Strong Underlying Indian Growth Makes India Small-Cap ETF Attractive

| About: iShares MSCI (SMIN)


Headline 7.3% growth doesn’t reflect three speed economy; Agriculture at zero due to bad weather, manufacturing >9%, financials and telecommunications >10%.

FDI at a record high and growing due to structural improvements in the investing environment.

Strong underlying trends of real income, underpinned by strong manufacturing growth.

Indian stocks hit by the same negative flows as other emerging markets strongly correlated with commodities, despite better financial position and a net commodities importer.

Headline growth could increase with good weather forecasts, easing of global headwinds could see rapid appreciation of stock prices.

The Indian economy is now both the fastest growing large economy in the world and the top Foreign Direct Investment (FDI) destination in the world. I see this strong economic growth continuing for the foreseeable future on the back of a rapidly improving investing environment and strong growth trends in private domestic consumption and real incomes. India has a fairly segregated economy with huge disparities between the rapidly developing urban areas and the agriculture dominated rural areas which have been badly hit by two years of bad weather. There is also a stark difference between the growth rates and the efficiency of output between the private and the public sector, especially as they relate to the risks to the financial sector from a non-performing assets (NPAs) build up on the books of state owned banks. The best prospects for profits and growth then, are those that stand to benefit the most from increasing urban consumption, as the strongest positive indicator is the strong increase in real wages in the service sector of the economy.

As a whole, in spite of a poor recent emerging market performance, I see a healthy private sector benefiting from significantly increased investment, and a growing consumer base which is both earning and spending more even as inflation has fallen and two years of unusually bad weather conditions have hurt agricultural output. Importantly, from an investing perspective, I see limited downside for the stock market as a whole. Risk analyses of the current situation tend to focus on either the fear of a liquidity crisis from the banking sector, or an apprehension about how well the GDP and GVA (Gross Value Added) numbers reflect the real improvement in the economy. While the first is definitely something we want to keep an eye on, I don't see it being a cause for widespread concern just yet, especially with inflation dropping and the RBI set to cut rates again in April. The accuracy of the economic numbers however is a little bit harder to gauge. My view is that even the slightly lower numbers offered by those who question the official statistics are still very good in a low global growth environment.

In this sense I see the iShares MSCI India Small Cap Index ETF (BATS: SMIN) by BlackRock as the ideal ETF for US investors to make the most of the potential in the Indian stock markets in 2016 due to:

i. Good diversification within sectors, the largest single stock (Havells India Ltd) represents 1.9% of the fund value

ii. A 24.1% weighting in stocks closely tied to consumer spending

iii. A heavy exposure to commodity prices and infrastructure development through a 30.4% composition of industrial and material stocks

iv. Low exposure to state owned banks (1.3%) where the NPA problem is focused

Growth Factors

1. Structural Improvements in the Investing Environment

The trend towards the removal of extremely restrictive foreign ownership laws in India beginning in late 2014 marked the start of a new era for foreign investment. 2015 saw India break new ground as a market for foreign investors, with the total scale of FDI inflows totaling $USD 40 Billion in the first 8 months of the 2015-16 Financial Year (April 15 - March 16), compared with $31 Billion at the same time the previous year.

It's hard to stress exactly how much this has affected the current growth picture in India, because the single biggest criticism for decades for anyone with even a passing interest in the Indian economy is the vast overreach of the government in the functioning of the economy. As scores of books have been written about this problem over the years, I won't delve too deeply into restrictive past policies. But one aspect of this has been the protectionist policies preventing foreign ownership of companies in most manufacturing related sectors of the economy in order to protect local businesses. What this did in effect was prevent competition which could make local business practices more efficient, stop the large scale influx of long-term investment into the areas of the economy that have needed them the most and essentially preventing foreign money from creating millions more stable low-skilled jobs in the manufacturing sector.

The reforms stretched across 25 sub-sectors of the economy, particularly concentrated among high-end manufacturing and service related sectors. 15 of these have seen relaxations with regard to foreign investment restrictions and less red tape for investors to deal with. While the increases have been well spread across the board, the biggest change has come in FDI into computer hardware and software manufacturing, with the total dollar investment more than doubling from $2.2 Billion in 2014-15 to $5.3 Billion in the first 8 months of the current April to March FY.

