Happy New Investment Decade

If you are a rational investor, you should be very scared of 2010. Very, very scared.
Almost everything has a good chance of going wrong. Food prices have gone through the roof, officially rising nearly 20 percent. As grains, pulses and simple vegetables like tomato increasingly go out of reach, millions of Indians will be forced to cut back their other items of expenditure to be able to feed themselves. The fear of shrinking demand has already led to a fall of nearly 50 percent in new borrowings by producers of goods and services. The government is spending much more than it is earning, leading to a record fiscal deficit in recent times. Interest rates are set to rise.

Shares and other assets like gold are already trading at levels much higher than their historical means and could go down. The capital that has fuelled their rally is likely to dry up. First, the extra money that came from the stimulus packages of various governments will cease. Next will come the unwinding of dollar carry trade, in which investors had borrowed cheap in abundant dollars and invested in currencies like rupees that have higher interest rates. Thus the twin Santas of liquidity and leverage will roll up their bags and ride their elves back to the Pole. A very reasonable conjecture: The year could see one or two sharp sell-offs. Take a snapshot of your portfolio today.

But the biggest worry is about the global recession. History has shown that economic disasters are often followed by a quick recovery, and then, a slower, less dramatic but more devastating crisis. It happened after 1929 and after 1987. We have seen the quick recovery in the form of asset price rallies since March 2009 and increasing industrial production in emerging economies. What next?

Face it, friend. If you are the type that believes in moderate blood pressure and homo sapiens’ ability to buy low and sell high, you should liquidate your investments and wait for serendipitous upturns in the markets. 2010 will be volatile, unpredictable, moody and potentially hurtful.

But we are telling you to invest.

Just like the turbulence on the surface of the ocean hides the calm potency of the advancing currents beneath, the vicissitudes on the surface of the economy mask the deeper, more profound shifts that are powering India’s march towards becoming a middle-income nation, and hopefully even a rich one. Playing out over several years, these mega trends are easily lost in the mayhem of day-to-day markets. The serious wealth builder peels away the layers to discern and profit from them.

Thus, a slight change of perspective reveals a completely different 2010. A set of rare and benign circumstances is coming together to create just the right conditions for the nation to take off on a higher growth trajectory, bring economic opportunity to a wider swathe of its population, encash its so-called demographic dividend and end inequity. This is happening right in front of us; the situation was not ripe earlier and may be too obvious later. So, this year may just be the time when the smart, patient investor looks beyond the next settlement and bets on India’s future.

The country’s tipping point has arrived and it is 2010.

Be Indian, Buy India
More than a decade ago, when India’s per capita income crossed $500, K.V. Kamath made a crucial decision. Looking at the economic history of many countries, the CEO and managing director of ICICI Bank figured that the crossing of key income thresholds always unleashed a new wave of consumption and thus, economic growth. He then launched a retail banking operation expecting a similar burst of activity among Indians. The following years showed he had made the right call.

Today, Kamath is excited again. India’s population stands at 1.17 billion and its economic size at $1.17 trillion. Its per capita income, for the first time in history, has touched $1,000 in absolute terms. Kamath, now ICICI’s non-executive chairman, believes India has reached a second tipping point.

Economists agree that $1,000 is an inflexion point for growth. “It is obviously a milestone,” says Shashanka Bhide, senior fellow, National Council of Applied Economic Research. “At that level of income, there will be a lot of people catching up and joining the consumer economy,” says Bhide, who specialises in macro-economic modelling and development issues.

Increasing prosperity will push demand for houses, vehicles, consumer durables and entertainment in the cities. The affluent will go for bigger brands. But an average of $1,000 means nothing if things stop at that. The market has to expand to include the poor too.

Thankfully, that too has begun to happen. The agricultural dependence of rural India is changing. Today, a village family derives anywhere between 20 percent and 50 percent of its income from non-farm activities. This acts as a natural safety net against the vagaries of monsoon and the unpredictability of agricultural income.

The most important spark for this change is the Central government’s National Rural Employment Guarantee Scheme (NREGS). It provides 100 days of employment to a rural family in a financial year. The implementation is patchy and there have been reports of corruption and inefficiency, but the value of NREGS in transforming the rural fabric cannot be questioned. “On balance, it has put more money in the hands of the village poor,” says Sivakumar Surampudi, chief executive of agri businesses at ITC. Now, NREGS has become far too important for the government not to improve its design and functioning.

