The Indian economy is powering ahead and, despite valuations looking stretched, is set to become one of the largest economies in the world, offering both domestic and overseas investors some promising opportunities
In the aftermath of the bursting of the dotcom bubble, we are all, as investors, perhaps a little more sensitive to the possibility that bullishness can easily shade into - in Alan Greenspan's celebrated phrase - "irrational exuberance". Attuned as we are to the idea that hubris often keeps close company with rising asset prices, we are entitled to feel nervous when we read that at the very moment the recent monsoon was inundating the streets of Mumbai, killing hundreds on the streets of India's financial capital, share prices were continuing to rise relentlessly along with the waters, pushing the Sensex index to new all-time highs.
But are these gains - the Indian market has risen by 171% over the past three years, while the emerging markets asset class as a whole has added 100% - simply a symptom of a new gold rush mentality, a different facet of the same irrational exuberance that we saw during the roaring 1990s? Or do they instead reflect a calmer, rational assessment by the market of the vast profits to be derived from India's rapid economic ascent, an ascent that seems unlikely to end until it stands alongside China in the ranks of the world's foremost economies?
Cause for concern
Certainly there are reasons to be wary in the short-term, with signs that a speculative bubble may just be starting to inflate. Firstly, recent months have seen massive cash flows into the Indian stock market from foreign investors, particularly from Japanese retail investors. Aggregate foreign inflows into the Indian market this year have amounted to over $6.5bn, the highest level of inflows the Indian market has received in the first seven months of any year. These inflows, familiar from the dash for TMT stocks in the 1990s, provide a classic contrarian "sell" signal, as do the recent launches of several India-themed investment funds.
Secondly, and perhaps more importantly, valuations on the Indian market have begun to look stretched in recent months, particularly when they are held up against the modest multiples at which most emerging markets trade.
The Indian market is currently trading on a prospective price/earnings ratio of around 14 times 2006 earnings, and around 12 times 2007 earnings. These figures are broadly comparable to developed markets, lying between the P/E ratios for the US (16 times 2006 earnings) and the UK (13 times 2006 earnings) markets, which are traditionally awarded a valuation premium due to the political and economic stability they afford to investors. Furthermore, a P/E ratio of 14 times is towards the high end of the Indian market's historic valuation range.
In part, these relatively full valuations are just another facet of the carry trade that has fuelled gains across emerging markets over the past two years, as low interest rates and bond yields around the world have created a pool of "cheap money" seeking yield. There is therefore a risk that, should rates in the US and other developed economies rise more quickly than investors currently anticipate, these flows could reverse, producing a sharp correction. While this risk is not confined to the Indian market, it does suggest that any forays made into the market at present must be undertaken cautiously, with careful stock selection and close scrutiny of valuation fundamentals; at current market levels, mistakes might prove expensive.
Therefore, short-term, tactical considerations might tend to suggest that now is not the right time to plunge into the Indian market. However, this tactical caution must be balanced against the considerable weight of evidence indicating that the long-term, strategic case for investment in India is compelling.
The potential for prolonged and rapid growth in the Indian economy, which has been for too long a "sleeping elephant", is remarkable. An influential paper written by Goldman Sachs on the potential of the so-called BRICs economies (Brazil, Russia, India and China) back in 2003 made some startling forecasts and helped to foster much of the current debate about, and interest in, the Indian market. One of the report's central projections was that, given current economic growth rates and demographic trends, the Indian economy will become the world's third-largest, behind only the US and China, and ahead of current G6 countries such as the UK, Germany and Japan by the mid 2030s.
Furthermore, alone among both the BRICs nations and the G6 countries, the report identified India as possessing the potential to enjoy economic growth at a sustained level of over 5% for the next 30 years, and for growth rates to remain close to 5% as late as 2050, given its current modest levels of development and demographic trends. So far, at least, these projections are being borne out by economic data - the Indian economy grew by some 6.9% in the year to end of March and appears on course to emulate that performance in the coming year.
The net result of this rapid growth is that, by 2050, India will have raised the per capita income of its rapidly growing population by 35 times in dollar terms. The opportunities this presents to Indian-domiciled businesses, to companies operating in the Indian market and, by extension, to equity investors, are obvious. The growth potential of Indian companies is also apparent from the recent rapid revenue growth they have enjoyed; until the second quarter of this year, which saw something of a slowdown with revenue growth of "only" 18.5%, BSE 200 companies have been reporting revenue growth of between 30% and 40% for several quarters.
For investors, the challenge will be how to harness this growth within their portfolios most effectively while minimising the risk that accompanies investing in an economy that is likely to see a degree of creative destruction in the next few years. One investment possibility is to look for companies domiciled outside India but which are geared into the country's rapid economic expansion and, in particular, are exposed to the rapid emergence of a middle class, which is projected to number some 160 million people by 2010.
For example, one approach might be to invest in South Africa's gold-mining industry, which should profit from India's ongoing love affair with gold - the country accounts for around 18% of global demand - and this love affair can only blossom along with the country's increasing wealth and growing population.
The middle class of India should also drive demand for retail banking products, for consumer goods and for mobile telephones, although careful analysis of political trends is required to determine whether it will be domestic players or overseas companies that will benefit. Furthermore, although there has been an encouraging degree of liberalisation in recent years, India still retains some of its ingrained protectionist instincts: there remain significant limitations on foreign ownership across a range of industries.
Political issues are a concern for investors in emerging markets, to a degree, which is now alien in most developed economies, and in this respect India is no different. The market dropped 17% on the day of the unexpected defeat of the BJP last year, and the business of keeping its coalition partners happy appears to be hampering the pace of the governing Congress Party's current reform programme. While the dominance of the state in so many sectors of the economy is, in many ways, unhelpful, it does also present opportunities for the long-term investor. Reform will bring unparalleled opportunities for both domestic and overseas businesses in the coming years as the vast Indian state is relentlessly rolled back and state assets privatised. This should not only broaden the market but also improve liquidity and provide valuation support by encouraging domestic investors (the emerging middle class already mentioned) to participate in the market.
In conclusion, although valuations for the Indian market as a whole may be high, rigorous analysis can still uncover reasonably valued, good quality companies with the potential to deliver growth at a rate that puts many Western companies firmly in the shade. Investors who ignore Asia's sleeping elephant do so at their peril.
The Indian market has risen by 171% over the past three years, while the emerging markets asset class as a whole has added 100%.
The Indian economy will become the world's third-largest, behind only the US and China, by the mid 2030s.
Reform will bring unparalleled opportunities for both domestic and overseas businesses as the vast Indian state becomes privatised.
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Thesis Research and Consultancy Service (TRACS)