18 The Gloom, Boom & Doom Report November 2010

India at the Tipping PointDr. Jon Thorn, Dan Tennebaum and Mihir ShahIndia Capital ManagementTel: +852 2526 7586; Email: info@indiacapmgt.com; Website: www.indiacapital.com

A COUPLE OF THINGS YOUMAY NOT KNOW ABOUT INDIA

Not long ago, the brightest graduates ofIndia’s elite Indian Institutes ofTechnology (IIT) typically went towork at New York investment banks,Silicon Valley tech companies andglobal consultancies. They went on tohead firms like McKinsey andVodafone, found companies like SunMicrosystems and become seniorexecutives of a range of multinationalcompanies. They were a diverse group,but they had in common that most ofthem made their mark outside of India.

That has changed. The percentageof IIT graduates now staying in Indiaafter they graduate has doubled to anestimated 70% in the face of job offersfrom all over the world. They havestayed in India because they see thegreatest opportunities for themselves athome. Indians already studying in theUS apparently feel the same way, with94% of those polled planning to returnto India.

Let’s look beyond the most highlyeducated to India’s middle class —defined as having more than $10K ofdisposable income. The Indian middleclass is the fastest growing of all theBRIC countries and is expected toequal that of the US by 2020 (SeeFigure 1). There are already as manymiddle class households in the BRICsas in the US or the Eurozone and thistrend does not seem to have nearly runits course.

IS IT SAFE?

This is in broad strokes the basis forIndia’s structural growth story and themain argument for India as aninvestment opportunity. But how hasIndia been affected by the recentglobal recession and how might it farein any other crises perhaps still tocome? Is this not a time for the safetyof a mature economy rather thanchasing the prospect of long termgrowth?

Figure 1 Households With Disposable Income over $10,000(Nominal Terms)

Source: Euromonitor

Sir Laurence Olivier memorablyand terrifyingly asked in the movieMarathon Man, “Is it safe?” Perhapsthis is a relevant question for our ownunnerving times.

The head of the IMF, DominiqueStrauss-Kahn, or ‘DSK’ to his confrère,recently commented that he did notconsider the West ‘safe’ after therecent financial turmoil and that ofthe 30 Million jobs lost since 2007three quarters of those had been lostin the West.

WHAT WILL HAPPEN TO INDIAIF THERE IS A GLOBALRECESSION/DEPRESSION?

So, let’s assume that DSK is not onlyright but positively spinning a bit andthat things get perhaps much worse.Let’s assume that final demand in theWest does not recover for 10 years andthat there is a mid-sized currency war(why not adopt the policy that madeChina so successful?).

So, how have China and India, theworld’s leading high growtheconomies, done in recent recessions?Through the Asian economic crisis,the burst of the dot-com bubble andthe Great Recession, India and China

grew in real dollar terms while theworld economy contracted (Figure 2).

China and India, like most of therest of the world, engaged in fiscalstimulus to help prop up growth —the difference between the two washow much money they spent. As apercentage of GDP, China spent themost of the major economies, severaltimes what India did (Figure 3).

In fact, through the crisis and overthe last five years, India is one of thefew countries to have reduced its debtas a proportion of GDP (Figure 4),leaving it much better prepared forany crises to come.

India needed little fiscal stimulusin part because domestic householdconsumption, the engine of its growthand 58% of GDP, remained strongthrough the downturn and it wasmuch less dependent on exports thanmany of its peers (Figure 5).

Likewise, India’s central bank hasthe standard monetary tools at itsdisposal to deal with a downturn inthe economy — options that havebeen largely exhausted in the West(Figure 6). This is so becausebeginning in 2006 India steadily hikedrates and withdrew liquidity while theUS Federal Reserve did the opposite.