Rural families are getting more income from another source as well. Their men who had migrated to cities are saving a part of their earnings and sending it back to their families. Sivakumar calls this a big wave of remittance that should encourage people to buy more articles of daily use, better clothes and even stuff like televisions and washing machines.

The third trigger has come in the form of billionaire Nandan Nilekani. The former co-chairman of Infosys Technologies is developing a template for a national identity project. To provide a unique identity to each citizen is not a new idea. But the scale is unprecedented. Nowhere on earth has such a project been implemented for 1.17 billion people. Earlier attempts have failed. But Nilekani brings an ability to manage scale and complexity to his job as the chairman of the Unique Identification Authority of India (UIDAI). If the ground he has covered in the last six months and the enthusiasm he has evoked among politicians are any indication, it is a certainty that citizens will get their unique identity in the years to come.

How can it help? M.S. Sundara Rajan, chairman and managing director of Indian Bank, says it will take credit to the large unbanked population, about 60 percent of India. The mobile phone, a medium for transactions, has already reached the villages; effective demand for goods is arising. The only missing piece in the puzzle was customer identification. Nilekani’s scheme could thus bring large parts of rural India to the financial mainstream. “Just give it two or three years. It will happen 100 percent,” says Sundara Rajan.

The wave of change does not stop there. There is something special about the youth of India now turning 18 and entering the voters list and the work force. They are the children of economic reforms, having been born around 1991. In 1996 or thereabouts, a stark change was noted in the villages. It may have been the reforms that brought new hope or the lure of the midday meals scheme that was expanded nationally, but parents, even the poorest, started sending their children to school. The People’s Report for Basic Education (PROBE), conducted in 1996, showed that the proportion of never-enrolled children in villages had plunged from 55 percent in 1986-87 to just 19 percent in 1996-97. “Most parents are willing to give schooling a chance,” the report said. Even accounting for the poor quality of schools, the new generation is better educated and capable of being trained in various professions. This national asset will be fully used up by resource-hungry companies in the coming years. In due course, the young people will also become active consumers.

There are enough indications that Indian companies are gearing up for a second wave of growth. The country has just come out of a slowdown that followed five years of heady expansion. Companies had invested heavily in plant, machinery and people and were faced with overcapacity when things started to go bad in early 2008. In 2009, non-food credit growth was just 44 percent of deposit growth. In 2008, it had been 86 percent. So, many concluded that companies had put fresh capital expenditure on hold.

However, there is fresh signal that companies have resumed executing projects. In the first six months of the financial year 2009-10, capital expenditure grew 11 percent. The gross block of Indian companies continues to be an upward curve. “We are at the beginning of a new capex cycle,” says Abheek Barua, chief economist at HDFC Bank. “In some ways, this is comparable to where we were in 2002-03,” he says recalling the earlier wave of investment that boosted economic growth. As India remains one of the world’s fastest growing economies, global capital will invariably find its way here.

One sobering thought, however. It is tempting to say that India’s emergence is pre-ordained. But the fact is it is not. We still need to work hard to convert all this potential into growth. There are many hurdles that can stop us from doing so.

 

Illustration: Hemal Seth

They could come in the form of corporate frauds or the loss of political will. But more likely, they could come in the form of internal dissatisfaction. The first wave of reforms has seen the gap between the rich and poor increase. Unless this gap is bridged, consumption demand will dry up one day. Sundeep Waslekar, head of Strategic Foresight Group, a think tank, says the lack of agricultural reforms and unequal growth has created the space for extreme movements like Naxalism to flourish. Companies will not be able to invest in areas where the violence is unlikely to vanish in a hurry. Add to this the lethargy of some states in creating economic opportunity and it is clear that some parts of the society will stay out of all the growth.

For the investor, the choice is clear. Putting your money behind a growth of 7 percent a year seems to be a low-risk bet. The growth could be much higher if India’s infrastructure is fixed and social inequalities bridged.

In particular, the new economic growth will manifest itself in six megatrends that seem to be clear winners in the years ahead. In the following pages, we detail what those themes are and how you must pick the right asset classes and the right securities to play them. The payoff might take three to five years to come, but is sure to be as big as the fuel tank of a Hero Honda motorcycle.

If you fill it, shut it and forget it, you won’t have to be scared of 2010.

BOTTOM OF THE PYRAMID: The Meek Shall Inherit the Mall
The consumption wave of the middle class started only after 1999-2000 when the country’s per capita income crossed $500. Now that the income level has doubled, the market is expanding to lower income groups. An estimated 500 million people are entering the consuming class. Not that they will be able to fly tomorrow, but if products relevant to them are offered at attractive price points, they are ready to buy.

