[India’s] equity market rally during 2014 was based less on the improvement of fundamentals and more on sentiment, which was largely driven by a renewed sense of hope for the country.
Prime Minister Narendra Modi’s election campaign evoked the belief that reforms could spark change in governance and growth, particularly by improving on executive efficiency and the ease of doing business. Important reforms are also anticipated in the usage of land, labour and other natural resources.
The easy, and the hard
So far, the government has made incremental changes to improve functional efficiencies, more so than structural reforms. To assess the government’s ability to make reforms, one has to understand how reforms can be implemented at various levels of government.
The easiest changes to make could relate to improved efficiency and fair dealings with the corporate sector. Clarity around necessary approvals to conduct business in the country should be helpful for companies. In order to do this, the government needs effective leadership and a sense of urgency.
Fortunately, the government does seem intent to make the necessary changes.
More difficult is implementation of legislative reforms, which requires varying degrees of political support, depending upon the nature of legislation. The ruling Bharatiya Janata Party (BJP) has a majority coalition in the Lower House of Parliament but not in the Upper House-and it only has a narrow majority coalition in the combined houses.
Some matters require a simple parliamentary majority. But others require a two-thirds parliamentary majority, and/or the additional support of 50% of the states. Currently, the BJP struggles to gain this level of legislative support.
We believe this is why Modi’s government seeks to temporarily affect reforms into law through promulgating ordinances, in spite of the fact that these reforms will eventually need parliamentary approval. Clearly, this is a short-term solution.
While concrete progress has yet to be made, the focus is on land, labour, insurance, as well as goods and services tax reforms.
Investment drivers in 2015
The most important drivers of the Indian economy over the coming year will be:
–Legislative reforms that would enable the fair and efficient use of resources and make India more business friendly
–Monetary policy as lower inflation would reduce the cost of private investment
–Executive efficiency which includes bureaucratic efficiency to approve projects faster and not stunt development
Outside influencers
There are also global or exogenous factors such as geopolitical risk, further moves in oil prices or US Federal Reserve policy that could have a significant impact on India.
Because India imports almost 80% of its crude oil needs, declining oil prices should reduce India’s current account deficit and contribute to the stability of its currency. India’s inflation is significantly affected by oil prices and lower inflation could eventu¬ally translate into a lower cost of capital.
Consumers also stand to gain with more discretionary income in their pockets, which can help fuel domestic demand.
On the corporate side, companies with pricing power can maintain higher margins in this environment. And companies with commodity-like products or services might have to pass on the benefit to consumers. We tend to focus more on businesses with pricing power; so a correction in commodity prices may actually benefit a number of our holdings.
Small and mid-cap positioning
India’s equity markets are trading between 18 and 19 times (trailing) price-to-earnings, slightly higher than the five- to ten-year averages. Companies that are seeing sustainable and profitable earnings growth are likely to do well over the next few years and we believe that this fundamental strength should eventually translate into solid market performance over the long term.
We tend to favour companies that control their own destinies, where management is able to steer through macro headwinds via strong fundamentals and solid business models. Such companies do tend to benefit from growth sparked by reforms. But these companies are not necessarily uprooted if reforms do not take place.
Companies that are dependent upon successful policy reforms could face disappointment, as the reform process in India is neither fast, nor institutionalised.
Small- and mid-capitalisation stocks generally trade at a discount to their larger peers-and often for good reason. These stocks can offer less transparency than large cap stocks. So there are additional elements around information discovery and evaluating the impact of market, economic, regulatory and other factors may be more challenging.
Smaller companies can also have untested business models and greater corporate governance risk, which require addi¬tional stock selection effort, compared to large caps. That said, our allocation is higher in small caps because we feel there are many long-term growth opportunities available at fair prices that are sometimes overlooked in this universe.
While the discount to large-caps has narrowed in the last 12 months-and a reversion to mean could very well happen in the short run-we believe these stocks stand to outperform over the long term.
Small companies are often at the forefront of change as economies become more oriented towards consumption and services, and less reliant upon fixed invest¬ment and manufacturing.
Sunil Asnani is portfolio manager of the Matthews Asia India Fund