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Figure 2 China + India GDP Growth in Periods of Negative WorldGrowth (Current USD Billion)

Figure 3 Fiscal Stimulus as a Percentage of GDP

Source: IMF World Economic Outlook Database

Source: ICR

Figure 4 Change in Government Debt/GDP for BRICS, Japan, US andUK (2005–2010)

Source: IMF World Economic Outlook Database

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20 The Gloom, Boom & Doom Report November 2010

Figure 6 Indexed US Federal Funds Target Rate vs. India ReverseRepo Rate (2007–2010)

Note: Both rates have been indexed to a value of 10 in January 2007Source: Bloomberg

Figure 5 Export Dependence as a % of GDP (2008)

Source: Edelweiss, Bloomberg, ICR

better’ without another crisis in thenear future. The West will still face adaunting set of structural factors: anaging population, a dramatic increasein debt and unfunded welfareliabilities that will extend debtburdens further.

The national balance sheets anddemography of Asia in general andIndia in particular are far morefavourable. Up to a point this is wellunderstood, but the magnitude andthe duration of the advantage issurprising.

India’s workforce is amongst theyoungest in the world and in thisregards, it stands apart from all othermajor economies. A low dependencyratio, the ratio of those too old andyoung to work to those in theirproductive years, has been the fuel formany Asian growth miracles, mostnotably China’s. While China’sdependency ratio is now increasing,India’s decreases steadily each year andis expected to cross China’s in thenext decade or so. In fact, under theUN’s favourable assumptions, India’sdependency ratio will be better thanChina’s ever was. This isn’t just aboutratios, but scale as well — India willadd more workers than any othercountry in the world over the nextdecade, nearly equalling China’sworkforce by 2020 (Figure 7). India isgetting larger, younger and moreproductive.

With this transition indemographics, comes additionalspending power; that rise in finaldemand that is currently so elusive inthe West. Also, the much talked about‘pyramid’ in the context of the Indianconsumer will be a pyramid no more,come 2025 as the ranks of the middleclass swell (Figure 8).

BANKING ON INDIA

India’s banking system offers a goodexample of these structural factors atwork. A growing population andeconomy results in structural creditgrowth at more than three times therate as the US, while creditpenetration remains very low relativenot only to the US but other emergingmarkets. Importantly, credit quality isvery strong (Figure 9).

When the crisis did hit in the fall of2008, India had room to increaseliquidity by lowering rates withouthaving to resort to the more exoticmethods employed in the US andEurope. As policy rates remain fixednear zero in the US, India has beenraising rates and withdrawing liquiditysince early this year.

India’s improved debt position,domestically focused economy andprudent monetary policy leaves it wellprepared for a future crisis and has notdented growth. In fact DSK’s

International Monetary Fund hasraised its 2010 GDP projections forIndia four times, from 6.4% to 9.7%most recently, as its forecasts attemptto catch up with the reality of India’srapid expansion through the trough ofthe global recession.

QE SUNSHINE WITH WHAT TOFOLLOW?

Let’s take a different scenario in whichQE basically works and the worldeconomy ‘muddles along till it gets

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November 2010 The Gloom, Boom & Doom Report 21

Source: NCAER, UN World Population Prospects, David Bloom, Morgan Stanley, UN, ICR

Figure 7aIndia and China DependencyRatio

Figure 7bPercentage Increase in WorkingPopulation (2010–2020)

Figure 8 India’s Demographic Transition

Source: NCAER, UN World Population Prospects, David Bloom, ICR

Note: UN provides low, medium andhigh population growth estimates. Thethree dependency ratio lines are forthese three different growth scenarios

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22 The Gloom, Boom & Doom Report November 2010

Figure 9 Indian vs. US Banking System

NON-PERFORMING LOANS

CREDIT GROWTH

Source: Bloomberg, Indian Economic Survey 1995, ICR

A lot of the praise for this belongsto India’s Central Bank, the ReserveBank of India (RBI). While the USFederal Reserve was arguably addingfuel to the fire, India’s was keepingprudential pace with the financialinnovation of the last decade. A timeline comparison of the regulatorydecisions taken by the two countries’central banks is quite revealing(Figure 10).

INVESTING TO MAKE MONEY— HOW DO WE DO THATNOW?