The concept of Bottom of the Pyramid (BoP), in which C.K. Prahalad taught us to treat the poor as a market, is too well known. Makers of toothpaste and shampoo have sold low-price variants for long and mobile phones have reached even where roads haven’t. But these were sporadic successes by firms that chose to be in that market.

Today, the BoP market is no longer a choice. It has become an absolute imperative. Affluent markets have reached near-saturation in some products (e-g mobile phone connections), suffer overcapacity in some (real estate) or are highly competitive in others (consumer durables). From banking to automobiles, health care to education, washing machines to affordable housing, producers are moving to the lower income groups. The rising per capita helps.

But the BoP market is much more than selling low-cost products, says Sivakumar of ITC. Companies will have to invest in innovation to develop products suitable for these markets. For instance, smokeless stoves that are less harsh on the housewife are becoming hugely popular. Somebody will soon make a detergent that produces lather even in the hard water that poor people typically get.

Philips with cheap X-ray machines; Godrej with Chotukool regrigerator that works on batteries, water purifiers, lanterns and low-cost houses; Glaxo and Merc developing medicines for Kala Azar. The list of BoP aspirants is endless.

There are two ways a company can go about its BoP business. The infrastructure in city slums and villages is inadequate and so are the customer database and distribution networks. So, a company can position itself as a platform for goods and services. It will have to invest heavily creating the systems and building trust, but it will be able to make the maximum profits. The other option is, of course, to use such a platform to sell products.

Watch This: ITC has chosen the first option. It has tweaked its eChoupal model to make training of rural youth its anchor business. It makes money from that activity, and at a marginal cost, can increase the profits by endorsing products or running a recruitment service.
The same is true of SKS Microfinance, which GlaxoSmithKline Consumer Healthcare tapped to sell a cheaper version of Horlicks to village households.

URBANISATION: The Tale of Too Many Cities
Paramount Airways, one of India’s only two profit-making airlines in recent times, does not fly to the country’s most lucrative destination, Mumbai, but connects Madurai to 14 cities. UK-based Liberty International’s real estate joint venture in India does not want to develop property in any of the metros but is looking at places like Aurangabad and Coimbatore. Nikon India is changing its distribution model focussed on the big cities to one also covering at least 28 smaller locations. Do you get the picture?

Sandwiched between villages which got political attention and the big, high-premium cities which companies were obsessed with, India’s small cities have so far lived far below their potential. Many goods and services available in the big six cities were not sold in these places, even though they didn’t lack in purchasing power or size of the market. For instance, the only way to buy a Nikon camera in most such cities was to go to the grey market because the company’s distributors won’t reach out.

Now, all that is changing. The so-called tier-3 and tier-4 cities of India are gaining economic importance. Led by retail and real estate companies, virtually every industry is going there. New job opportunities are being created, encouraging villagers to migrate to a smaller city near their village rather than the faraway Mumbai or Delhi. Goods warehouses are coming up in small, off-track locations. “The appetite for consumption is clearly growing in India’s emerging cities,” says Sunil Chandiramani, partner at global accounting firm Ernst & Young.

The catalyst for the rise of smaller cities is the big-time development of road connectivity that began with the launch of the Golden Quadrilateral in the early 2000s. Many more road projects have been launched linking these cities with the metros. It is that connectivity that gives companies the confidence to set up operations there.

For instance, Nashik has begun to see business process outsourcing outfits and a moderate real estate activity on the back of plans for a Rs. 4,000-crore expressway linking it to Mumbai. Experts say the Mumbai-Pune-Nashik corridor can become a mega urban agglomeration.

Chandiramani cautions companies entering these markets against two pitfalls: Don’t think these are low-value markets where shoddy products can be pushed. And don’t sit in a metro and make plans for 30 cities. Hit the ground and learn.

Watch This: Gitanjali Gems, which has transformed from a diamond cutter to jewelry retailer, is positioning itself as a multi-brand retailer in small town India. The company’s lifestyle unit plans to set up 60 stores in cities like Indore, Raipur and Guwahati. The stores will not only sell Gitanjali’s brands but also outside labels in jewelry, apparel and accessories.

INFRASTRUCTURE: Build or Perish
Question No. 1: Which industry grows at four times the rate of GDP rise and presents the single largest opportunity for Indian investors?

