The economy of India sails along

“Ladies and gentlemen
This is Mambo No. 5!
One, two, three, four, five
Everybody in the car, so come on let’s ride
To the liquor store around the corner
The boys say they want some gin and juice”

– Lou Bega, Mambo Number 5


India sails along

Very little of what we were taught in textbooks of investing – or during our 7 year partnership with Tom Hansberger (he of the legendary Templeton, Galbraith, & Hansberger – the grandmasters of international and value investing) seems to matter these days.

Investors seem to be happy to jump in the car and head to the liquor store for some flirtatious cocktails.

At many global investment conferences, India is touted as Exhibit A for an example of a country that will have the highest GDP growth in the world. A cautionary note that “GDP does not equal to share price movements” is made and then quickly passed over to emphasize that Indian stocks look attractive.

Sure, GDP may not always result in higher share prices but shouldn’t share prices be driven by earnings?

And – in case we are the only people looking at the data points – earnings for the large cap, mid cap, and small cap indices have declined since the arrival of Prime Minister Modi (not his fault, we assure you!).

Despite this the large cap index has surged some 50% and mid-caps / small-caps have surged over 100%! Aha, but the market always waits for future earnings! Every bullish estimate since 2014 has been ‘bull’.

The sell-side and buy-side has been touting rapid-fire earnings growth for the Indian market since February 2014 – when it became apparent that the BJP would win the May 2014 general elections

With lower reported earnings and higher share prices, the underlying historical PER shows an alarming missile-like trajectory. One that would make the supreme leader of North Korea rub his trigger-happy hands with glee.

Unashamed and unrepentant by 42 months of fiction-writing, the orchestrated flood of “Buy India Big” reports parrot the fabled, “This time it’s different” slogan. To which, we can only counter with the famous lesson from Sir John Templeton:-

There are 5 important words in the field of investing, of which you will hear the first 4 a lot: This time it’s different….the fifth is never said out aloud, but is whispered; that fifth word is “sucker”!

Economic planning unhinged?

India has had a (bad?) history of Five-Year plans and the omni-present Planning Commission which had, since 1950, allocated scarce resources based on what the anointed chief economists and think-tankers felt the country needed.

In a market-driven economy, the relevance of the mandate of the Planning Commission was rightly questioned by the BJP. However, rather than amending the mandate of the Planning Commission and retaining some of its history and think-tank characteristics, the BJP decided to shut it down and replaced it with NITI Aayog (National Institute for Transforming India), led by renowned international trade economist, Dr. Aravind Panagariya.

But NITI has not had a major impact since its creation in January 2015. Dr Panagariya has now resigned and will return to academia.

A year ago, Dr Raghuram Rajan announced his decision not to seek an extension of his position as the Governor of the Reserve Bank of India. Dr Rajan is still missed and his achievements, though being corroded, are still visible. As a senior person in the central bank of a G-20 nation noted, “India has fallen off the map” in the world of central banking since the departure of Dr. Rajan.

Dr Panagriya’s exit will be easier as he is likely to be forgotten: NITI Aayog has not made any dent on India’s economic development map. GST and digital IDs were ideas from the Congress regime. If the BJP was pushing the “vikas” (development) angle of their election manifesto, few seem to have heard about it. And, sadly, neither has the economy seen any lift-off to the Promised Land of 8% to 10% p.a. real rate of growth in India’s GDP.

Adjusting for a new statistical series, India’s GDP is probably still mired in the 5% range – a level last seen during the sunset days of the previous, corruption-riddled, Congress-led, UPA coalition government.

Capital formation, suffering from over-investment by the private sector in the BRIC era coupled by limited resources from a government rightfully keen on establishing its sovereign ratings, may get another shock if there is a GST stall.

If the after-effects of demonetization linger in the form of loan write-offs to the rural economy, India’s fiscal imbalances will prevent a government-led, capital investment revival in the economy.

No 8% supercharged rate of growth of GDP.

We remain impressed by flows from local (under-invested) retail investors and the impassioned buy-in by foreign investors. Most GEM funds are overweight India, though – on an aggregate basis – global institutional capital is still dramatically underweight India.

Our struggle is not with the thesis that India is a great place to invest, but an argument over what valuation levels to invest at – and how much to allocate to India at these valuation levels.

We are the ‘original India bulls’ with a history that spans 27 years but, somewhere along the line, we have been contaminated with the disease of adhering to a disciplined thought-process and that, too, (alas) of the “value” kind! Given the Mambo 5 drive to the liquor store, we should have been trained in Tulip Valuation processes!

We continue to believe that successive governments have failed the test of taking on true policy reforms to lay the foundation for a break-out 8% to 10% p.a. rate of growth in GDP.

The BJP may have been the Last Hope. Having swept the 2014 elections on the plank of development and rooting out corruption, the BJP wasted much of its capital on a social and religious agenda which has focused on showing Muslims that the Hindu majority within India is willing to strike back (or strike first) and on policing what gets cooked in our kitchens.

