Imagine the beautiful and ornate white marble of the Taj Mahal flooded by muddy river water not just once, but several times over the past few centuries. Yet in 360 years it’s never been flooded even though it was built on the bank of the Yamuna river, which regularly overflows. The ability of this world heritage site to remain dry over the centuries is due in large part to its unique foundation created by chief architect Ustad Ahmad Lahauri. The main architectural challenge was how to develop a foundation that wouldn’t sink during the annual monsoons that swell up the Yamuna river. Lahauri came up with an ingenious system of conduits and drainage pipes encased in mortar. In addition, shafts or “wells” made of ebony wood were sunk into the conduit system to keep it ventilated and dry. A strong foundation was a key criterion in the stability of the Taj Mahal. Similarly, I believe that three key factors are in place that will provide a solid foundation for an enduring bull market in Indian equities.
Why nominal GDP growth eventually translates into corporate earnings growth
According to the IMF’s April 2018 World Economic Outlook, India is now the 6th largest economy in the world with a nominal GDP of $2.6 trillion. Additionally, with the IMF forecasting real GDP growth in 2018 of 7.4% and 7.8% in 2019, it’s also the fastest growing large economy globally. Although nominal GDP growth doesn’t directly translate into stock returns, it is a good proxy for total revenue growth generated by India’s largest publicly listed companies. Additionally, in the long run corporate earnings growth can’t outstrip nominal GDP growth. Thus, it’s a fair assumption that earnings growth can be sustained at 10% (7% real GDP growth + 3% inflation) from a macro perspective. From a micro viewpoint many small and mid-cap companies will grow earnings at much higher rates than 10% for the foreseeable future. That’s why we believe in an active stock-picking approach. However, strong corporate earnings growth is one of the key foundations of the secular bull market in India.
Although inflation bounced off a record low of 1.54% in June 2017 the RBI (Reserve Bank of India) has done an admiral job of controlling inflation. It’s hard to imagine that India is the same economy which was struggling with twin deficits and double-digit inflation a few years ago. Ed Hyman of Crestmont Research calls the impact of inflation on P/E ratios the “Y-curve effect.” In his book, Unexpected Returns, he states: “P/E ratios tend to rise when inflation moves toward price stability, periods of stable, low inflation. When inflation moves away from price stability, either from low inflation toward higher inflation or from low inflation to deflation, P/E ratios tend to decline.” The move towards lower inflation and price stability has resulted in lower interest rates and higher P/E valuation levels for the Indian market.
The Indian rupee has been one of the most stable emerging market currencies over the past few years. The strength in the Rupee has been driven by the decline in inflation and strong foreign portfolio inflows. As a US based investor, the prospect of a stable currency is highly attractive. Strong corporate earnings growth and higher valuation levels will translate into higher total shareholder returns even in US dollar denominated terms.
How a politician is actually making it easier to do business in India
India recently made an astounding jump of 30 places in the World Bank’s Ease of Doing Business 2018 ranking. India is currently ranked 100 among 190 economies that the World Bank rates. That’s an improvement from 130 in 2017. The situation reminds me of the lyrics to Drake’s Fake Love, “I’ve been down so long, it look like up to me.” When you’re starting from such a low base there really is nowhere to go but up. Fortunately, reformist Prime Minister Narendra Modi has been aggressively pushing through market-based reforms over the past three years and doesn’t show any signs of slowing down. The CEO of the World Bank has noticed and was exceptionally laudatory by stating, “in reforms what pays off is persistence, what we are seeing is extraordinary achievement by India.”
Possibly one of Modi’s biggest achievements was the passage of The Goods & Service Tax Act. It was passed on March 29th, 2017 and came into effect on July 1st, 2017. It’s not an exaggeration to state that it has completely revolutionized the Indian taxation system. For the first time in its 70-year post-independence history, there is one taxation regime across the entire country. India has finally become a unified common market. Prior to the implementation of GST, businesses in India faced a byzantine set of taxation rules that varied from state to state. The passage of the GST bill has facilitated trade and commerce across the country.
Modi’s reformist credentials have been bolstered and he’s publicly stated, “we have placed the highest emphasis on Ease of Doing Business.” India is already the fastest growing economy among the G-20. If the economic reforms continue and Modi hits his target of reaching a top 50 ranking, GDP growth could accelerate further. The so called “Hindu” rate of growth is now a relic of India’s socialist centrally planned past.
Why the recent infighting at some of India’s largest corporate boards is a positive sign for minority shareholders
As a global equities analyst, I can say from experience that all emerging markets have corporate governance issues. The main problems revolve around the misappropriation of corporate assets by majority owners, misuse of related party transactions and exorbitant managerial compensation. As a minority shareholder you want to own businesses run by honest and competent management teams with a record of good corporate governance.
India ranked 4th globally in terms of protecting minority investors in the aforementioned Ease of Doing Business Index. This achievement was not fortuitous but by design. India recently carried out an ambitious and exhaustive overhaul of its Companies Act. The result was improved disclosure norms, greater transparency and the mandatory inclusion of independent directors on Boards.
Many commentators have provided the recent in-fighting at Infosys as proof that good corporate governance is still a moving target at even one of India’s largest corporations. In my view, the recent dust-up at Infosys reflects the fact that Boards will no longer kowtow to management teams and will take into account the views of all stakeholders including minority shareholders. Former CEO, Vishal Sikka, was forced out of his position last August due to allegations of wrongdoing related to three acquisitions and an exorbitant severance package given to former CFO Rajiv Bansal. Although the battle against the former CEO was led by Infosys’ co-founders, his resignation was a victory for minority shareholders.
Many academic studies have shown that good corporate governance leads to better shareholder returns. India has better corporate governance than most of its emerging market peers combined with faster growth. This unique combination makes Indian equities attractive for US based investors.
The mid-2017 slide in GDP growth was transitory
Despite the positive reforms being enacted by the Modi government, GDP growth slid to a three year low of 5.7% in 2Q2017. Many economic commentators and members of the opposition party were quick to comment that the slowdown in growth was the beginning of a secular downturn. In my view, the slowdown was the transitory impact from de-stocking ahead of the implementation of GST. The reforms being undertaken will require short-term pain in order to achieve long-term gains in terms of GDP growth. Economic growth subsequently accelerated in the second half of 2017. Additionally, India’s growth story is domestically driven and will not be materially impacted by the recent round of trade wars between the US and China.
In summary, the three critical factors providing the foundation for a secular bull market in India are the following:
• Strong nominal GDP growth and price stability, as measured by consumer inflation, will result in high corporate earnings growth and a higher justified market P/E.
• Prime Minister Narendra Modi has already delivered on his ambitious reform program with the passage of the GST bill. GDP growth will accelerate as India improves in terms of its Ease of Doing Business ranking.
• Good corporate governance improves minority shareholder returns. India is already well ahead of many of its emerging market peers.
Just as the well-designed foundation of the Taj Mahal has allowed it to withstand the waxing and waning of the Yamuna river over centuries, the critical foundations for a secular bull market in Indian equities is also in place.
(Ankur Shah is a graduate of Harvard Business School and currently runs Ashva Capital Management LLC, an India-focused investment fund targeted at the U.S. Shah has been interviewed numerous times by ETNOW and his articles have been published on various leading financial websites.)