338. Why investors should be excited about India’s ‘Boringly Steady’ economy

31 October 2024 (pre-recorded 18 October 2024)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week’s interview was pre-recorded on the 18th October and looks at the economic and investment potential of India, one of the world’s fastest-growing and most demographically favourable markets. We discuss both strengths and challenges posed by market valuation.

Darius McDermott (DM): Hello, I’m Darius McDermott from FundCalibre, today I’m delighted to be joined by Ajay Tyagi, who’s manager of the UTI India Dynamic Equity fund. And he’s based in Mumbai, but he’s in London for a whirlwind visit seeing clients, so Ajay, thank you very much for coming and seeing us.

Ajay Tyagi (AT): Pleasure, Darius.

[INTERVIEW]

DM: So based here in London, UK is – and politics and budget – we have an upcoming budget. It’s all very topical, and of course there’s the big election in the States, which we can’t get away from even if we want to. But let’s focus in on India. Your region and and your area of expertise. Tell us what’s going on there. Where we are in the cycle and how India is looking from from the ground.

AT: Sure. I would say that India continues to be very steady in terms of its economic growth. Some people may call it boringly steady.

DM: There’s nothing wrong with boring if it’s going up! <Laugh>

AT: So no surprises either on the positive or the negative side. Interestingly, we are at very early lapse of our economic growth. And I say that because if you look at our GDP, we would be the fifth largest and about to become the third largest in the next few years. And one may say that, look, third largest economy in the world, is it going to go X growth or would it continue surprising us on growth?

But if you dissect this and look at the per capita income for a typical Indian, it’s $2,500. So we are in very, very early laps of our journey, very early stages. And I would say that growth should ideally continue for decades to come. If we keep growing at 6%, we would take two decades to reach to the level where other emerging markets are today in terms of their per capita income. I’m talking here about China, Russia, Brazil, even South Africa. So yes, te could remain boringly steady for about a decade or more.

DM: So let’s dig under the bonnet a little bit. I think it’s well known that India has this fantastic demographics, a large population, but a large young population unlike many parts of the developed markets and many parts of, say, China, for instance, which has an older population. And also, it’s a very old stock market. It’s got strong corporate governance. And I’m aware that it’s a very digitised growing economy. Banks are all done on phones, et cetera, and all that sort of stuff. So that’s all in its favour. Yet, maybe the uninformed would just say, and look at the Indian stock market, it’s very expensive at a headline PE rate a) versus its own history and b) potentially versus other emerging markets because India always trades at a premium to the broad emerging markets. What’s your observations around that?

AT: So I would say let’s dissect it into two parts. You’re absolutely right in saying that India has been trading at a premium to other emerging markets over the last couple of decades. I think that will continue. And I did say and I did mention about the very steady outlook for India in terms of economic growth. I think it’s this steadiness, which always makes it appealing to a lot of longer term investors, who want to actually be positioned in India structurally rather than tactically. And that’s why the valuations are always high.

But you also made an observation, which is very interesting, which is we are trading at a premium to our own history. And I should not you know, kind of defend the high valuations at this stage. I think I would categorically mention that. Perhaps the Indian stock markets are about 15, 20% overvalued compared to their own longer term history. It does suggest that maybe we could be looking at some bit of consolidation in the markets over the coming quarters. Who knows, possibly a 5, 10% correction. But the good news about a growing economy like India is that we continue showing steady earnings growth. So if markets were to correct 5, 10% and over the next few quarters earnings were to grow another 10 to 15%, we are essentially talking about the markets becoming cheaper because of these two forces.

DM: So, if the earnings are going with the growth, then it’s potential that some parts of the market aren’t super expensive.

AT: Absolutely. So yes, episodically, you would see some parts of the markets being expensive, certain other parts not being as expensive, so long as earnings keep coming in. I think you know, the overall markets, notwithstanding the fact that certain pockets are expensive, certain pockets not so, should be fine. But yes, a word of caution, certainly don’t look at the last two or three years in terms of returns and have those expectations around the market’s returning in the same order every year. That usually doesn’t happen.

