A transformational journey: four positive drivers for Indian equities

Indian equities have outperformed their Asian (ex-Japan) and emerging-market (EM) peers over the past two years.¹ We expect this trend to continue in 2019 despite the current global economic backdrop, which is defined by trade tensions between the United States and China and slowing growth.

In our view, India’s outperformance is driven by two long-term factors:

1. The country offers a unique bottom-up, domestic demand-driven story characterized by relatively low export dependency, favorable demographics, and a large services segment.
2. Recent reforms undertaken to formalize the economy will help unlock its potential in the long run.
   

Of the two, we believe the latter will play a more significant role in driving sustainable economic growth.

India has implemented several key structural reforms in the last 18 months—for example, overhauling its indirect tax system and revising the legal framework for the resolution of bad assets—with the goal of formalizing its economy. 

We believe the Indian economy could grow 2.5 times over the next decade on the back of these policies. Although economic growth in the country moderated recently due to global financial tightening as reforms are implemented, they’ve laid the foundation for sustainable growth.

From an investment perspective, we see four themes emerging: formalization, fiscal stability, financialization, and reforms on banking asset quality. 

With the introduction of the Goods and Services Tax (GST), which replaces the country’s numerous federal and state taxes, companies in India are now operating on an almost level playing field from a regulatory perspective: Firms that didn’t have to pay taxes previously due to various regulatory loopholes are now required to do so. Indeed, the organized corporate sector now has an opportunity to capture market share as many smaller and informal businesses press on with their restructuring efforts to comply with government regulations and taxes. This transformation is causing value to migrate from the informal sector to the formal sector—a process that we believe has just begun.²

In the next several years, we expect tax-compliant companies to find opportunities to grow their market share in fragmented sectors, particularly those with a large number of informal players; we believe the retail sector will be a prime beneficiary. Additionally, we see structural long-term growth opportunities for organized retail players—which had a market share of just 9% in 2016³—which we believe will continue with its upward trajectory.

As the government’s efforts to formalize India’s economy continue, we expect its tax collection revenue to grow—albeit with a lag—as the tax base expands. This will enable the government to gradually increase fiscal spending further and build more infrastructure assets in rural areas without risking a larger fiscal deficit. Indeed, government projects aimed at the building of assets pertaining to rural electrification, road connectivity, and better sanitation have seen substantial investments in the last three years despite a decline in the fiscal deficit.⁴ In the long term, these investments should ultimately

benefit the economy as productivity rises. We’ve already seen the positive impact the increased investment has had—for instance, sales of electrical consumer durables have accelerated, a development we find very encouraging. In our view, as the trend strengthens and takes hold, it could represent a structural opportunity, particularly for companies with the appropriate manufacturing and distribution footprint. 

As economic formalization deepens and transactions migrate from cash to formal financial channels,⁵ the level of financial savings should grow. Financial savings increased from 52% of total household savings in fiscal year (FY) 2014 to 61% in FY2017.⁶ Some of those financial savings are flowing into the banking system, which has seen many customers who are new to banking. This, in turn, is expanding the deposit market. Meanwhile, higher financial savings will also likely broaden credit availability and lead to greater aspirational consumption.

Democratization of credit availability

The transition toward a formal economy has led to profound changes in the availability of credit. As households and small businesses conduct more transactions on digital platforms, their digital footprints grow. This could be very useful to lenders, who could use the relevant data to promote relevant products to existing customers and reduce loan origination costs, as well as expenses associated with monitoring and debt collection. This data can also drive financial inclusion by making credit available to customers who previously didn’t have access. According to our estimates, total outstanding retail credit in India totaled US$478 billion as of March 2018. We believe this could double to roughly US$1 trillion over the next five years should the existing trend continue.⁷ Recent developments have been encouraging: Overall loan growth in the country grew at a pace of 8% CAGR (compound annual growth rate) between FY2014 and FY2018. During that period, retail credit grew at twice that rate, at 16% CAGR. Interestingly, within that segment, private banks,⁸ nonbanking financial companies, and small finance banks grew their loan book at 20% CAGR during the same timeframe.⁹ We believe retail lending activities at private banks and small finance banks are poised to accelerate.

