Practical analysis for investment professionals
04 December 2013

Special Report: Is Corporate India Healthy?

Posted In: Drivers of Value

Is Corporate India Healthy?

As we continue our special coverage of India, it becomes important to ask the obvious: How are Indian companies doing?

For that, we turn to the chief investment officer of SBI Mutual funds, Navneet Munot, CFA.


Listen to the discussion or read the transcript below.


Will Ortel: I am looking at a report from the Reserve Bank of India that says corporate profitability — this is a broad group of corporations in India — is down about 2%. Now it’s still big — it’s one crore, 74 lakh crore rupees — but how does this make you feel about business fundamentals in India? Is it still a rosy picture?

Navneet Munot, CFA:  There is a part of economy that has been impacted more badly, and that is the investment side of it. So companies in industrials and infrastructure, those are the ones who got impacted. But if you look at the latest results, there is another set of companies that have benefited from a weaker rupee. So those who are exporters, those who are into information technology, pharmaceuticals, engineering — they have benefited because of the weaker rupee.

There has been pressure, particularly in the financial sector, because given the downturn, there has been stress [over] the asset quality of the banking system. So financials have been a bit under pressure; though the banks are financial services company who cater to the retail market, they seemed to be chugging along well because the overall retail delinquencies have not increased much in this downturn.

By and large, I think the corporate profitability is bottoming out. Two things that kept pressure: One was that lot of people who expanded capacity, extrapolating the 9% growth that we were witnessing till 2008, came for a shock when the growth fell and the global environment turned very negative.

For them, there is lot of capacity which is yet to come on stream and then generate revenues and also because of the government’s slow decision making and [because] the political environment has resulted in lots of infrastructure projects which are at the last mile from lack of environmental clearance — land acquisition or forest clearance or several ministry bureaucratic clearances and they have been pending.

So that got impacted and also the pressure on margins because the raw material prices went through the roof, the labor cost in India was going up in excess of 15% and 20%, interest cost was going up, currency was weakening, so they got impacted on margins. But from here on, I believe, as the cycle turns, the asset turnover improves, and also the pressure on margin recedes, I see better days ahead for corporate profitability.

I just want to drill in on one of those comments, which is, you mentioned basically companies that have dollar revenues and rupee expenses as being a particular bright point in this environment. Does that signal a return to sort of offshoring and business process outsourcing-based competitive structure for India, or is that just sort of a short-term thing?

I think that’s quite structural because [when] all is said and done, India has an advantage in terms of having a large English-speaking, educated talent pool and the cost pressure has receded for them, while the global environment has turned positive with the growth reviving in the US and other parts of the world.

These companies have benefited, and also the rupee depreciation obviously is helping them. But we have other sectors who lost competitiveness between, let’s say, 2005 and 2008–2009, when our economy was doing very well, the labor cost and, as I previously mentioned, I think, the cost structure went up and the rupee was strong, so they lost competitiveness.

But we are seeing a renewed way of thrust on getting the competitiveness back and several sectors. Autos is a classic example, and we saw the two‑wheeler companies — the Bajaj Auto and then some others. We are gaining the market share in the world market.

Similarly, several companies in auto ancillaries and in engineering particularly — there are other factors where India has the advantage of R&D skills and low-cost labor. Across sectors, a weak rupee is likely to help corporate India.

You are talking about the changing international investment climate. That’s something that has fascinated me as I have kept digging into India. I wonder if you could comment on flows a little bit. How important and how closely you’re a domestic Indian investor, how closely are you watching international investors in equities and their flows in and out of the market, how material is that to you?

They have been extraordinarily important because what happens is that foreign institutional investors now almost own 22% or so of the market cap of India. If you have adjusted for the floating stock — because a large part of the market cap is with the promoters, be it the government or the private entrepreneurs or some of the multinational companies, they own a substantial chunk of the floating stock. They are a large part of the daily volumes, and their flows dictate the market.

To put it simply, we dance to the tune of global investors who get, in turn, driven by the global liquidity and the global risk environment. Why it is that because we run a large current account deficit, obviously the country needs a huge amount of capital flows. The flows by these foreign investors impact the currency market, impact liquidity, and interest rates here and impact the sentiment in the equity market as well.

