When investors talk about innovation they tend to mean the latest Fintech development or electric car.
While India is seeing this kind of innovation with the growth of 4G and smart phones, perhaps more important for its long-term strength, says Sandeep Kothari, portfolio adviser for the Fidelity Funds – India Focus Fund, is the change in the governance of its companies and the reform of its institutions.
This is creating a richer, deeper market as more entrepreneurs realise the importance a healthy relationship with the capital markets to scale up their businesses.
The headline reforms under Modi have been the demonetisation of bank notes and the introduction of a uniform indirect tax across the country (the Goods and Services Tax or GST).
Bankruptcy code is major reform
These have been useful for the economy as a whole, but there have been other reforms that have been as important for the corporate sector.
Kothari says: “The introduction of a bankruptcy code has been a major reform. Previously, entrepreneurs were funded by banks as in the case of a default for any reason, banks had to take the haircut while entrepreneurs did not lose equity/control of the company.
“With the new bankruptcy law, the entrepreneur will have to give up the business to the highest bidder for equity. This will go a long way in improving the credit culture and capital allocation in the country.”
He believes these and other reforms are increasingly reflect in the strength of India’s companies: “The banking system is just coming out of a bad loan cycle and the leverage in the system is low,” he adds. “Private sector capex is yet to recover but the consumption side of story is doing well.”
Uplift in corporate governance practices
The impact of government reform has been matched by a significant improvement in corporate governance practices and awareness about minority shareholder interests.
There has been a notable evolution of management from family-owned to more professionally-run companies, which has led to increased scalability in Indian businesses. Kothari points to companies such as HDFC Bank, Hindustan Unilever, Wipro and ITC as examples of well-run companies.
The problem with India has long been that this strength is widely reflected in stock market valuations, which tend to outstrip their emerging market peers. Does Kothari believe Indian equities represent good value?
“Indian equities have performed well over the last five years with MSCI India Index generating 14% annualised growth in USD terms” he says.
“As a result, valuations are at the higher end versus long term average. However, at the stock level there are wide disparities in terms of valuations, as well as earnings prospects and balance sheet quality. I continue to believe that India is a stock picker’s market and going forward, a fundamental-based bottom up approach will be even more important.”
Overweight in financial services and consumer goods
The Fidelity fund focuses on identifying opportunities in high quality growth stocks, which have higher returns on equity, stronger free cash flow and lower debt.
Its approach has put it in the top quartile of the offshore FO Equities – India sector over three years. It has also defended capital better that many of its peers during the recent rout in Indian equities, sitting 5th out of 40 funds in the sector over one year. It has fallen 8.5%, compared to falls of over 20% for some of its peers.
The fund is currently overweight in areas such as financial services and consumer goods companies such as HDFC Bank and India’s largest footwear retailer Bata India, which have greater scope to grow.
Kothari adds: “We are also finding opportunities in sectors that benefit from a revival of the capex cycle, such as Larsen & Toubro, a high-quality engineering and construction company with strong project execution track record.
“We also hold a position in staffing firm TeamLease Services as it benefits from structural growth amid changing labour laws and the ongoing formalisation of the Indian economy.”
There are concerns in the short-term, says Kothari. With an election looming, further structural reform looks unlikely for the time being. At the same time, while India has relatively low external debt – 20.5% of GDP, with large forex reserves to act as a cushion – and relatively low export exposure to China and the US, it cannot be completely immune to the difficulties in global trade, rising oil prices and a high dollar.
He says: “India runs a trade deficit and it is one of the largest importers of oil. A rise in oil prices and/or depreciation in INR versus the US dollar adversely impacts its trade balance and creates inflationary pressures in the economy.
“Also, the Indian economy is dependent on foreign capital, fund flows into the country could reverse if trade wars lead to higher inflation in the US, rise in US interest rates and resultant strengthening of the dollar.”
However, he believes the long-term case for India remains sound. The country has a large domestic economy with a growing pool of young, well-educated workers, increasing penetration of goods and services, growing urbanisation and efficiency gains due to infrastructure development.
More importantly, for the time being, it remains under the radar of the US administration. This alone makes it a relatively safe haven as emerging market turmoil continues.