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Summary

  • Election of Narendra Modi has India on the path to reform.
  • Recent focus on foreign policy disappointed some who want to see big reforms, but the trips were as much about economics as diplomacy.
  • Recent dip in India ETFs offers buying opportunity.
  • Small caps offer the best way to capture domestic growth.

In a summer rife with geo-political tensions - Russia and Ukraine, Israel and Hamas, Iraq Kurds and the Islamic State of Iraq and Al Sham - as well as an unsettling geo-biological event with the Ebola outbreak in several West African nations, investors seeking positive news are turning to a quietly improving story: India ETFs.

Securities that track a basket of equity and commodity indices, ETFs represent an entry strategy to a market poised to take advantage of the momentum that Prime Minister Narendra Modi and the victory of his Bharatiya Janata party have brought to India since the May election. Investment in India's markets through ETFs allow for diversification, avoiding higher risk plays on specific industries, sectors and geographic regions. And unlike actively managed mutual funds, ETFs provide the option for short selling and buying on margin with generally lower expense ratios.

There are several options for India ETFs, among them WisdomTree India Earnings (NYSEARCA:EPI), iShares India 50 (NASDAQ:INDY), iShares MSCI India (BATS:INDA) and Market Vectors India Small Cap (NYSEARCA:SCIF).

To his detractors, Mr. Modi's focus on foreign relations during his initial weeks in office seems an unnecessary distraction to the many pressing internal needs facing the country. However, if Mr. Modi's first three months in office are a harbinger of things to come, his active foreign policy agenda could be but the first volley in a strategy to warm India's relations with its neighbors and position the country of 1.3 billion to increase its energy imports and manufacturing exports.

Coming to office with 12 years' experience as Chief Minister of Gujarat, a prosperous, manufacturing-heavy state, Mr. Modi witnessed firsthand the benefits of implementing company-friendly labor laws. Were Gujarat's template to be replicated across India, the country's labor force could expand by an estimated 40 million new manufacturing jobs in the next 10 years, according to a Wall Street Journal story citing a 2014 Goldman Sachs report.

However, effecting such change in manufacturing requires something that is taken for granted in many manufacturing economies but is in short supply in India: reliable, ample electricity. Hence, Mr. Modi's visit to Nepal in August, the first by an Indian PM in 17 years, while generally promoting goodwill also more specifically sought to advance a joint hydropower project that would include the construction of a dam and infrastructure such as roadways. However, serving as ballast for India's need for clean, sustainable electricity is Nepal's need to believe that negotiated electricity rates would be fair and mutually beneficial if it enters into such a joint venture with its much larger neighbor.

Mr. Modi's search for energy also extends to Japan with his planned visit to that country in September. Representatives from the two countries will reportedly discuss ongoing negotiations for a civil nuclear agreement, which stalled in the wake of the 2011 Fukushima disaster.

To be sure, significant internal obstacles remain to realizing India's true manufacturing potential. Observers define the list of primary challenges as twofold: first, enactment of a national sales tax to raise revenue and manage the fiscal deficit to replace the current patchwork of state-controlled taxes and, second, an updating of antiquated and constricting labor laws that penalize companies for hiring large workforces.

To expect immediate reforms on all of these fronts is unreasonable and shortsighted. Intractable and long-standing policies that serve narrow but influential regional interests as well as those of the opposing and defeated Congress party are deeply ingrained. But reform is more likely earlier in Mr. Modi's term than later, as would be the case for any new incumbent who rides an initial wave of optimism and expectation.

Whether ultimately successful or not, Mr. Modi's first year as PM holds the potential to advance India's manufacturing sector. The resultant promise for India's markets has brought a welcome alternative for investors facing a summer of geo-political risk. Investors who seek to position themselves now for the potential benefits to the markets of the world's largest democracy should consider India ETFs.

By The Numbers

India's GDP growth rate slowed markedly after 2010, and forecasts put 2014 growth at around 5 percent. For years, it has been expected that India would surpass China's growth rates, given a lower level of overall development, but it failed to happen.

Prime Minister Modi's conservative approach to development resembles the leadership style that has served China so well, and shows another facet of why Gujarat was able to become "India's Guangdong." Now that the entire nation will be under the prudent leadership of Modi, a reevaluation of growth rates is in order and we believe the new government's 7 percent growth target is well within reason. With less than one-third of China's GDP on a per capita basis, there is room for India's growth rate to increase substantially, but even a 1 percent increase in the growth rate would translate into solid gains for equity investors.

Indian stocks are relatively cheap when compared to GDP. India's stock market capitalization is around $1.6 trillion, while the economy is on pace to reach nearly $2 trillion by the end of 2014. At 80 percent of GDP, the stock market is nearing fair value territory, assuming growth rates do not pick up. That said, Indian stocks have tended to peak when the market capitalization moves well in excess of GDP, as it did in 2008.

The Indian stock market traded sideways from 2008 to 2014 before breaking out in 2014. This year's 23 percent move through August 17 looks to be a bullish breakout following a 6-year bear market. Were Indian GDP to push back towards the high single digit growth rates, India's stock market could enjoy a multi-year bull market before stocks became substantially overvalued.

The key part of the return equation for foreign investors is the currency. The Indian rupee devalued by more than 30 percent between 2008 and 2014. Stronger leadership and faster economic growth will attract foreign investment, as will a rising stock market, and the net result will be an appreciating currency in the years to come.

Currency losses are why ETFs such as WisdomTree India Earnings still need to rally more than 20 percent to hit their old highs. The picture for Market Vectors India Small Cap is even more stark: shares need to climb more than 100 percent in order to surpass highs set in late 2010.

SCIF is attractive on valuation. It can be purchased for about the same price-to-earnings ratio as the large cap ETFs. EPI had a P/E ratio of 15 at the end of June, while SCIF had a P/E of 15.3 at the end of July.

The small cap SCIF is similar to the other large cap offerings in that financials are the largest sector exposure, at 26.5 percent. However, where the others have large technology exposure, SCIF counts consumer discretionary (23.3 percent of asset) and industrials (17.1 percent of assets) as its second and third largest categories.

Since the story here is stronger domestic economic growth, owning the companies most likely to benefit from domestic growth is the goal. Sectors impacted by global prices, such as energy and materials, are less predictable. A slowdown in Europe or China could hurt these industries even if the Indian economy grows rapidly. Finally, even ignoring sector exposure, small caps are more likely to be involved in the domestic economy due to their size.

Conclusion

Indian stocks and the rupee have sold off in the wake of Modi's landslide election. Investors expected the new government to use its large majority in parliament to quickly enact far reaching reforms and are disappointed that Modi has focused on foreign policy. However, Modi's first moves were to secure energy with projects that could take many years and even decades to develop, making their early start extremely important for long-term growth.

Meanwhile, a recent move to create a uniform general sales tax will make the domestic economy more efficient, but some were hoping for bigger budget reforms. Furthermore, this tax change opens the door for tax reform. Members of Modi's Bharatiya Janata party and coalition partners have previously proposed cutting taxes on work and savings, and the addition of consumption taxes makes such as shift more likely.

Investors should not evaluate each item by itself, but rather as a piece in a large and evolving picture with faster economic growth as the long-term goal. As with the foreign policy moves, domestic policy changes are opening the door for more reforms down the road. So long as these changes continue to move in a positive direction, long-term investors in India ETFs, particularly the small cap ETF, will be rewarded.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: India ETFs Poised To Capitalize On Prime Minister Modi's First-Year Momentum