DM: And I’m told that there has been maybe a bit more of that overvaluation in the very small companies, and that there is even from a very low level an an increase in Indian subjects actually now starting to buy the Indian stock market using that technology. And that their wallet size, even from a small base, has doubled in the last three years. But that sort of fuelled this small cap bubble. [AT: Sure] And potentially some of the, sort more value parts of the market, but you are more of a quality growth investor, if I’m correct. [AT: Yeah] What are you seeing, is that part of the market being a bit unloved and is that now coming back into favour?

AT: That’s an absolutely correct observation. I would say over the last two, three years, we’ve seen the value part of the market do exceedingly well, India goes through these cycles once every few years. [DM: Yeah] So it’s not uncommon to see you know, value doing very well at the expense of quality and at some stage…

DM: And what sectors are the value sectors? What areas have done well?

AT: So value sectors are typically the ones which are cyclicals, which actually you know, see their growth either being super strong in certain years, and being extremely weak, in fact, even turning into losses at some stage. So I think the typical value bastions are global cyclicals, energy and utilities real estate, infrastructure, construction. These are the ones which you know, show amazing cyclicality in their earnings. So their earnings have actually seen a very strong cycle over the last two, three years.

DM: The re-rating that they’ve enjoyed.

AT: Absolutely. The quality camp on the other side are more steady companies. These companies are not as volatile either in terms of their revenues or earnings. These are companies which are actually on a structural basis continuing to show strong secular growth. The typical bastions here would be the consumer goods and services it services, the retail focused banks and companies from the healthcare sector. So, yeah, I mean that’s the differentiation.

And as you rightly mentioned, value has done exceedingly well. Quality has actually done very poorly. We are already seeing early stages of this rotation happening. Many of the small caps actually come from the value stable rather than the quality stable. So that part of the market has also done very well.

DM: And your strategy, if I’m right, it is more quality and growth, but you are more of a large cap manager, you know, rather than the small cap? Or do you do all parts of the market?

AT: So we actually end up doing all parts of the market. Your observation number one is right. We have a quality tilt. So we are indeed highly focused on quality. That’s our north star in a way. We never buy anything which is not displaying the typical quality characteristics like high cash flows, high return on capital strong balance sheets, and so on.

At the same time, in terms of our market capitalisation bias, I would say we are agnostic. [DM: Right] We are an all cap strategy. We have the right mix of large, mid, and small. A lot of our success over the last decade, indeed, has come from identifying these smaller companies relatively, which are right from the early stages displaying the quality characteristics and which have grown many times over, over the full cycle.

DM: Yeah. So if that rotation comes back to that quality, which I think of India as a growth market, not a value market. [AT: Right] I think more of China as a value market maybe. [AT: Right] But you know, I think if you want to be investing in India, it is to enjoy that long term, maybe even steady growth cycle that one would expect. [AT: Right]

So we noticed that you talked over the summer about the chemical sector, not a sector that we’re super familiar with. Maybe give us a little bit of detail about that. What the characteristics are that either you like or you dislike.

AT: Sure. I think this is a very interesting question, and let me just take a step back and tell you about the bullishness that we have on this sector. So you know if you go back all the way to 2016, that’s the time when US started putting up these tariff barriers against China. [DM: Yes] Now, we all know from common knowledge that China has been the big daddy in terms of you know, being the manufacturing partner to the world, whether it’s the chemicals or the pharmaceutical sector or you know manufacturing electronics or manufacturing auto components. China really has been that one go-to partner. But yeah, post 2016, we have seen global resistance towards towards China. It first was noticed during the tariff war, and then later we saw during covid, the massive shutdown that China saw leading to massive problems with the supply chains around the world.

DM: Yeah, of course.