In the last couple of years, the domestic savings — India has a very high household savings rate, but unfortunately a large part of that saving effect is not coming into the financial instruments but going into real assets like real estate and gold. The domestic investors are becoming very marginal players in the equity market, and that’s why the foreign investors, their flows, make all the difference.

If you can do a chart of last 15 or 20 years, every single year where foreign investors poured in money, the markets did well. In every year where foreign investors were sellers, market didn’t do well.

But I hope that going forward, domestic investors will start reallocating their savings into equities as equities are relatively becoming more attractive compared to the other asset classes and that equation may change going forward. But as of now, foreign investors are a very, very critical variable in the overall direction of our equity markets.

I want to pick up on the current account deficit thought in a second, but first I want to go to the comment you had about domestic investors. Now, what really needs to happen in order to spur that growth in a domestic shareholder base basically? Is that something that’s just like a last-mile problem, similar to those infrastructure projects, or is that really a big challenge?

A variety of things. In the last 20–25 years, domestic investors — just like anywhere else in the world, they came at the peak of the market. They didn’t have the experience with the equities. There were some structural flaws in the system where probably the retail investors didn’t make money.

Also, India didn’t have a very sustained long‑term bull market. We had markets that delivered exceptional return; next to the year 1992 are the years 1999, 2000, and then 2006–2007, but unfortunately, the retail investors came at the peak. They had bad experience, and generally, equity is still perceived as something that is very speculative.

Another structural factor is that we don’t have enough of 401(k) type pension plans or all the retirement savings infrastructure in place, where a good part of savings automatically go into the equity market, like in the US and some of the other parts of the world. India needs to get that right. The pension reforms have just begun, and I hope that over a longer period, given the demographics and the high savings rate, people will start investing a lot more into equity.

Though the infrastructure now is in place, I think in terms of whether the settlement cycle — in terms of dematerialization, the overall infrastructure of the stock exchange, corporate governance, the regulation — everything is in place, but somehow, as you mentioned, the last mile. People will need to be educated, and given the importance of the equity in their overall savings portfolio, to get inflation adjusted at times, once that is done, a lot of money can come into the market.

Another interesting feature is that two other asset classes where people have put money in the last 10–15 years — real estate and gold — both have done phenomenally well, even adjusted for the volatility and liquidity. That’s why [there is] this perception that it is always better to put money in real estate rather than a paper asset. That needs to change. Hopefully, I think it will change over a period of time.

I just want to underscore for the audience that investing in gold is not just a 15-year-old trend in India. It seems like to me a 2,000- or 10,000-year-old trend. There is a cultural focus on doing that that may not be very clear to an international base of investors.

Yeah, but in last couple of years, [it has] increased significantly as a percentage of our GDP: Gold imports just shot through the roof for the simple reasons that real interest rates were negative and consumer inflation was running much higher than the policy rates. And that led people into more physical assets, and then also something to do with the cycle that in the last decade, at least in the rupee terms, because the rupee deficit people made good money in gold.

Also another reason that — I am an Indian, so I have had a fascination for gold for 2,000 years, but having said that, in the last 20 years, we have built a very good financial market. We have built good infrastructure in terms of whether it’s banks or mutual funds, insurance companies who are reaching out to millions of investors. But still, the proportion of savings coming into financial assets has declined, particularly in last three four years, which is a bit worrisome for the policymakers and for us.

That gets back to the current account deficit thought. I was actually just listening to Mr Shanmugaratnam — the head of the Monetary Authority of Singapore — talk about the role that a current account deficit can play. He makes the point that a current account deficit in and of itself is not intrinsically bad.

Do you see the lighter side of a current account deficit, or is it the sort of thing that you and perhaps the market more broadly are viewing as kind of holding India back?