2. Increasing Real Wages

A key trend is that of increasing incomes. Towers Watson estimates that wages increased 10.8% in 2015, even as inflation slowed to under 6%, leaving a 5% real wage increase. The biggest increase came in pharmaceuticals (11.5%), high-tech services (10.7%) and professional services (10.9%). But again, these numbers are also not completely reflective of the situation, as most of these happen in the service sector which is almost exclusively based in urban areas, where inflation is even lower than the national average meaning an even higher real wage increase for workers who've seen the biggest increases in nominal wages. Deloitte, who estimate a slightly lower (albeit still impressive) 10.3% increase in 2015, are expecting an even bigger increase in 2016 which is to be almost uniformly spread between management levels. This comes as the federal government is planning to increase wages for about 10 million federal employees by around 24%.

3. A Consumption Trigger

The single biggest indicator for how India is going to grow over the next few years, and what I see as the likely prime driver of corporate profits, is private household consumption expenditure. As the data for 2015 is not yet out, it is hard to draw any meaningful conclusions just yet. But based on higher FDI, increasing incomes and slowing inflation, it seems almost inevitable that if this keeps up, private consumption data is going to follow suit at some point. At the very least, this should be the case in urban areas. And there are some indications that this is the case. For example, PC sales grew more than 10% in the 4th quarter of 2015, while Smartphone sales have more than doubled from 44 million in 2013 to 100 million in 2015, a figure expected to hit 160 million in the next fiscal year. And the expectation is that this is going to be the case for more industries going forward, if the trend in incomes continues.

4. Better rainfall conditions, agricultural output

There are other factors that add to my bullish overall view of the Indian economy. One factor is that while the growth has been lopsided, there is the caveat that agricultural output has been badly hit by bad droughts for two years in a row now (the second due to the worst El Nino in 20 years). My estimates suggest that even a normal year of GVA from the agriculture, fishing and forestry sector adds at least a further 0.5% annual GDP growth. Also, while the budget math suggests that the government will have to choose at most two from the three options of i) keeping the deficit at 3.5% of GDP, ii) an increase in pay for civil servants and iii) keeping its commitment to increasing infrastructure development, this is essentially all because the current budget design is so dedicated to improving wage security for farmers, who currently need it the most and are also likely to be key to Modi's control of the upper house of parliament, where most of his political opposition is coming from.


1. Questions over the accuracy of government data

A common concern for almost anyone who has covered the Indian market over the past year has been the quality of the data. In spite of its growing importance to the global economy, data is surprisingly hard to obtain, and where they are available they are often subject to significant scrutiny given how hard it is to verify the Government's claims. In GDP data for example, a common concern among analysts is that the data offered by the government is not reliable and exaggerates the growth of manufacturing to improve overall GDP figures even as other parts of the economy suggest an overall slowdown in activity.

The government's response to most of these accusations is to point out that the methodology for calculating GDP changed in early 2014 moving from using prices at factory costs to calculating them at the gross value of goods and services produced at market prices, which takes into account indirect taxation. The difficulty is that it is essentially impossible to gauge the accuracy of the government's claim, given the absence of publicly available raw data.

To counter this situation, a firm called Ambit Capital has created what it calls India's version of the 'Keqiang Index', the index that was used by many to gauge the actual GDP growth in China due to the unreliability of official figures. The Indian Keqiang index, which Ambit says has an 0.81 correlation with the old GDP numbers and a lower 0.35 correlation with the new GDP numbers, takes into account four factors - Auto sales, cargo volume, capital goods imports and power demand. But this is rather an estimate of economic activity in heavy industry, which is not exactly what drives the Indian economy. As the breakdown of GDP below illustrates, more than half of the total share of the economy comes from services (shades of blue), which grew at 9.4% last year and involves significantly less cargo movement, auto sales and capital expenditure in general. Also, auto sales in India are primarily driven by rural demand and as I've pointed out, the brightest points in the Indian economy are in the urban areas.

While I myself have some doubts about the accuracy of the manufacturing growth figures, I can't see the actual numbers being very much worse than the real ones and the truth is it is almost impossible to verify these claims one way or another without access to the raw data that the government uses to calculate them, and indeed given the massive size of India's informal economy.

