313. Investing in India’s future: manufacturing, digitalisation, and market valuations

23 May 2024 (pre-recorded 17 May 2024)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. In this episode we discuss the implications of Prime Minister Modi’s potential third term on India equities and the future prospects for investing in India’s dynamic market.

I’m Staci West, and today I’m joined by Mithran Sudhir, client portfolio manager of the Goldman Sachs India Equity Portfolio fund. Thanks for joining me today.

Mithran Sudhir (MS): Thanks Staci, pleasure to be with you.

[INTERVIEW]

SW: Now, the news recently seems to point towards Prime Minister Modi securing a third five-year term. So, apart from stability and economic policy, what does this election mean for Indian equities over the next, say, five years?

MS: Sure. I’m going to preface my comments with the fact that we aren’t political analysts, but clearly we do have a base case and our base case is that the status quo that we’ve seen for the last 10 years continues. Essentially you have a single party majority under the BJP [Bharatiya Janata Party], which is, I think, what most market participants have come around to. Obviously any deviations from that could result in some kind of market moves, either on the upside or on the downside.

If you end up in a scenario where there’s potentially policy paralysis where you’ve got a hodgepodge coalition government, I think that could result in momentum potentially slowing down and then obviously the multiple could correct in that scenario. But again, let’s not lose sight of the fact that Indian corporates have delivered double-digit earnings growth over 30 years, annualised, irrespective of which government has been in power. So, I think, again, I don’t want to attach too much importance to the politics, but clearly our base case scenario and overwhelming majority of market participants expect this continuity of reformist government which I think has served investors and the broader populace quite well for the last decade.

SW: And part of those reforms has been the ‘Make In India’ programme. So, maybe you could just tell us a little bit more about that and what does that mean for foreign investment?

MS: Sure, I agree, I think it’s been a huge change in the way India operates, to be honest. If you think about it, India’s historically has quite strong competence on the services side of exports, but it’s clearly under-delivered on the manufacturing side historically. We’re now seeing a concerted effort in order to enhance the manufacturing base within the country. I think just if I were to take a step back and look at specific reforms that encourage manufacturing, it would be things like the implementation of a nationwide goods and services tax, the streamlining of labour laws, significant corporate tax cuts that have been passed in the last few years, enacting a strong bankruptcy code. All of these have improved ways of doing business in India.

On top of this, now, the government’s put in place production linked incentives – or the PLI scheme as it’s called – within certain industries aimed at localising production. Think about places like smartphones where it’s already quite successful and I’m sure everyone’s seen the stats around Apple manufacturing, something like 10% of iPhones [are made] in India every year now compared to let’s say three or four years ago when really it was non-existent. The ambition for growth of that production from India is also quite significant. And the whole supply chain has now come in; a lot of the assembly work has now come to India, but you still need the components coming in from outside. That’s the next leg of the journey where you start localising more of the value add in the country. This is expanding into semiconductors where you have new fads that are being put out, consumer electronics, automobiles, generic drugs are all other categories for which production linked incentives are eligible. So, I think it really is a broad push for manufacturing that’s playing out within the country.

Crucially, it happens at a time when multinationals have actively tried to now diversify out of this reliance that they had historically developed on China. I think moving to this ‘China Plus One’ sourcing model has clearly meant that this take up for Indian incentives and push for manufacturing has been quite strong.

Obviously, the benefit for the economy is manifold: you could see job creation pick up, you could see productivity gains coming through, moving percentage of population in rural areas within agriculture into manufacturing and higher value-add. You will also see other benefits like the current account deficit for the country narrows because you’re not spending as much money importing smartphones. If anything, you move to a net export kind of category. And similarly, the currency could have positive linkage with this reduction in the import bill.

SW: And do these types of initiatives then offer more opportunities for you in terms of stock picking in some of these areas that you mentioned of manufacturing or infrastructure, semiconductors, all of those sectors that you mentioned. Do you see more opportunities now for the portfolio?

MS: Yep, of course, I think that’s the beauty of the Indian market. Unlike some other emerging markets where there’s a slight delinking between the economic opportunity and the stock markets, I think India has historically done a fairly decent job [and] I think the stock market is actually quite representative of the opportunity set. Which again, I think if I were to address your question head on, on where are we seeing more opportunities, it really is things like consumer discretionary is a great place where a lot of this hard manufacturing in the form of autos or in the form of auto ancillaries or indeed, maybe more broadly on some of the other reforms I’m sure we’ll talk about, the consumer internet complex et cetera, is really quite interesting.

Industrials are another complex, the infrastructure boom that’s playing out in the country as well as obviously the push towards manufacturing. We’re seeing a number of smaller cap names within the industrial space show up as particularly interesting candidates – and you’re seeing that in the IPO market as well compared to a few years ago. But also I think speciality chemicals within the material space. Metals and mining typically is a segment where we’ve struggled to find great ideas. But then when you look at the speciality chemicals, again, the ‘China Plus One’ sourcing is making things quite interesting and the levelling of playing field in that market is really quite, quite exceptional.

SW: And there has been some fears that the Indian stock market is overvalued. So, what’s your view on this? How do you see that playing out?