AT: So therefore, the last two, three years, we have increasingly heard of this term called China Plus One, which means that yes, we would continue outsourcing you know, goods to China, but we also need partners who can add as a backup to China. And I think different emerging markets have strengths in different sectors. India does have strength in pharmaceuticals, chemicals and also electronics. And it is from this perspective that we have seen a lot of chemical companies in India actually getting business from the global giants. And they are now becoming outsourcing partners to a lot of these big global chemical giants.

So it is with this perspective that we’ve been looking at opportunities, we are looking at companies particularly, which have you know, a very strong advantage in two or three molecules. And this advantage basically is in terms of lowest cost of production and ability to produce at mass scale. Our research has thrown up a few opportunities, and that’s where you know, we are positioned.

DM: Yeah. I think the China Plus One thing is very important. I think, I believe the iPhone assembly is more than doubled in three years in India at the expense of China. And I think that’s probably a trend that Apple would like to continue. [AT: Absolutely] And not be reliant on China. But also I think India’s positioned itself very well politically, right, with the Americans, with the Chinese, even with the Russians. It has done what is best for India. And that I think is also slightly overlooked.

Again, the US election dominates most parts of the world, but you know, although with a reduced majority, Mr. Modi did win again. And he has been market friendly and business friendly. And it would appear that politically stable is also very positive for India.

AT: Absolutely. I would say Mr. Modi coming back for the third term is both unprecedented within India and unprecedented for most democracies around the world. It just shows his stature and his popularity continuing despite being the prime minister for 10 years. [DM: Yeah. Back to back.] So, yes, it does lead to political stability. But at this juncture, I should also state that you know, India has two big political formations and power keeps rotating between these two formations.

So one is Mr. Modi’s party, which is BJP, along with its allies. The other party is the Congress, along with its own allies. Now, while Mr. Modi has been in power for the last 10 years, but prior to him, the Congress party, along with its allies were in power for 10 years. Now, the reason why I’m giving you this background is that regardless of which party you know, is forming the government, the economic policies in India have been fairly steady because in terms of the economic agenda of these two parties, they’re fairly similar.

The two parties have different political agendas. One of them is more right-leaning, which is Mr. Modi’s party. The other one is more left-leaning. But when it comes to economic policies, there is huge convergence. So I would say that yes, it’s always good to have the same party come back, but at some stage I’m sure that the power will go back to the Congress. And even at that stage, I would actually say that we would not see any big reversal in policies. The economic reforms will continue as they have continued over the last 35 years. And in the last 35 years, power has actually changed hand at least five times.

DM: So maybe that demographic, the educating, the higher level of education for that young population is more important driver and the upscaling in the consumer and the per capita GDP is more important than who the actual government is.

AT: Absolutely. Darius, I think you couldn’t have been more correct at this. You know, I don’t wish to use jargons today, but I can just say that economic growth ultimately is a function of three things. Increasing capital, increasing labour force, and increasing productivity. [DM: Yeah]

The hardest thing to generate is increasing labour participation, because if the country starts to see negative demographics, by which I mean aging population, then to reverse that takes decades and decades. So India is very, very favourably positioned in terms of the young population, which means adding more and more people to the labour force. And I think that would be a big driver for growth to sustain over the coming decade.

DM: So we’ve talked about the demographics and all the strong growth drivers within the country. And we’ve also touched a bit on the sort of valuations of the market, which by your own admission is expensive versus its own history. Not super expensive, but relatively expensive. And we also know investors, traditionally chase performance, and India has been – outside of America – the standout global equity market for now a number of years, not just one or two years, but a number of years. Are you optimistic on returns for 2025, particularly given that style rotation we touched on earlier?

AT: So if you’re talking about the next one year, I would actually hesitate to say that the performance of the last couple of years should not be extrapolated.

DM: Unlikely to continue at that great pace.