Regardless, some context is required here. First, in the current global environment where there has been a huge pullback in emerging market stocks over the past 3 months due to risk-off sentiments, even the poorer numbers offered by most critics of the official numbers, are still relatively good. Second, where numbers are questionable, the inclination is to consider the qualitative factors that can shed light on the current situation, especially that in manufacturing. And in this case what we have is a big shift in the relationship between the government and business interests.

2. Emerging market conditions, correlation with Commodities

Another perceived risk, is that emerging markets have had a terrible start to the year and that the recent rally on the back of the last FOMC meeting minutes suggesting a slower tightening of fed monetary policy is going to dissipate as soon as the US economy starts to pick up speed, and to an extent I agree with this. But what we're seeing is a huge divergence between emerging markets, so the idea that the correlation between Indian stocks and overall emerging market stocks should continue to hold seems a bit irrational, especially since India is a net importer of oil and hence not subject to the same problems that have so badly roiled the Russian and Brazilian economies. Over the past year, the SMIN index has a correlation of 0.85 with the iShares MSCI Emerging Markets Index ETF (BATS: EEM) and a 0.91 correlation with the iShares MSCI India Index ETF (BATS:INDA). While I expect the correlation with the INDA index to continue, economic realities suggest there SHOULD be an easing in the correlation with emerging markets.

iShares MSCI India Small Cap Index ETF- Breakdown




Other (includes pharmaceuticals)



Consumer Discretionary



Consumer Staple



























Total stocks



1. Heavy exposure to consumer spending.

As I've discussed in the preceding analysis, a big factor for growth will be private household consumption. The base case situation, in the event that global demand doesn't pick up, there should still be pockets of strong demand from within the Indian market. In this case, there is very little to choose from in terms of overall exposure to consumer stocks, although I favour the SMIN index in this case because of the lower exposure to the Automobile industry, which gets 2/3rds of its' demand from rural areas. My expectation is that there will be an acceleration in private urban consumption regardless of the developments in rural India.

2. Exposure to Industrials and Materials

Going back to the government's budget and the dilemma it has of having to choosing at most 2 from (it has promised all three, but will almost inevitably have to break one of them)

i) Restricting the budget deficit to at most 3.5%

ii) Keeping its commitment to increasing the wages for civil servants by 24%

iii) Keeping up infrastructure spending

I expect what is most likely to happen is a compromise of some sort between infrastructure development and a small increase in the budget deficit. But this would still be just the base case, assuming that external demand doesn't pick up speed and that the Central Statistics Office's claim of accelerating manufacturing growth is grossly exaggerated. Another year of strong manufacturing growth could help spur infrastructure development.

Also emerging markets as a whole have fared poorly since the start of the year largely due to concerns about China, commodity prices, and fed rate tightening. There's been a rebound since the last FOMC meeting and these have seen big bounces in Russia and Brazil, where stocks have seen much bigger drops over the past 2 years over falling oil prices. India's performance has been underwhelming given the lofty expectations of the Modi government, but its stock market is still in fairly good condition, especially compared to Russia and Brazil, both of whom are expected to remain in recession this year. It is reasonable to assume that if the second half of the year sees improvements in global risk appetite then Indian stocks, especially Industrials and some Materials could see a prolonged rally.

3. Low exposure to state owned banks

If you haven't been following the story read this, from the First Post India. As at the time of writing, only 1.38% of the fund was invested in State owned banks in spite of an overall 17.8% exposure to financials.

4. Diversification, moderate expense

The last factors are those related to the fund itself.


Expense ratio

Average Spread (%)



















As the table above illustrates, SMIN is a relatively cheap ETF to invest in compared to most of its peers, including the comparable Market Vectors Small Cap ETF (NYSEARCA:SCIF) which has also performed worse over the past year (-24.98% vs -16.46 for SMIN).

Although it is worth noting that SMIN is less liquid and hence has a higher average spread ($0.16), as I am recommending this as a long term trade I do not see this as particularly expensive.

Conclusion: There's a lot going on in the Indian economy and the headline number doesn't say everything. There are some parts of the economy (Services) that are moving much faster than others (Agriculture), and in between there are reforms that are happening but not quite fast enough. The good news is that the fastest growing section also happens to be the biggest section in terms of contribution to GDP and there are real signs of favourable long term trends in FDI and in rising incomes. What's really missing is the consumption data, and if you start seeing evidence of the rising real incomes in private household consumption- or similar evidence in auto sales and tourism and other consumer industries- then we could see a sustained rally in Indian stocks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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