MS: Sure, all good things come at a price. I think it’s hard to argue that the Indian market is cheap, but clearly there are good reasons, like it’s always traded at a premium to broader emerging markets and we think it’s warranted, given India is a stronger for longer growth asset class; it has structurally higher returns and equity than other parts of EM, frankly, most other parts of the world. It has lower state ownership compared to other emerging markets as well as better sectoral diversification versus other emerging markets. So, to me, I think India’s premium over emerging markets is certainly well warranted.

I think what we need to address is the fact that India currently trades at a premium to its own history. And I think on that front, the fact that the market’s currently trading at about 20 times one year forward multiple versus its 10 year average of about 18 and a half times, I think that’s the range of premium we’re talking about, a high single-digit kind of premium to history, which really seems quite reasonable given we’re talking about a market which is delivering in the high teens level of earnings growth and frankly, has delivered that for the last three to four years.

So, I would argue that for considerably above historical average earnings growth and considerably above the global and emerging market average on a sustainable basis, and the fact that it’s not a rebound story, but one that’s well-entrenched growth that’s playing out, you can have higher conviction that next year India grows at similar levels versus some of the other markets which are just aggressively rebounding on a one year basis before they’ll settle down to a more modest, more moderate level of growth. So, to me, I think given all of these aspects, we still feel fairly confident.

Again, the final point within that is the fact that if you had entered this market at similar valuation level and held on till date, essentially you would’ve seen double-digit market returns in all of those scenarios because the multiple has canceled itself out and you’ve had double-digit compounded annual earnings growth. I think that’s the beauty of the Indian market and I think that that’s really what you’re buying with this valuation entry point.

SW: Well it certainly is a growth story, isn’t it? And we’ve spoken in the the past about some of these longer-term trends that are fuelling this. So we’ve talked about the growing middle classes, internet penetration, et cetera, and one of the things that I noticed looking at your factsheet was that you have about a quarter in financials at the moment. So, is that part of a particular trend or the valuation story, what’s happening there?

MS: Sure, it’s definitely a high conviction idea. Frankly, it has been for a long time for our portfolios. Essentially, maybe I’ll break it down to the banking and the non-banking side of things. We generally favour private sector banks. We are structurally underweight state-owned banks and I think that’s a trend that continues. Banking is at a fairly interesting point because you’re seeing strong asset quality, housing affordability is improving, the CapEx cycle domestically is kind of clearly picking up. And as we’re seeing broader interest rate pressures outside the country as well in the West begin to subside, you should see borrowing costs ease and I think the uptake for credit will continue to pick up. It’s still a slightly under-penetrated segment, so there is a long way for growth and private sector banks continue to gain market share of their state-owned peers. So I think for us, this is a long-term and a growth segment for us.

I’d say the second complex is clearly on the non-banking side of things. This is a segment that has really boomed in recent years. You think about just under-penetrated segments like insurance, stock broking, asset and wealth management, stock exchanges, SME lending or the broader kind of FinTech complex with a number of these changes that are happening with online payments and ubiquity of mobile phones and mobile transactions. These are really segments where you’re seeing market leaders emerge and come into the public markets for the first time. These are mostly smaller cap names and I think that abundance of new ideas is really something that’s quite exceptional. Hence I would say both in the banking space with some of these private sector banks and in the non-banking finance space with these grossly under-penetrated segments, we are really seeing huge opportunities play out in the financial space in India.

SW: Are there any other additional trends or changes in the region that you could kind of tell us about since we last spoke?

MS: Yeah, of course. I think there may be two things we haven’t covered. Obviously we spoke about manufacturing, which I’d say is one of the huge changes that has played out since the last time we’ve spoken.

But I’d say the second one is really this digitalisation and the formalisation of the economy that’s playing out after that. Some of the stats on the UPI – United Payments Interface – initiative are really quite staggering. Essentially this is the government-built backbone supporting digital transactions in India and I had the pleasure of being in the country just two weeks ago and it’s really staggering how even basic transactions right from your tea vendor at the corner of your street to someone who’s selling you coconut water and let’s say even things like your rickshaw drivers, all of these transactions are happening online, everyone has a QR code and that’s what is the preferred mode of payment.

I think this is changing things quite rapidly. If you think about – just a crazy stat would be things like credit card transactions are now somewhere to the tune of about one sixth or one seventh of what is happening on the UPI platform or mobile wallets. Essentially a technology that has emerged in the last, let’s say, six or seven years, has completely eclipsed credit cards and debit cards which have been around for decades. I think these are huge changes that are playing out if you think about the opportunities that are being created because of that.

And if there’s online payments, e-commerce, we own companies in the food delivery space, for instance, which are also huge beneficiaries of all of these structural trends like on the consumption side, there’s things that are playing out, of course, the people are getting wealthier, disposable income is increasing, there’s greater urbanisation, there’s a bigger middle class that’s building out more millennials, more women in the workforce. All of these trends are playing out and that supports these kind of, let’s say food delivery businesses, but over and above that, there’s online payments and smartphone penetration, one of the lowest call and data rates in the world. So, really, it is a sea change.