AT: Absolutely. So, you know, investors should definitely take a longer term view on India. What I’m extremely confident in stating is the very sure and steady nature of India’s growth. And there are many factors behind this. We just talked about demographics. We just talked about how the government is you know, wanting to step on the reforms continuously whether it’s one party or the other. We also spoke about the educated population. So there are multiple factors which will keep India in good stead in terms of its economic growth over the coming decade.

But look, the stock markets are always volatile. The stock market certain times get ahead of themselves at certain times become too anxious about things. At this stage, it’s our reading that the markets are slightly ahead of themselves. So we won’t be surprised if the next one year would would be you know a weak year for the markets possibly you know, sideways, maybe a slight negative drift. But do remember these are also times when you actually start building in your position into a country like India. So rather than timing the market, I would urge our investors to make staggered investments into India over the next 12 months. Possibly this would be one of the better times to actually invest into India and then hold on for the long term.

DM: Yeah. And we’ve also talked a bit about some of the extreme valuations being in the parts of the market that you don’t traditionally go to, that sort of value end and some of that small cap value where other Indian managers tell me summit valuations are very extreme.

AT: Absolutely. So thanks for bringing this up, Darius. I mean, I would say that specifically as far as our fund is concerned, we haven’t touched those parts of the market, which are extremely frothy. So we have a very strong quality tilt, which means that we are really investing into businesses which are steady, which are short footed, which have strong balance sheets, and we have actually not participated in this small cap rally at all. So from that perspective historically as well as our expectations about the future is that our fund should provide a much better downside protection compared to what happens in the market.

DM: So maybe then let’s just finish up last question. I think we’ve covered a wide range of subjects, but let’s just talk about the fund and the positioning within the fund. Which sectors do you favour at the moment? And I don’t know if there’s a sector or something you’d like to just finish on and just why you like that sector? What are the growth drivers or the quality parts of those type of sectors?

AT: Sure. So let me again, take a step back. If we deconstruct India’s GDP and India’s economy, you realise that the steadiness in India is coming on account of its domestic consumption. So you have an economy which is you know, forever consuming. And in fact, those consumption trends are becoming better and better. [DM: One way, right?] Absolutely. Only one way young population.

You have per capita income, which is still low, but then rising every year. And you see there is no better industry than the one where the penetration levels are very low. [DM: Yeah] And the penetration levels keep rising year after year. So in a way, we are most positive and most bullish on the consumer goods and services sector because that’s that part of the economy which will continue to grow. Penetration in categories is very, very low. If I dissect this further, I would say that the more essential day-to-day items are the ones where we have seen the penetration become you know, strong right now. Therefore, we don’t expect these businesses to have a very, very strong growth. But the items of discretionary consumption, which do require a much higher per capita income and much higher disposable income, are the ones where we are seeing trends that will you know, sustain growth over many, many decades.

I mean, consumers everywhere are aspirational, right? They want to move up the ladder all the time. And the discretionary, or the high ticket items are the ones where Indians are now stepping up in terms of the demand because their wallets and their disposable income are just now allowing them to go there and enjoy some of these discretionary items. So we feel that just like the staples growth or the essential items growth over the last 20 years, were very strong in the coming 10 years and beyond. It’ll be the more discretionary items which will emerge as very strong in terms of growth. And many of these brands actually lead to very strong outlook for these businesses in terms of their margins, in terms of their profit growth and so on.

So yes to sum it up, I would say consumer goods and services is that one sector where we are super bullish.

DM: Ajay, thank you very much for your time today and come and talking us through all things India, economies sectors, demographics, and stock markets.

AT: Thank you very much.

SW: The UTI India Dynamic Equity fund invests in a mix of large, mid and small-cap Indian companies. The investment process is based on quality, growth, and valuation, and the team conducts thorough on-the-ground research to identify and monitor companies with a high potential for significant market outperformance. To learn more about the UTI India Dynamic Equity fund please visit fundcalibre.com