Based on that analysis, we think private banks with strong liability-gathering franchises will do well, as will innovative small finance banks that have adapted their business models to serve their customers in a faster and cheaper manner, therefore using the new digital footprint to expand their market share.

Aspirational consumption

Millions are gaining access to better infrastructure and assets such as energy, roads, water, and sanitation facilities. We believe improved infrastructure will play an important role in deepening the process of economic formalization; over time, these assets should help boost productivity and income. Crucially, formalization and digitization are widening the availability of credit. Given that the level of credit and aspirational consumption remains quite low in India, we foresee many years of consumer driven-demand growth in this area.

Specifically, we see substantial opportunities in the passenger car segment, which has a very low comparative penetration level. In our view, companies with wide distribution networks enabling them to capture rising demand from lower-tier cities, as well as suburban and rural India, are likely to do well.

The introduction of the Insolvency and Bankruptcy Code, 2016 (IBC), has led to notable changes in the banking system, speeding up the recognition, recovery, and resolution process of bad assets. Before the IBC was implemented, the Indian banking system lacked the legal framework to deal with corporate insolvency quickly, meaning that capital could be locked in nonperforming assets for years as costly and lengthy legal processes unfolded. The IBC has changed that; this is evident from the large recoveries made by the banking system in the last two years. We expect a fall in credit costs for large banks in the future, which should coincide with a pickup in loan growth as balance sheets are repaired. For this reason, we expect large private banks with corporate exposure to do well.

In our view, structural reforms introduced in the last few years have set India on a transformational journey, which should propel the economy forward. As the process of formalization of the economy takes hold, credit will become more widely available, empowering the country’s emerging consumers. We believe these factors will have a very positive effect on India’s equity market.

From a valuation perspective, Indian equities may appear richly valued—as of this writing, they’re trading at 17.2 times earnings, which is about 18% higher than its 10-year median.¹⁰ However, we believe the valuation is reasonable:

• Earnings growth is expected to pick up. Adjusted operating profit growth for MSCI India companies in each of the last three quarters has been greater than 15%.¹⁰
• The rising share of domestic inflows can help insulate the market against volatile foreign flows.

We believe the market could continue to receive some support on the policy front: Lower oil and food prices have put a lid on inflation, creating room for the Reserve Bank of India (RBI) to loosen its monetary policy—the RBI has already started to provide liquidity through bond purchases and cut interest rates in February 2019. The government, in its 2019 interim union budget, has augmented income of marginal farmers through a targeted cash transfer program and for the middle class through income-tax cuts.

There are, however, two potential risks to our investment thesis in 2019. The first relates to a potential rise in oil prices. India is a large net importer of crude, and sustained higher crude prices (above US$75/ barrel) could put pressure on the country’s external position and corporate bottom lines. The second risk is political: India will hold central government elections in the second quarter of the year. Around election time, rising political rhetoric could lead to short-term volatility. While it’s too early to predict the outcome of the election, investors should take heart from the fact that India has maintained policy continuity during past changes in governments. Barring a huge surprise, we believe the election won’t derail India’s long-term growth trajectory.

1 Bloomberg, January 2019. 2 For more discussion of the benefits to workers and the broader economy as a result of formalization, please see this blog post, “Moving from informal to formal sector and what it means for policy makers,” World Bank, September 20, 2016. 3 Avenue Supermarts Draft Red Herring Prospectus (DRHP), Credit Suisse estimates, August 2018. 4 World Bank, Kotak Institutional Equities, August 2018. 5 For a detailed discussion of formal and informal financial sectors, please refer to this explainer, published by the Global Development Research Center. 6 CSO, Ambit Capital, December 2018. 7 Manulife Asset Management, February 2019. 8 Private banks refer to banks where private investors own 51% or more of total shares. 9 Company Filings, RBI, MFIN, IIFL Research, July 2018. 10 Bloomberg, as of December 31, 2018.