A Summary by Gaurav Patankar
Having spent over two decades in research, investing, capital allocation, entrepreneurship and serving on public company boards within emerging markets, I strongly believe that emerging market equities are a story of 3 G’s: Growth-premium (vs. DM), Globalization, and Geopolitics. With sufficient inefficiencies, there is typically a solid opportunity-set for absolute and relative value investments. However, more recently EM equities as an asset class has flattered to deceive – screening as a value pocket within global equities but the promise of realized returns being hampered by cross-currents of de-globalization and geopolitics. It is this context that Institutional Investor hosted a series of discussions centered around the role of pan-EM investing and dug a bit further into the two biggest components – China and India – each of which has enough depth and breadth to be a stand-alone allocation.
One of the biggest takeaways from a series of series of spirited discussions at II Chicago involving over 50 asset-owners was the potential opportunity to think of India and China as standalone markets. We decided to explore this theme further by bringing together four investment leaders with unique vantage points - Harshal Chaudhari, a steward of one of the largest pensions in the country as Chief Investment Officer of GE Asset Management; Anurag Pandit, Chief Investment Officer of ALSAC/St. Jude Children's Research Hospital; Sophia Tsai, Managing Director, Investments of Trinity Church Wall Street, represented E&Fs; and Hiren Ved, the CIO of one of the longest-tenured India equity funds. Alejandra Grindal at Ned Davis laid out a thoughtful framework for discussion and Michael Oliver Weinberg leveraging his unique perspective as a practitioner and an academic served as a moderator.
My 5 key takeaways from these discussions:
1) India takes top spot: General consensus on the emergence of India as an expanding market with the highest future potential within emerging markets
2) EM equities viable if done right: EM equities as an asset class, while less viable recently, still provides enough opportunities across major markets like India and China but even including, Brazil, Mexico, Vietnam, and ASEAN countries.
3) Criticality of on-the-ground presence and a tenured track record: India today is akin to China in 2002 and primed to emerge as a single country asset class. However, strong on-the-ground partnerships are necessary to be successful due to governance challenges.
4) Governance challenges make private markets less attractive in EM: Private markets have negative convexity in India and other EM’s, often due to diminished governance resulting in more frequent left-tail events.
5) Low duration and low-net are a way to play China alpha: China is still a viable investment market that is inexpensive, but opportunities will be driven by alpha rather than beta.
- India lags China’s market size, but economic and geopolitical momentum is unstoppable: India’s economy is about a fifth of China’s, and it lags far behind on per capita income. However, a combination of India’s geopolitical alignment (with the West), better demographics, and thoughtful policy has given it a unique economic momentum. This can be seen in various economic numbers ranging from real GDP growth, PMI, stable inflation, industrial output, and many other hard economic metrics. “India is the fifth-biggest economy, and that makes it bigger than the UK and under Japan. Perhaps on track to be one of the fastest growing major economies. Manufacturing, particularly the high-tech electronics sector, has emerged as an engine of growth in India. While China will still be one of the biggest contributors to Global GDP, the momentum has shifted to India,” said Alejandra Grindal, Chief Economist, Ned Davis Research Group. I have previously written extensively about capital misallocation and transparency as areas of concern in China, and continue to believe that these issues in combination with geopolitics make China a difficult investment proposition at least for US based institutions.
- Are Oil, Rains and Policy the 3 Key Risks for India?
o In India, almost half of its CPI basket is food. Agriculture is driven by domestic supply, in turn driven by the monsoon rate. This is and will remain a cyclical risk, but between structural reforms in government procurement, de-bottlenecking in distribution, and digitalization of payments, India is at an improved place today.
o An exogenous oil price shock will continue to be a medium term-risk despite India making rapid strides in alternative energy. “One of the challenges of India is its dependence on energy because we don’t produce that much oil. Having said that, I believe 40% of energy today is being created in the renewable sector. India’s exports are now higher than Saudi Arabia’s exports driven by the high-tech sector; $6 billion of smartphone export is an example of this,” said Hiren Ved, Director and Chief Investment Officer, Alchemy Capital Management.
o Although India’s policy outlook has steadily improved, there is still room to ease the friction in doing business on the ground. Between smart geopolitical alignment (procuring cheap Russian oil paid in rupees, simultaneous Saudi-Iran friendship hedge, etc.) and building an FX war-chest, any oil-shock to India will be milder than in the previous decade. According to Alejandra Grindal, Chief Economist at Ned Davis Research Group, “While the INR has held in well recently the fact that India doesn’t produce its own energy and depends on foreign supply always creates some air-pockets. It’s still difficult to do business in India. India ranks 63, versus China’s 31. Climate change is also going to acutely impact India, especially with the monsoon, and because the country relies on agriculture.”
- “Is China + 1 = A real opportunity for India?”
o India is in a sweet spot as the trends of de-globalization and friend-shoring (away from China) take hold. Political volatility, rising labor costs, and demographic weakening are headwinds for China’s unit production costs.
o According to Harshal Chaudhari, Chief Investment Officer, GE Asset Management, “History is not necessarily what the future is going to look like. If you’re talking about the ACWI index and outperforming it, I would say thinking about EM as a whole matters. There’s a lot to be said about Brazil, but between China and India, both of these have potential going forward. China today is pretty cheap, but rightly so, because of the macro pressures we’re seeing. While India is expensive, the growth and the demographic dividend make that market interesting standalone and particularly as a key driver of EM.”
o India’s working population is set to grow 15% over the next decade, whereas China’s is set to see an outright decline of 10%, according to Ned Davis research. Our view is that there is material slack in the Indian labor force with low participation, and there are a lot of women working in the informal economy. We believe that they could increasingly join the formal economy as it becomes more digital.
o According to Anurag Pandit, Chief Investment Officer, ALSAC / St. Jude Children's Research Hospital, “There are three things that contrast India and China, and frankly, they’re complementary. China has order, less law; India has a legal framework, no order. China has valuation; India has momentum; neither has both. If you extend it even further, I would say, just having overall EM exposure (Because China+1 strategy is not India; it’s the Philippines, Vietnam, and Mexico), so having a broad exposure today is important.” Our analysis shows that though emerging markets theoretically provide diversification in a global equity allocation context, in reality they have flattered to deceive as “beta” investments.
