Investors should look to take advantage of any short-term market volatility in India as the market is in a “sweet spot” over the medium and long term, according to Neptune Investment Management’s Kunal Desai.
The manager of the five FE Crown-rated, £107m Neptune India fund said both on a macroeconomic level and from a corporate earnings perspective the market looks set to benefit from long-term structural drivers.
Yet with reforms from the government – such as demonetisation and the goods and services tax (GST) – coming into effect, earnings may be affected in the short-term, and any falls in the market should be seen as buying opportunities.
“In the last three or four years we have had a lot of structural change led by the government and the central bank and I think where we are today is a very interesting place for the market,” the manager said.
“India is currently under transition: if you are an optimist on India then the next 10-to-15 years could be remarkable for this market really driven by an overriding ambition from the government and the central bank to digitise the economy.”
Performance of indices over 2yrs
Source: FE Analytics
Over the last two years, the MSCI India has underperformed the MSCI Emerging Markets index by 1.89 percentage points, but returns have been strong.
There are several catalysts that have dictated this performance, including a change in central bank governor and a change in government.
As well as this, India has benefited from the collapse in the oil price and seen earnings begin to accelerate. More recently the reform agenda from the government has begun to kick into motion, Desai noted, giving investors reasons to be optimistic.
On a macroeconomic level, the Neptune manager said India is becoming a perceived ‘safe haven’ from an emerging market context during periods of difficulty.
“India has moved from a current account deficit to a sustainable surplus,” Desai noted.
“When you think of the firepower or ‘war chest’ of any central banks across the world it is the amount of FX reserves it has. That is what allows it to weather bouts of volatility and India’s is touching all-time highs.”
Therefore, while the global monetary policy appears to be changing, moving into an era of higher yields and a stronger dollar which has classically been bad for emerging markets, this transformation should allow India to weather some of these outside vulnerabilities, he added.
As well as this, in a world of potentially rising interest rates, India is one of those few markets where we have seen two percentage points of interest rate cuts in the last couple of years, which should lead to more borrowing and lower costs of capital.
Whilst the macroeconomics have been important, it has taken a backseat in recent years to the reform agenda being pursued by prime minister Narendra Modi.
“Reform which has become this really important phrase for all markets over the last few years and there is good reason for that,” Desai said.
“In the days of easier liquidity, quantitative easing and ETF money coming in, emerging markets didn’t have to work too hard for their growth – it was gifted to them through easy monetary conditions – but that has changed.
“What happens now is that emerging markets will need to work far harder for their growth and an array of reforms that are now taking place in India.”
Recently there have been concerns that the much-anticipated GST reform has taken a long time to come through, but the manager said now it has been passed there should be traction.
“GST, which is the goods and services tax bill, essentially creates one VAT tax rate for India across its 29 states and that has been pushed through,” he noted.
“India has got busy from a reform perspective and is very aggressive in trying to generate job creation and GDP growth. This is a way you get growth.”
However, this may cause some company earnings expectations to be reduced in the short term as they adjust to the new tax rate.
Looking to March 2018, the market has priced-in year-on-year earnings growth of 14 per cent, but with reforms set to come through over the next two quarters this could well be revised down.
“It will be interesting to see how the market responds to this quarter. I expect it to be a weak quarter for earnings and it will be interesting to see how that plays out in terms of share price,” the manager said.
“I believe if you do get a correction in this market – be it 5, 10 or 15 per cent – the reasons for that will be very positive.”
And over the longer term he argued that corporate earnings are in the “sweet spot” thanks to a combination of factors that rarely come together at the same time.
“The first thing to think about is manufacturing utilisation: how much stuff is being made in India and how much is being used. In 2004 utilisation was 75 per cent and it ramped up to 86 per cent when the emerging markets were on fire,” Desai said.
“We then had the financial crisis and then since 2010 it has drifted down from 80 per cent to 72 per cent last year and 73 per cent this year. So excess capacity exists.”
The second is an uplift in GDP and therefore demand, which the International Monetary Fund (IMF) forecasts to rise 11-to-12 per cent in the next four or five years.
The manager said: “If you are a company sitting on 73 per cent utilisation and incremental demand is now coming into your business this essentially goes straight into your bottom line in terms of revenues, rising margins and essential positive operating leverage is coming in.
“For us as investors that is great. You see earnings reflect, companies being far more positive, a renewed investment cycle take hold.”
The final point is a lack of capex growth, which Desai said is the third factor that markets rarely experience but is key for the long-term success of companies in India.
“In 2007, companies were expanding capacity very quickly but what we have seen since 2014 is that drift down,” he noted.
“Essentially what has happened is companies have had their fingers burnt in the last cycle and are very cautious now about putting that money into capex and expanding that capacity.
“What we are seeing is returns picking up as earnings are reflecting positively but also invested capital is still very low – companies are showing balance sheet restraint – which sets the scene for us as investors as a really interesting sweet spot with return on equity stepped up and that is what will drive the next investment cycle.”
Desai has run the Neptune India fund since 2012, during which time it has outperformed the wider MSCI India market by 34.7 percentage points.
Performance of fun vs benchmark since manager start
Source: FE Analytics
The fund has an overweight to small- and medium-sized companies and is currently 28.4 per cent weighted to financials with 16.2 per cent in consumer discretionary firms.
It has a clean ongoing charges figure (OCF) of 1.18 per cent.