We own companies in all of those spaces, including on the financial side where SME lenders, small and medium enterprise lenders or micro-finance businesses now are winning share from money lenders who would have charged extortionate rates because they were lending to a cash-only business. Now that you’ve got six years worth of online transaction history on your mobile wallet, you can access formal channels of credit and pay materially lower interest rates for that and for them, they get a materially better customer with a higher interest rate than what they would’ve charged a salaried employee, for instance. So, I think that’s one major change.

It also has government fiscal benefits. So, if you think about when most transactions are online and there is a digital record, it can help from a tax compliance perspective that is clearly picking up a broader section of the population can come into the tax net.

And on the flip side, the fact that you now have 400 million zero balance bank accounts that were opened, enables the government to target subsidies better. These are linked to your biometrics, to your Universal ID, allowing the government to identify individually whose account it is, what kind of subsidy that person deserves based on their household income and the number of mouths they need to feed, and that is transferred into your bank account. These direct benefit transfers have reduced the subsidy burden and certainly the leakages within that system. So, both on the expenditure side, it’s more targeted and more managed, and on the income side of the government’s balance sheet, essentially income statement, you’re seeing greater tax receipts. So, to me I think it’s having significant impact.

I think the second major change that we’re seeing in the economy is clearly on the rise of the retail investor. Essentially over the last, let’s say five or seven years, there’s been a pickup in what’s called the systematic investment plan, or SIP [Systematic Investment Plan]. Think of this as the 401k in the US where X percent of your salary is going into your nominated mutual funds. Essentially, we’re now seeing something like $2 billion a month come into this market through just the Systematic Investment Plans and the monthly amount keeps increasing. So, that’s added a $20+ billion bid on this market, year in year out.

A couple of interesting years to look at would be 2022 when a number of investors baulked at India’s valuations – foreign investors – and pulled money out in aggregate from the Indian market at a point when China was potentially reopening and people got excited by the exceptionally cheap valuation entry point in China. That year, actually domestic investors piled into this market or continue to put in more money and completely offset the foreign investor outflow, resulting in double-digit returns from the Indian market. Obviously earnings came through quite nicely as well so that resulted in some amount of multiple compression leading to a better entry point at the end of the year.

In 2023, we saw a reversal in that appetite; foreign investors came back as China disappointed and the domestic investors continue to pile in and essentially you saw the market up about 20-odd per cent in response to that.

So, I think it’s quite an interesting dynamic and provides some valuation support for this market. There is also a <inaudible>, if you think about still household savings, only about 5% of that is invested in equities versus, let’s say, gold is about 15% of household savings. So, there is a long way to catch up with this greater financialisation of assets and a lot of other more mature economies, let’s say, places like the US or maybe even China, are materially higher than the 5% we’re talking about in India. So, this is a long-term trend and one that should support the market valuations.

SW: And then just to finish up, one thing you’ve kind of touched on throughout a few of your answers is smaller companies, and you do have close to half of the portfolio invested in these SMID –  small and medium – companies. So what type of opportunities are you finding in that part of the market? And maybe just tell us a bit more about the opportunity set.

MS: Yep. No, of course. I think our view, our overweight on small and mid-cap is really not so much a view on small and mid-cap outperforming large-cap, et cetera. It’s a fairly structural allocation we’ve had in the 15 plus years we’ve been running this strategy. It’s more a function of the alpha potential, our ability to pick great stocks and outperform our benchmark. Just given the level of under-researched nature of these businesses, there are companies that we own where we would be the first or second major institution to really look at it versus in the larger cap space, there are companies with 50 or 60 sell side analysts that would be covering that, so the informational asymmetry is clearly higher within small and mid-caps.

We are seeing completely new product categories come to market in India. It really has been a fairly euphoric few years. I think 2022 was maybe slightly tougher for IPOs, but broadly, India’s still a market where the number of companies, the number of new companies, coming to market continues to increase, just new product categories like online food delivery, e-commerce, online payments, luxury auto dealership or watch retailers, just niche manufacturing segments, stockbroking, wealth management companies, pharmaceuticals, these are all completely new segments that have come to market where market leaders in their respective niches are IPOing for the first time and we have participated in a number of these names.

So, to me, I think that is an indication of the richness of the Indian equity landscape. And clearly the broadening out of this opportunity set is proving to be a fertile ground for active managers like ourselves and especially given our strong local presence in the country and this longstanding expertise that we’ve built and the disciplined research process that we’ve outlined, we feel by differentiating ourselves from the benchmark and being able to go into this small and mid-cap space, we’re able to deliver sizeable alpha for our clients. And clearly, it’s a risk that we think is worth tolerating.

SW: Well, Mithrin, thank you so much. That was an excellent overview of the Indian market at the moment and a number of opportunities that you’re seeing today so thank you very much for joining me.

MS: No, perfect, Staci, very happy to be here and and look forward to speaking to you next time.

SW: The Goldman Sachs India Equity Portfolio is an all-weather India fund with a well-resourced and experienced team, based in Asia. It aims to capture the growth potential of the Indian economy focusing on sound businesses of all sizes. To learn more about the Goldman Sachs India Equity Portfolio please visit fundcalibre.com