While this may be good for the religious mojo and the nationalist ego, it does little to create employment. Unless there is a tangential plan to generate employment by letting loose the squads of brown-shirts to kill Muslims. Those who work in cow slaughterhouses or beat up lower caste Indians who eat beef because it is the cheapest form of protein. Obsessed by the consumption of beef, India could be the next Turkey.

The BJP is now so focused on winning the state elections and the big federal election (sometime in mid-2019, but don’t be surprised if there is an early federal election), that economic reforms have taken a back seat and handouts have taken the limelight.

But India has a wonderful internal consumption pattern that offsets the miserable performance of many governments over the past three decades.

It is this domestic consumption story that makes us bullish. The export and infrastructure themes require policy direction and action which India is woefully inadequate on. The BJP, like the previous governments, has been great at slogan mongering but overall poor on delivery.

The chant that the Congress was in power for 40 years and the BJP less than 3 years is a wimpy excuse: India was ripe for a breakout to the 8% level of growth and the BJP dropped the ball.

Shades of risk.

The Indian economy is vulnerable to a range of external and internal events and, while none of these risks may materialize, the fact is that not a single risk is priced in.

1) There is a risk that the recently launched GST, a national sales tax, will lead to a slowdown in the economy and/or the economy (and tax collections) may feel the impact of a technological glitch of the new and untested software that is expected to handle 3.5 billion filings every month. Investors are dismissing this as a “J” curve effect in the run-up to a more robust economy. The problem is that the economy is already feeling the “J” curve effect of a questionable demonetization policy. A GST stall could lead to a “double-dip”.

2) The monsoon has begun well. While the impact of the quantity of rainfall, the location of the rainfall, and the timing of the rainfall on agricultural income (which affects 60% of India’s population) will be known by October, 2017 the water levels in the reservoir are looking good.  This is essential for water supply and also for irrigation for the November to March winter crop, which accounts for 45% of the annual food production.

3) The Jammu & Kashmir issue between India and Pakistan is boiling over before winter sets in while the China-Bhutan border has flared up. A series of statistics on the India-Pakistan “Kashmir problem” shows no signs of letting up.

On the north-eastern corner of India, China has moved its engineers to build a highway in what is Bhutanese territory. Bhutan, a quaint kingdom known for its focus on Gross Happiness Product, has outsourced its defense to India.

The Chinese incursion triggered an “invitation from Bhutan” to India to step in. India has: with troops and guns. China has threatened that India will be taught a lesson yet again (China trounced India in a 1962 border conflict). The Indo-Chinese bitterness has global overtones. India, trying to flex its muscles on the world stage, has been part of the Malabar naval exercises with USA and invitee country Japan.

In June, 2017 the Malabar drill of the 3-nation navy armada streaked through the South China Sea, drawing warnings from an angered China. Suspicious of India’s regional ambitions and global friendships, China has consistently vetoed any discussion to grant India a permanent seat on the UN Security Council.

Furthermore, sending a few bags of money of aid across to Pakistan to continue to irritate India adds to India’s defense expenditures and to its fiscal burden. China may be the sole dominant power in Asia, despite the Axis of Convenience between India-USA-Japan.

4) The global geopolitical and economic situation remains tense with multiple economic variables that can be impacted including interest rates and oil prices; an increase in either will be a negative for India which has had an annual windfall of over USD 70 billion from cheap oil.

Not flirtatious, but wedded to India.

India as an investment destination is not a Mambo Number 5 flirtatious escapade for us: India is what we do and we are wedded to it!

As value investors, we are being tested for our discipline and the conviction of relying on our assessment of facts v/s the basic instinct of a larger pool of money that is, in some sense, willing to roll-the-dice and pledge its faith on Alternative Facts.

We are not India bears: with rising stock prices, not surprisingly, our cash levels have inched up and the Upside Potential Indicator has slipped from very attractive levels of 60% at the start of the calendar year 2016 to current levels of 24% over 2 years in our forward-looking proprietary chart. That is a very respectable number, no doubt, in a world where returns are hard to find. But someone needs to assess the risks, too – and wait for an opportune time to go overweight on India.

In line with our inflation assumption of 5% (RBI says 4%), it seems prudent to change the long term Government of India 10 year bond rate to 7% p.a and the expected return on riskier equity as an asset class to 18% over a 2 year period, reduced by 2% from our earlier assumption of 20%.

The old normal of 6.5% p.a. rate of growth.

We contend that India’s economy was on a natural, extended recovery in November 2016 when Modi dropped the bombshell of demonetization. The earnings of the recently concluded financial year March 31, 2017 reflect that.

The still unknown and unmeasured impact of demonetization on rural India and on the “informal” mom and pop economy, suggests that a good crop output is necessary to create farm incomes and to add to food production – and to place those lofty estimated earnings for March 2018 and March 2019 that pop up on your Bloomberg screens within the realm of the achievable!

