Financial Times: Hands-on investor: India not just a short-term prospect

Hands-on investor: India not just a short-term prospect
By Stephen Schurr
Published: August 10 2005 16:34 | Last updated: August 10 2005 16:34

“Hot or inevitable?” – Motilal Oswal Securities, an Indian brokerage firm, asked this question about the Indian stock market at a conference it co-sponsored with Bear Stearns last week in New York. Most of the hedge funds that turned out in droves for the conference were probably predisposed to answer the latter but two days of one impressive presentation after another left no room for doubt. I have plugged India enthusiastically before but I heard enough compelling ideas to justify another column.

Hedge funds are flocking to India. While this group has been accused of chasing hot markets, the India story is different. Hedge funds are patiently cutting through thickets of red tape, racking up thousands of frequent flyer miles and teaming up with local money managers to establish beachheads on the Indian subcontinent. This is not about a hot opportunity: it is an investment.

The Motilal Oswal keynote presentation came to the same conclusion, starting with a convincing analysis suggesting India may be where the US was in about 1984 – at the beginning of a phenomenal bull cycle spurred by lower interest rates. The analysts showed growth in gross domestic product alone does not drive markets, as evidenced by the flat return of US equities during the 17 years to 1981 when GDP grew 373 per cent. While GDP growth was 177 per cent over the next 17 years, the stock market soared 1,050 per cent, thanks to sustained interest rate cuts.

The Indian stock market fell 29 per cent from 1992 to 2003 in spite of solid GDP growth of 281 per cent. However, interest rates began drifting lower in 1996 – falling from 14 per cent to 5.1 per cent in 2003. The Indian market is only beginning to adjust positively to the new interest rate environment, which is expected to remain benign. “The value of Indian financial assets,” the presentation argued, “must change in response to the dramatic fall in interest rates.”

Of course, India has seen some impressive changes. A phenomenal two-year run has pushed India’s benchmark index up 99 per cent. But if valuations and earnings growth count for anything, this bull market may be merely stretching its legs. “The Indian equities market is experiencing its 15th consecutive quarter of earnings growth in excess of 20 per cent, with an overall price-to-earnings ratio of only about 13,” says James Breiding, managing director of Zurich-based Naissance Capital, which has just launched an India hedge fund. Mr Breiding says his fund will stick to long investing, partly because it is difficult to short Indian stocks but also because “this is a bull market story”. The P/E of 13 compares favourably with the US market’s 19, it is also well below India’s average P/E of 17 since 1993.

So, where are the best opportunities? I overheard one conference attendee say: “The stocks I’m interested in aren’t big enough to be over here yet. The ones here have made it and don’t have the same upside potential.” While it is no doubt true that the small-cap and mid-cap opportunities in India are robust, there were plenty of companies who made it over with lots of potential to appreciate intact.

The one that struck me as particularly promising was the Jammu Kashmir Bank. The bank’s name provides a clue about its big challenge; the Jammu Kashmir region has long been a hotbed of territorial disputes between India and Pakistan. But with the peace process taking root, the J&K state looks poised for economic growth expected to be 14 per cent a year and the J&K Bank is perfectly positioned to bloom.

J&K Bank, which is 53 per cent-owned by the state government, has an 80 per cent market share in the state and a virtual monopoly when it comes to state banking business, according to Haseeb Drabu, its new chairman and chief executive. To the delight of attendees, Mr Drabu discussed the massive investments in the region by the state government and the Asian Development Bank – the latter making an autonomous expenditure of 43,000 crore (one crore equals 10m rupee), which works out at $9.87bn. “All this money,” Mr Drabu says, “will pass through J&K Bank.” Meanwhile, J&K Bank is seeing increased borrowing among tourist and horticulture ventures, the two biggest sectors in the state.

Thus the growth side is robust but the cost side is even more interesting. J&K’s stock trades at about 1.2 times book value. Based on Motilal’s projections, the P/E is 15 for 2005 and 5.8 for 2006. Meanwhile, J&K recently announced it would pay 80 per cent of its earnings in a dividend, and the stock has offered “four decades of uninterrupted dividends”. Considering the challenges of the past 40 years, J&K’s may be the safest dividend in the world.

Not all investors have access to Indian-based equities. Motilal offers several recommended Indian companies that do have American depositary receipts (ADRs) that trade in the US. Dr Reddy’s Labs, a beaten-down but still richly valued (for India) pharmaceutical company, is among its favourites. “We believe the stock prices in the worst while ignoring the significant cost leverage and potential to scale up revenues,” Motilal says, projecting a 40 per cent return over the next year. Motilal also expects strong returns from IT companies Wipro (symbol: WIT) and Infosys (INFY); unfortunately, the two ADRs trade at 19 per cent and 37 per cent premiums to their Indian-based counterparts. Dr Reddy’s (RDY), conversely, trades at a mere 1 per cent premium. For investors interested in the banking sector outside of J&K, HDFC may be the strongest bet, and it has an ADR (HDB) that trades at a 9 per cent premium. And ICICI Bank, a new favourite of Motilal, has an ADR (IBM) with a 2.3 per cent premium.

Of course, India is a good enough story that it does not have to be about buying one stock. Motilal puts a price target of 8,607 on the Sensex, up about 11 per cent from current levels. The Morgan Stanley India fund, a closed-end fund that trades under the symbol IIF, remains a rare solid option for getting exposure to India.