- Is India ready to be a “Single Country Allocation”?
o There was a clear consensus on India as a standout market that has both scale and potential, suitable for single country investing. With a depth of roughly 7,000 listed companies, one of the strongest corporate governance frameworks in EM and catch-up potential (per capita GDP ~$2,600 vs ~$12,000 in China), India offers investors a unique opportunity to deploy in a single country allocation much like China was in the early 2000’s.
o “India is a very underleveraged economy. There’s a lot of headroom for high quality debt driven by high ROE assets. You’re seeing a significant amount of domestic savings come to the market. The mutual funds are getting very strong inflows across market cycles. Debt markets opening up is a big step. Foreign portfolio flows are no longer the price setters. The Indian macro story is also about the coming of age of its market structure. India’s debt to GDP is low, they have massive potential for fiscal stimulus, if and when they ever want it,” said Hiren Ved, Director and Chief Investment Officer, Alchemy Capital Management.
o India’s structural reforms, financial liberalization, political stability, and digitization were very well received by investors. Tax reforms, execution against ambitious targets in roads and transportation build and focus on economic formalization via digitalization makes India a standout market in many ways. Tax revenues have followed up, as a result. “Multiples are high, but they’re high for a reason. If you just look at the infrastructure, the amount of activity going, I would say, around the world, India would be one of the best performing economies in the world just on that count,” said Harshal Chaudhari, Chief Investment Officer, GE Asset Management.
- Small Cap Public Equities Could Provide Better Risk-Reward Vs. Private Markets:
o Governance and monitoring make investing in private markets a unique challenge. Moreover, the lack of exits and governance issues resulting in left-tail events have made it very difficult for institutional investors to sustainably create value. “It is too much PE/VC money chasing too few quality deals, and that’s why they end up overpaying. Investing in small caps in India is like investing in PE, but the advantages are the superior transparency and liquidity. I’m not saying all of private is bad, but I don’t think that the private industry has given a risk adjusted return compared to what you can get in public investments. In the public markets, if you have a trusted and reliable manager on the ground, there are a lot of opportunities, especially now, with new avenues like the electronics sector and digitally enabled businesses,” said Hiren Ved, Director and Chief Investment Officer, Alchemy Capital Management.
o Locking-up capital for 7 years and not having an ability to maneuver have been problematic. Although our panel saw some opportunities in the private markets, a growth focus via small cap public equities seemed to be the optimal trade. “You need to watch the supply demand balance or imbalance in Indian private markets; it’s overflowing with capital, the valuation of 83 unicorns in India, 63 are in the red, collectively losing $8 billion. Especially in venture, you have to be very careful about entry point, and picking managers that are good in valuation,” said Sophia Tsai, Managing Director, Investments, Trinity Church Wall Street.
- “Ecosystem relationships and ground game vital to avoid blowups”:
o The one clear theme that emerged was the need for a robust ground game, an ecosystem of relationships, and finding the right local partners. India has always produced some great managers who communicate well and have received institutional capital over the years. However, anecdotal analysis of various institutional portfolios leads one to believe that style drift (buying privates as a public manager), insatiable appetite in capital raising and therefore poor portfolio construction decisions have led to a steady stream of manager blowups in India.
o “Investing in EM is not for the faint of heart, but investors like inefficient markets, so how are you going to manage it effectively without managing it actively? We believe in on the ground managers: We have been consistently managing it that way. Is China still investable? We still think it is, and it is inefficient especially when it comes to small companies focused on domestic demand,” said Sophia Tsai, Managing Director, Investments, Trinity Church Wall Street.
o Long track record, consistency, and augmented institutional wisdom (memory) seem to be key attributes for sustained winning in India. According to Hiren Ved, Director and Chief Investment Officer, Alchemy Capital Management, “We have been in the business for 22 years and have not had a blow-up ever in any of our positions. A couple things need consideration, 1) From an environmental perspective, there was a lot of adverse incentive for entrepreneurs to take money out of the country but in the last decade or so a lot of entrepreneurs understand that having a healthy multiple driven by clean books has more value than stealing money out of the company. Second, as a good steward of capital it is imperative for the manager to have that network of ecosystem relationships built over the years on the ground with CEOs and entrepreneurs etc. We know the people, we know the founders, and more importantly, we have an objective framework to measure them, it’s extremely important to have those boots on the ground, rigorous background checking. For example, Satyam, we always knew through the ecosystem in the sector that the margin and revenue growth they showed never tied up with a worthy competitor like Infosys, which we owned and knew every well.
Our relationship with the software contractors gave us an early warning that something was not right with that company. As far as Adani, you’ve got to use some common sense. A lot of growth was driven by leverage, and irrespective of dynamics, our process would never allow us to invest in something like Adani. You don’t want to be aligned with a group where there could be political risks. I think we avoid companies that are growing too fast and using too much leverage.” Having invested and allocated over two decades, I can vouch for the criticality of “on-the-ground” presence.