As long as it’s manageable, as long as it doesn’t create extraordinary pressure on the currency market, it doesn’t lead to destabilization in financial markets, it doesn’t lead to some kind of instability in the overall macroeconomic environment, and it saw the signs between June and August when the Fed announced — or probably the Fed announced — the intention of tapering and the massive impact it could have not only on the financial markets in India but also on the sentiment in the real economy.

The current account deficit, it is a point where the funding becomes a day-to-day challenge that is quite worrisome. But a 1%–2% of current account deficit for a country like India, which needs to invest more than private saving, it is largely in order. If you think from a global perspective, a few countries have to run the current account deficit; if everybody runs current account surplus, it is building reserves. I think that may not be good.

Yeah, that’s definitely true. In places that need investment, that’s OK, that’s what a current account deficit is. You brought up the word “tapering.” I wanted to ask you, just how often do you think about that word? Because here in New York, we think about it quite a bit. But on the other side of the world, it may not be obvious how important is to you.

We hear almost the same [as] what people sitting in New York [hear] because, ultimately, our markets are governed by what people in New York think. As I have mentioned earlier, the foreign investors are extremely critical for us, for the equity market, for currency, and for, recently, the bond market as well.

Tapering — at least in the very near term — makes some impact, but longer term, if you look at last 20 year,s every time the US Fed was increasing interesting rates or the US Federal Reserve was tightening its policy, it turned out to be good for the Indian markets.

The first few days or first few weeks, markets would tend to react negatively because that would mean less liquidity available in the market, but over a longer period, if the US economy is doing well, I think that generally augurs well for the Indian economy.

One is the trade linkages, probably whether it’s IT export, health care, or some of the other industries. And over a longer period, there is a bit of correlation between the Indian IFT [Institute of Foreign Trade], the Index of Industrial Production, and the US ISM [Institute for Supply Management], which may be 3‑ to 6-month lag. So, a revival in global growth is generally good for India.

But the market takes a few weeks to realize that fact, and then the first reaction, just in line with every other market in the world when Mr. Bernanke or Ms. Yellen talks about tapering, people perceive it a bit negatively. But my sense is that once the tapering starts, eventually it helps to be adding; if it is driven by strength in the US economy, I think that should be good for the Indian economy and markets.

Does the same linkage apply to other monetary zones, or would you say that you are concerned with things coming out of the ECB [European Central Bank] as you might be with things coming out the Fed?

If I remember correctly, it was January and February 2012 when it announced the LTRO [long-term refinancing operation], and the Indian market, despite an extremely challenging micro and political environment, markets went up 25% and for no reason but just that the ECB showed signs of printing a lot of money and then the LTRO money came into India.

We get a lot more impacted by global liquidity, the global central bank stance, and global risk on/risk off sentiments. They impact a lot our markets, at least in the very near term. Of course, in the longer term, logically it is corporate fundamentals and economic fundamentals that should drive the market, but in the interim, I think it’s the global liquidity that impacts a lot.

I want to ask, is it challenging in that case to sort of search for value among these equities? And if you are in this environment where you have this essentially tidal international investor sentiment, how does that frustrate your hunt for adequate risk/reward for your investors inside of the country?

It actually also creates an opportunity for a domestic investor. Somebody who has a slightly longer-term horizon and he can, rather than getting trade by the volatility which is induced by the behavior of global investors. Sometimes it creates good opportunity, so if these markets are rising just because the global liquidity environment is improving, you can be on the other side of the fence rather than vice versa. It creates an opportunity for those who can take advantage of the differential arbitrage.

Another aspect is that, in the last five years, we would have gotten more than $80 billion from foreign investors, while the domestic investors have continuously been selling in the market. Now a large part of this money, or a bulk of this money, has chased around 50 or 60 odd stocks, and it has created a valuation gap between so-called defensives and the cyclicals.

Some of the stocks that foreigners are chasing — the large mega-caps within the consumer, health care, IT, and in some of the private sector retail banks — the valuations have risen there, while the rest of the market, because the domestic investors are not buying the cyclicals, had become a lot cheaper. Now I am seeing a trend where the domestic investors are focusing on finding value within those stocks which are neglected by the foreign investors.