The answer, until a few years ago, was software. Today, a historical laggard has taken over that honour. Infrastructure.

India has had a pretty long learning curve in infrastructure development and its first steps in most sectors have invariably been wrong. For instance, power was opened up to private players first in generation, even though its problems mainly lay in transmission and distribution. So, private capital failed to come in. With similar bottlenecks in many segments, infrastructure never caught the fancy of investors as software or retail or telecom did. It was always acknowledged as the most crucial element of India’s growth but something that the government did not understand.

But wait, something has changed.

Question No. 2: Which is the industry that grew faster during the global recession instead of being affected by it?

The answer: Same as above.

“You might find this funny,” says Satnam Singh, chairman and managing director of Power Finance Corporation. “In the pre-meltdown days, our profits grew at 30 percent year on year. After the meltdown, our profits have begun growing at 60 percent.” The breakthrough was the government’s removing the little niggling rules that delayed execution of projects.

The same is true of the road sector. Construction firms have all along complained about many irritants: A developer can’t sell off stake in a project and move on even after its completion; bids got disqualified on technical grounds that were difficult to follow in the consortium bidding process; the eligibility clause was too stringent and required experience in building projects double the size of the ones bid for.
Now, all these irritants have been removed and an unprecedented potential for contracts worth 37,000 kilometres of road-building has opened up from the Centre alone, Edelweiss Capital said in a report. Roads and Highways Minister Kamal Nath wants to award 20 kilometres of road-building every day. He is also pursuing innovative financing models such as allowing property development along highways as an additional revenue stream.

More changes are coming in: The concept of take-out financing has become a reality and will help banks move out of projects after seven years and fund newer ones; repo deals have been allowed in corporate bonds that will ease capital raising.

Watch This: Mundra Port & SEZ runs India’s largest private port whose cargo traffic, at 29 percent, is growing at four times the speed of other major ports. But its trump card is a 100 sq. km. industrial zone, where Mundra is attracting factories that will provide the port’s future traffic.

POLICY REFORMS: Going by the Ruler
On May 17, 2004, as the Congress-led coalition moved towards forming the next government, the stock market gave a vote of disapproval falling over 11 percent. The fear that the new regime will slow down economic reforms dominated all discussion. Five years later almost to the day, the same government returned to power and the same stock market rose more than 17 percent. The market may be finicky, but this approval was unprecedented. Its bet was that Manmohan Singh, stronger without the restrictive friendship of the Communists, would be able to push through policy reforms.

In the last seven months or so, Singh hasn’t disappointed. His government has moved to overhaul various laws, especially those relating to companies and taxation, and is trying to attract private sector talent to execute crucial projects. It has also speeded up reform measures that got stuck in his first tenure. Their combined impact will take years to sink in but will open up immense investment opportunities.

“We may be entering a golden era of state-building in India,” political commentator Pratap Bhanu Mehta wrote recently. “If at the end of this government’s term, we have universal ID well established, GST and tax reforms up and running, modest progress in administrative reforms under way and increasing capacity to administer larger welfare schemes, the Indian state will be very well positioned,” he said.

The most immediate big change will be GST, or goods and services tax. It will free Indian businesses from the current prohibitive regime of indirect tax, known for multiplicity, complexity and the practice of levying taxes on taxes. GST will unite the various regional markets of the country into a national one. It will boost government revenues while reducing the tax burden on businesses. A comprehensive GST system has the potential to raise gross domestic product by anywhere between 0.9 percent and 1.7 percent, says NCAER.

NCAER expects the return on land, labour and capital to increase with GST. It expects the largest increases in output to occur in textiles and readymade garments; minerals other than coal, petroleum, gas and iron ore; organic heavy chemicals; industrial machinery for food and textiles; beverages; and miscellaneous manufacturing. The sectors where output could fall are natural gas and crude petroleum; iron ore; coal tar products; and non-ferrous metal industries.

Watch This: A new companies law to encourage entrepreneurship; listing of at least 25 percent equity in all widely-owned companies; a separate bankruptcy law that will speed up the asset disposal of insolvent companies and thus give a fillip to mergers and acquisitions activity; a change in labour laws to give companies more freedom in staffing decision, and; opening up foreign direct investment, especially in the insurance sector.

