Evolution or Revolution in India

Equity markets are always in a state of change reflecting the evolution of the economy, corporate profitability shifts and business dynamics. In some economies, particularly emerging markets, this state of change is significantly stronger given the influence of Government policy and capital flows. At certain points, it becomes more like a revolution than an evolution, depending on the degree of disruption, reform and cultural change.

With respect to India over the last five years, we have seen a reformist environment since the party lead by Prime Minister Narendra Modi (the BJP) came into power. Apart from economic, regulatory and market reforms, the economy was already dealing with a troubled banking environment (due to non-performing loans, a leftover from the last business cycle of 2006-2010). This spilled over to the non-bank lenders, who had played a role in India’s increasing financialisation, when a significant player defaulted in 2018 leaving significant fear about contagion and illiquidity in the financial system.

The Modi Government, Reserve Bank of India and SEBI (regulator) are also tightening the norms regarding governance and compliance. This is increasing the accountability of companies, their directors and business practices. We have witnessed in the past few years significant auditor and director resignations, management changes and scrutiny on promoter (founders) cross holdings and pledges taken against stock. The Central Bank has also tightened the noose of monitoring of banks and non-bank financial companies, whilst the Regulator has asked for a separation between the Chairman and Managing Director roles. 

Through our interactions with company management and our team and partners on the ground, we have witnessed significant revolutionary changes to the way businesses operate in India. Previously small and medium sized businesses were thriving on India being a “localised” market where state and border taxes imposed a penalty on companies operating across India relative to those who were in neighbourhood locations. With the advent of GST, this has changed the dynamic in favour of larger businesses with strong economics and scale, who are now able to take market share from those thriving from localised markets who lack a compliance framework and have previously operated businesses within a non-tax-paying culture. We think the changes afoot in India are more a revolution than an evolution and will dramatically change the landscape going forward.

This creates an interesting environment for stock picking. There is no doubt that some of the changes being made today will lead to a better and more efficient India over the next decade. Today corporate profit to GDP is at a cyclical low at present (from a 20-year average of 4.3%).

In the US, that ratio is closer to 10%! Corporate profits in the US are growing at faster than GDP, largely driven by cost-out despite weak revenue growth. In India however, this ratio is one of the lowest of major markets at present.

Over the next 5 years this ratio in India should increase towards its recent cyclical peak (2008) of 7.8%. India’s high logistics costs to GDP of 14% is likely to drop substantially with significant new infrastructure, a national tax and greater scale for pan-India businesses. Additionally, the Government’s proposed infrastructure pipeline of A$2tn over the next five years will bring with it a significant productivity loop as illustrated below

The Government of India has set itself a target of being a US$5 trillion economy by 2025. If it was to achieve this target, it would need to grow its nominal GDP by around 11-12% per annum (or around 7-8% real GDP assuming 3-4% inflation) over the next five years. If that target was achieved on a higher profitability through efficiency, then we are talking about a tripling of corporate profits over 5 years! Far-fetched it may seem however, doubling is conceivable.

It can be expected that the winners in this scenario will be companies able to thrive through an economic moat, significant scale and distribution strength through technology (need to invest to keep pace and grow faster). So how will the Index change from here? – less Government owned enterprises. Less companies earning less than their WACC and more weight to compounding growers. The Index is likely to evolve towards a greater component of consumption and infrastructure.

Equities

History doesn’t repeat itself in India

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For example, the IT Industry didn’t exist in 1995 and within 10 years had become one of India’s comparative advantages. On the same note, Financials grew from 10% at the turn of the century to over 40% now – typical of an increasing credit culture and financialisation. We expect Infrastructure (Industrials), Consumption and Healthcare will all add in significance over the next decade.

Whether its revolution or evolution in India – the ecosystem is changing and requires an in-depth understanding of India's government, corporate and consumption culture to succeed, rather than investment strategies, ETF’s or indices that apply a backward-looking lens to build portfolios.