National momentum

Market deregulation, political stability and a growing middle class drive demand for everything from motorcycles to financial services, which could help India overtake China as the leading economic powerhouse, writes Anthony Beachey.

“Reforms to the tax system are set to get under way in the next 18 months or so. The government is abolishing a series of state-level taxes, such as excise duty and sales tax, and replacing them with a national VAT system. In this way, they will bring a much greater proportion of the population into the tax system. Currently, trade taking place between companies or individuals in different states can easily avoid incurring any tax. The government is also reducing personal and corporate tax rates, with a view to disincentivising tax avoidance. Independent estimates suggest that as a result of all the above changes, national tax revenues will double two years after the implementation of the new tax code. This in turn should have a positive impact on the fiscal deficit.”

Eliminating the public sector deficit would clearly assist the battle against inflation over the long term. Vazirani argues that the interest rate hikes introduced this year should also help to contain price rises in the short term.

India’s economy looks set to develop on a sustained basis, and in time to supersede China’s growth rates. An obvious question thus arises: how can investors profit from the sub-continent’s ascent?

Gaining exposure to companies selling to India’s consumers is one route. Nitin Rakesh of Motilal Oswal says that increased economic growth has lifted consumption significantly; hence, people no longer have to think in terms of affording merely the basic necessities.

“The boom in consumption has been a major driver of economic growth over the past five years, and we expect this trend to continue over the next 15 to 20 years, a development that provides the biggest opportunity for investors in India.”

The deprived sector of Indian society accounted for 93% of the population in 1985, a figure that had fallen to 54% in 2005, and is expected to be just 22% by 2025. Meanwhile, the number of middle-class Indians will surge from 50m in 2005 to about 583m in 2025. Consequently, the discretionary element of consumer spending could rise from 52% of expenditure in 2005 to 70% in 2025.

Economic growth and the demographic dividend apart, Vazirani has identified a further factor that will propel domestic demand over the next few years:

“The government has launched a national biometric ID card scheme, with the aim of issuing 600m cards in the next two years. Within five years, the entire 1.2 billion population of India will have a card. In our view, this is a major game-changer on a number of fronts.”

According to Vazirani, the authorities estimates that 80% of subsidies fail to reach their target, owing to a combination of bureaucratic inefficiency and corruption. With the roll-out of ID cards, individuals will be able to collect subsidies much as they would social security payments. The central authorities will save significant amounts of money by issuing targeted subsidies, and those most in need of help will stand a much better chance of getting it.

“The increased financial assistance will not only allow people to buy necessities such as rice or wheat, but will put them in a position whereby they can purchase discretionary items such as toiletries. That increased purchasing power will be felt across the market, and we consider it to be of major significance in the future.”

Sonthalia says that the expected boom in consumer spending will benefit several sectors, including: processed foods; alcoholic beverages; two-wheelers and cars; auto finance; airlines and white goods; entertainment, media and telecoms; and education and healthcare.

”Given the low levels of competition in many sectors, this creates enormous potential for profits growth”

“We anticipate that consumption will quadruple over the next 20 years or so,” says Sonthalia. “Given the low levels of competition in many sectors, this creates enormous potential for profits growth.”

“Just three players account for around 85% of the two-wheelers in India, while there are only three players in the organised paints sector. The massive explosion in demand that we foresee will create humongous opportunities for these companies.”

“Hero Honda, for example, the largest two-wheeler motorcycle company and one of the stocks that we own, launched a plant in 2008, with the ability to produce one-and-a-half million units. Yet already its capacity is exhausted, and the company is building another plant much earlier than it expected, to cope with demand.”

The growth in financial services is also mirroring increased incomes and consumption. People that are moving out of poverty are beginning to be able to save, and growing savings will drive demand for financial services such as banking, insurance and stock-broking, according to Sonthalia.

The Gemini MOSt India fund is targeting a third key area. “A flood of new savings, allied to the government’s massive infrastructure spending plans, will fuel huge demand for engineering and construction services, as well as for construction inputs such as cement, steel and capital goods – particularly those related to the power sector,” says Sonthalia.

Turning to the outlook for Indian equities, Avinash Vazirani says: “After the sharp rise in the Indian market in September, we remain cautious about valuations but do not believe that we are in over-extended valuation territory. If the markets consolidate at current levels, they will come into line with what we consider reasonable. We also believe that growth in the October to December quarter will surprise on the upside, due to significantly increased consumption that is being reported across various sectors.”

Sonthalia, meanwhile, expects the Indian stockmarket to double in value over the next five years. Corporate profits growth is a key driver of equity markets. After reaching a high of 7.1% in the fiscal year 2009, the ratio of corporate profits to GDP corrected itself to an estimated 4.7% in fiscal year 2010. Sonthalia argues that this ratio has bottomed out and should hit new highs in the next four to five years, on the back of strong economic growth.