MULTINATIONALS: Aliens in the Attic
When iconic motorcycle brands Harley Davidson and Ducati got launched in quick succession, much was made of how the Indian market has moved up the premium chain. The admirers, however, missed a couple of news stories that revealed how it was also moving down the premium chain. Procter & Gamble and Panasonic both said they were shedding their long-held premium tags, rolling up sleeves and getting their hands dirty in the mass market.

Over the past six months, it has been impossible to read business newspapers without coming across yet another multinational company rejigging its strategy in India, regretting how it had not focussed on the market earlier and talking about multiplying sales.

One day, it was news giant Bloomberg bringing its television venture to India and the boss of its multimedia business expressing embarrassment and surprise that it did not happen earlier. Another day, it was General Electric announcing a new country head and a product localisation strategy, with chairman and CEO Jeff Immelt admitting past growth had not been up to the mark. And then, it was Nikon changing its distribution; Sanofi-Aventis entering the rural market; Philips innovating in its marketing; Volkswagen buying 20 percent in Suzuki with an eye on India.

When multinational companies came in droves to India in the 1990s, socialists feared that they will marginalise local companies and with their deep pockets, come to dominate the consumer. Truth be told, many multinationals indeed thought this was a low-value market where end-of-life products could be peddled.

But today, they stand humbled by their experience in India. The consumer not only demanded localised products of high quality, but also asked for them at his own prices. “Today, multinationals know that India is a difficult market, and a different market,” says Vikas Vasal, executive director at KPMG. “They have learnt that you cannot transplant a business model developed in the Western world, that you need products for India.”

The financial crisis and the muted growth projections for developed markets have forced many foreign companies to take another look at the Indian market. Nimble as they are, multinationals have not hesitated to admit that investments and decision-making power should shift to where the growth would come from.

It is clear multinationals are raising their game. They will change the competitive landscape in India and local companies will lose their comfort zones. More interestingly, many multinationals will also list their shares in India to show their commitment and raise capital locally.

Watch This: Standard Chartered Bank is a prime example. It is not easy for the British bank to be visible in a country dominated by state-run banks and dynamic private banks. It plans an Indian Depositary Receipts issue to enable investors to buy its global underlying shares.

EMERGING MARKETS: The Newer World
From the notes of Prakash Menon, president, NIIT China: “Met Mayor of Wuxi. We needed some infrastructure. He had it ready in a week. We trained 1,500 students. He asked about training 10,000 students. We said we needed 300,000 sq.ft. He gave it to us in a week. The government is very fast. We have to keep pace with their speed.”

NIIT is a rare Indian company that has managed to crack the Chinese market and build scale. For many other Indian companies, used to doing business with the US or Europe, China is still a mystery. But NIIT showed that if you understand the local needs and build trust, you can do profitable business there even though you are an Indian.

After the global recession exposed the risk of doing business with the developed world alone, there is a new sense of urgency among Indian companies to tap the big markets of tomorrow — Africa and Asia. The recovery seen in the last few months has also shown that these regions will be the consumption engines of the world in the next few years. Africa and China account for a third of the world’s population and their purchasing powers are rising.

Just like the domestic market is expanding from cities to towns to villages, its export market is expanding from the developed world to the developing world. And almost all the rules of the game are similar in both: Get local insights, design relevant products, listen to the customer and try to provide comprehensive solutions. And they are exactly the lessons that foreign companies coming to India learn.

Stepping into unknown territories will be highly rewarding because competition is negligible. But the risks are also big. A civil war is raging in Sudan, where Oil and Natural Gas Corporation has invested $720 million for a 25 percent ownership of an oil field. ONGC’s other selections aren’t a bed of roses either. It is developing gas fields in Iran, for instance.

“The good thing is that Indians, by nature, are welcome in many of these markets,” says Vijay Subramaniam, CEO of international business at Marico. A large number of Indian companies have entered Africa and the Middle East and often learn from each other the nuances of the local market, he says.

These markets also offer lessons that can be used back in India. Marico figured that in order to build scale in the Middle East, it had to launch a hair cream product. Parachute hair cream became so
successful there that Marico brought that product to India as well and found a
ready market.

Watch This: After running a hospital successfully in Bangladesh, Apollo Hospitals plans a chain of hospitals in Africa. It already understands the African healthcare scene, having been part of a continent-wide telemedicine programme. It might work with Nigeria’s government to overhaul that country’s healthcare system. Apollo also plans specialised knee clinics in developing nations.

(Additional reporting by R.N. Bhaskar, Dinesh Narayanan, Neelima Mahajan-Bansal, Prince Mathews Thomas and N.S. Ramnath)