Talking about finding value, there is obviously the chase for value through all the listed equities, but I think if you reach into your wallet, I assume that there are some rupees there. Is that a source of worry, a source of confidence, both, or neither? It hasn’t been an easy 18 months for you probably.

Yeah, basically for Indians, gold is a dollar as such somehow because if the domestic one is not doing well and you have higher inflation, then through the weakened currency, you get the benefit in your investment and in gold.

Maybe people don’t talk about it, but subconsciously, it is the global diversification. Talking about as an individual, your expenses are in rupee and then you are running in rupee, and the last couple of years, the income growth has been in line with the nominal GDP growth. So, people are that way, OK. We haven’t seen investors really chasing and trying to diversify into global assets or investing overseas. We haven’t seen that trend catching up.

One of the comments in doing this research that really surprised me came from Pradip Shah when he said that the [Reserve Bank of India] now views its job as protecting the purchasing power of currency, which again sounds a bit weird here in New York. Is that your perception? Is that translating into action to really defend the rupee? And if so, is that action viewed as credible in the market?

Exchange rate has not been a major factor driving the monetary policy for several years, but I think there are periods when the bouts of volatility in the exchange market lead the central bank to take monetary action.

Having said that, the stated objective over the years has been that they want to contain volatility rather than protecting a certain level of the currency. Two things that have been a lot of the point is there — the currency will be stable if perceived inflation is well behaved, and the new governor Mr. Rajan, he has been very clear on two things.

One is that the primary target has to be containing inflation, and not only the wholesale inflation because that gets driven by global commodities, but the consumer inflation that impacts every household. And second is India needs to rebuild savings, so the real rates have to stay positive for some time to induce savers to come back into financial assets, to come back into deposits.

That’s why we need slightly higher rates, while the government and businesses have been clamoring for the lower interest rates to support growth. He thinks that we need a balance between these objectives.

That’s it. Switching over to sort of a debt outlook, I’ve heard some chatter about a downgrade, a debt downgrade, for India the country. My country got downgraded not too long ago, and everything seems to be very much the same. Is that something that seems likely plausible or overblown? What are your feelings on that?

Two aspects — one is that the actual event of India getting downgraded to a junk status, I think, is very, very remote. The macrofundamentals are reasonably strong, and they don’t justify that India should be in the junk category.

If you look at the public debt to GDP, if you look at the — there are hardly any implicit liabilities of the government, unlike most of the other parts of the world, where a very little pension liability or medical liabilities that the government has. And also, I think, even the demographic, the growth potential, the overall strength of the financial sector at a very low leverage among the households — the household balance sheets are very strong.

By and large, corporate balance sheets are in reasonably decent shape. India getting downgraded to junk is very, very remote, I would say. Having said that, I remember one good thing that has happened because of the threat of the downgrade; [it] has done lot of good to the country in a sense that the central government, despite this being an election year, it has been behaving very sensibly on the fiscal side because it knows that the sword of downgrade is hanging on us.

Because of that, the fiscal deficit has been under control, and serious reforms to consolidate the fiscal side, the budget deficit, began a year back. And I think some part would have been played by the threat of the sovereign rating downgrade of India.

Also, lots of reforms are taking place in the financial sector. The government has taken a lot of steps to revive growth and contain deficit. That’s a good aspect of this threat. But the actual event, I’ll be highly surprised. I’ll be shocked if S&P [Standard & Poor’s] takes the step and says that India doesn’t deserve an investment grade.

One more aspect that people neglect is that the bulk of the Indian government’s borrowing is in the domestic market. It has borrowed from the domestic banks and the households, and it has not borrowed overseas. That way, the vulnerability of India defaulting to global investors is hardly there. I’ll be very surprised if that event takes place. That’s a little overblown in that sense.

That is certainly, probably, refreshing news to many investors. Navneet, thank you so much for joining us.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Will Ortel

Will Ortel has worked in investment management since 2006 and joined CFA Institute in 2010.

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I try to see the world in its particularity and convey my curiosity clearly. I hope you think I do this in a fair and transparent way, and invite you to write me if you feel otherwise (or just want to say hello).

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