It is estimated that 70% of the tradeson the NYSE are now algo/HFT andit needs to be asked if sloggingthrough the search for fundamentalvalue in an emerging market is stillrelevant in this brave new world. Butthe high frequency traders swarmingover and next to the NYSE serversare not a new breed of speculators;they have long been with us. They

are memorably visible in the image ofJesse Livermore, the ‘boy plunger’who profitably short-term traded thetape prices of the ticker machine inthe bucket shop brokers in the 1890s/1900s, but lost money when he triedthe same approach on the NYSE.The bucket shop plunger in effecthad a visible price/small timeadvantage over the exchange traderand traded to that advantage. Hisgains were their losses and of coursethose gains/losses would not existwithout that inefficiency — theycannot be therefore described as partof the zero/sum game of investing asthe advantage is structural. It is a taxon activity.

The more traditional form ofinvesting as practised by WarrenBuffet and others and indeed bySoros, still, is based on a differentassumption than ‘faster than thou’; itis ‘being right’ = stock/sector/trendpicking. If stock picking isproductive, where can it be done to

greatest effect, in the matureeconomies or in emerging marketslike India?

Variance, both from underlyingvalue and from consensus estimates,is an enduring feature of the Indianmarket. For example in the Junequarter’s results, actual earningsgrowth rates for various sectorsdiffered from analyst estimates byanywhere from 9% to –45%(Figure 11).

It is this variance that creates theopportunities for active stock pickingand deep fundamental research of thekind our Fund (the India CapitalFund) performs, as our Fund’searnings continue to outperformthose of the companies in thebenchmark Sensex index (Figure 12)over the last many quarters. Thisvariance in India’s earnings helps toexplain the high degree of variancein its share prices: Correlationsbetween the MSCI index and a broadgroup of individual stocks are far

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November 2010 The Gloom, Boom & Doom Report 23

Figure 10 Timeline of Central Bank Regulations

US FEDERAL RESERVE

Source: Center for Economic Policy and Research, Reserve Bank of India

RESERVE BANK OF INDIA

Figure 11 Variance — Actual vs. Estimated Earnings Growth Rates for IIFL Coverage Universe

Source: IIFL Research

1QFY11 reported PAT growth Actual Estimated % variance

Financials 23% 14% 9%

IT Services 12% 4% 8%

Pharma 28% 21% 7%

Media 53% 49% 4%

Utilities –12% –3% –9%

Auto 18% 28% –10%

Energy 3% 27% –24%

Real Estate –4% 41% –45%

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24 The Gloom, Boom & Doom Report November 2010

Figure 13 Percentage Change in P/E and Earnings for ICF Equal-Weighted BFSI Portfolio (2008–2010)

Source: ICR, Bloomberg

Figure 12 Sensex and ICF YoY Earnings Growth (Q3 2008 – Q2 2010)

Source: Prowess, ICR

lower for India than for a developedcountry like the United States, onereason why an index-replicatingstrategy may leave something to bedesired in India.

Interestingly, stock picking is justas relevant and potentially fruitful ina crisis environment. In 2009, as assetprices suffered the world over, so didthey in India. But what happened tounderlying earnings? Our fund’sinvestments in banking and financialservices provide a good example(Figure 13). Valuations sufferedbetween 2008 and 2009 as P/E ratiosfell in excess of 40%. But in the sameperiod earnings grew by over 20%!

Through most of the ‘financialcrisis’, the health of the financialsector in India was actuallyimproving in the forms of lowerNPLs, growth in advances andincreased margins. As soon as marketfear receded enough to appreciatethat fundamental strength, valuationmultiples began to recover sharply,only they have been applied tomarkedly increased earnings andequity bases that hadn’t suffered thekind of overwhelming dilution as hadmany Western banks, making theIndian financial sector a stand-outshare price performer over the pasteighteen months.

Via the India Capital Fund (ICF),we have invested in India since 1994and have therefore seen many upsand downs and just about everythingelse besides. Most of our investorsalso knew this about Indian banks,and in 2008 and 2009 the ICF hadnet capital inflow — in each of thosetwo, difficult years — with no gates

or other redemption limits.And if the rest of the world

chooses again to re-value the bestIndian companies and banks sharplydown at a rate twice their actual realEPS growth rate, which we had neverseen before in 16 years of doing this…what a great opportunity. But whywould it?

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