The macro risks of higher government subsidies to pull rural India out of an economic slump remain.

Is Crony capitalism inching its way back in the system?

There is a hypothesis that money power is back in play since money is needed to fight elections in India: and India will be in election mode till May 2019.

In the 2014 general elections, those who had to give money to the politicians did so. When the BJP won the election, there was a feeling amongst the crony capitalists that “their man was in”. But the givers of money got nothing out of it – barring some photo ops of sweeping the perpetual dusty Indian streets with the Prime Minister.

The BJP lost the Bihar state elections in November 2015. That may have been a wake-up call for the BJP to cuddle up in bed with the crony capitalists. It is possible that the BJP realized they need money to win elections for the many states and, eventually, for the national elections due before May 2019. Hindutva needs money just as Mahatma Gandhi needed money to keep his image of simplicity alive! Industrialist Birla had said, “it costs us a lot to keep Gandhi poor”.

There is a stream of thought that suggests the situation has changed and reality has seeped in within policy making arm of the BJP. On both sides of the table, those who receive money and those who give money, there may be more candid discussions. Those giving the money have become a little smarter – and bolder. They may agree to fund political parties, but they would like to see some benefits now and some benefits later: maybe via milestone payments? I pay; you deliver benefits for my businesses; I pay more. Kind of an evil version balancing ying and yang.

If this is true, then the one huge victory of slaying corruption at the federal level that Prime Minister Modi should singularly claim credit for is at risk. After 40 years of runaway corruption under the Congress Party, Modi had wiped out crony capitalism from the distorted map of India’s economy. Is that still the case?

We remain optimistic on India’s economic potential.

India has some world class managements running world class businesses! Indians still haves a near insatiable need for many goods and services.

So, if the markets fall a lot out of fear or bad news, we will quickly evaluate the long-term impact on the underlying businesses of these companies before we actually place orders to buy more – and potentially ask you to allocate more capital to India. If markets surge and stray above what we would consider ‘value’, we will be firm to sell and let our cash levels inch upwards.

As our Upside Potential charts suggest, a 24% potential gain over 2 years is compelling and reason enough to be neutral on India (allocation at 50% to 75% of what you think your long term weight should be).

1) Low oil prices have been a boon for India.

2) Everyone is excessively bullish on India, most of the time! Be careful! Every bullish ESP forecast for the past 4 years has failed to materialize and resulted in a “next year will be better ESP” story!

3) The sensible, long term approach to investing requires a commitment to the simple – and suggested – thesis: India’s GDP may grow by 6.5% p.a. over the long run (the past 35 years has seen a growth of 6.3% p.a.) and this gives opportunities to invest in a portfolio which can have an earnings growth of 15% p.a. in INR.

Keeping liquidity of your overall India exposure in mind, we would still argue for a 70% allocation to public equities as a simple and safe way to participate in India’s long-term economic growth – with maybe 30% in less liquid assets.

An aside: Will Crony Capitalism make a comeback?

If there is one clear victory to the Modi regime, it is the wipeout of crony capitalism. Modi seems to have made his “Sophie’s choice”: he wishes to rescue the 250 million Indians who voted for him as a Ray of Hope. The money-bags have been sent to the gas chamber.

After 40 years of Congress rule that supported a few well-wishers since 2005 – and allegedly mastered the Russian-style oligarch theft – Prime Minister Modi had (in one short year) knocked out the crony capitalists from their lofty perch.

For this he gets an unequivocal “10/10”. However, if winning state elections with money power becomes a focus point of the government, the suppliers of money will ask for their pounds of flesh. While corruption at the federal level is reduced, could state-level corruption be increasing?

Ajit Dayal
For The Daily Reckoning UK



Ajit Dayal is a longtime friend and business associate of Agora founder Bill Bonner. Ajit’s publishing house in India, Equitymaster, agreed to partner with Agora back in 2005. Ajit and Bill hold several joint investment interests to date.

Before Equitymaster, Ajit was acknowledged as #1 India Equity Analyst, “AsiaMoney” in 1993 & 1994. He was formerly Deputy Chief Investment Officer of Hansberger Global Investors, Inc with USD 5 billion of assets; lead manager on the USD 2 billion Vanguard International Value Fund and lead manager on a USD 300 million pension account. He was named to the All-Star Asian Team by “Institutional Investor” 1994, and was CEO & CIO of QIEF Management, LLC from January 2007 to March 2015.

Ajit is the founder of Quantum Advisors Pvt. Ltd., an asset manager based in India. You can track the Q-ACPI India Equity UCITS Fund he co-manages here.

Ajit has over 28 years of experience in the Indian capital markets, including 7 years of experience in the international stock market as an analyst and a portfolio manager. He brings a wealth of Indian investment knowledge and experience that is unique for the UK and world markets. He gives Agora Financial UK kind permission to publish his writing here in England.

Ajit receives no fee for writing for Agora, and Agora receive no fee for the mention of his fund above.