of the economy. Yet they represent 31 of the 50 Nifty stocks.
India has typically had a strong linkage of GDP growth to corporate earnings. However, over the last 5 years, despite nominal GDP growth averaging 11.3%, earnings have only averaged 4%. However, this hasn’t stopped the Nifty Index rising 74%.
This indicates a significant P/E rating as global investors have flooded India’s large and liquid stocks. On a historical basis Nifty now trades on 24x, up from 16.5x in 2014. From here, earnings growth is needed to see price increases.
The chart below aligns a pick-up in economic growth to out-performance of mid-caps relative to holding exposure to the Nifty.
Typically, given India is a high growth region, you would ideally like to own a significant proportion of mid cap companies which are selected through primary research and taking heed of market opportunity, industry positioning, corporate governance, leverage to the cycle, free cash flow and level of debt.
Holding compounding growers which emerge to be large players in their industry is the secret sauce to succeeding in India, rather than owning the large and typically over-valued companies, which are favoured by large global fund managers for liquidity reasons and inability to do on the ground, primary research.
India’s active management industry has performed with distinction relative to their benchmarks over rolling 3-yr periods. Over time this has averaged just over 4% annualized. However, we can see the impact of 2018 and the resulting alpha degradation. Typically, these managers have been highly skilled at finding companies which exhibit compounding earnings growth at an early stage and holding them till they reach the large to mega-caps.
It’s is our view that there are several reasons why local market investors can extract alpha over rolling 3-year periods. These factors include:
- General level of market inefficiency in mid and small caps relative to large cap companies. Given a significant amount of sell-side market participants, India’s top-50 by market cap usually has over 20 plus analyst covering the company. However, in mid and small caps the analyst coverage drops away rapidly, leaving ripe for alpha generated through primary research
- Local knowledge, insights and deciphering of cultural and market specific nuances make local stock selection teams a must. Rather than avoid companies due to lack of knowledge or liquidity, it is better to understand strengths in governance and founder ethos towards minority shareholders as that is where money can be made. In markets like India it is important to monitor related party transactions, valuations of asset sales and insider buys/sells, given significant founder ownership
- Identifying strong free cash flow generating companies which takes the vagaries of accounting out of the analysis. Typically, companies benefiting via market opportunity or industry consolidation can generate strong cash flow, particularly maintenance and regulatory costs are controlled.
Our view is that you should not invest in something you don’t understand well via a passive structure. A strong IP partnership with your active fund manager can really drive a far superior compounded result over the long term – particularly in a market like India. If you think about it, then why would you invest in already over-broked, large companies, that are a poor representation of India's future growth. As an inefficient market outside the top 50, it is a market begging for primary research and price discovery.
Domestic Investor know this very well hence Assets Under Management of domestic ETF's are just 4% of Total Industry despite 100 bps fee differential between active and passive funds.
Thanks for the wire. Topical given the nifty 50 passive index fund just about to launch in Australia and a competitor talking about their own Indian etf with a quality theme likely not far behind. Not too many retail options for focused Indian exposure for those with limited capital just yet.
Ben, the Fidelity India fund is a standout performer available to retail investors