Reforms Push Makes Indian Equities Attractive

by: Disruptive Investor

Until a recent flurry of reform measures was announced by the Indian government, equities in India did not seem to be a particularly attractive investment.

Leaving aside recent developments, the Indian rupee was plunging, economic growth was collapsing, and corruption in the government sector made headlines every other day.

Of course, all of this has not changed overnight, nor it is supposed to happen that way. However, the anemic government has suddenly embarked on a reforms push in order to support growth, encourage investments, and prevent another fiscal and current account disaster for the country.

The reason for pressing the development button also has to do with the 2014 elections, which the current government might lose miserably if they don't do anything substantial over the next year and half. As an investor looking to generate superior returns for my portfolio, I would not investigate more deeply into the reasons for the reforms push, as long as it benefits the country, the private sector and investors.

This article looks into some of the recent growth boosting measures announced, its impact on growth, expected reforms and the outlook for Indian markets.

I mentioned the plunging rupee at the beginning of my article. The reforms measure announcement and a subsequent surge in equity markets has helped the rupee appreciate meaningfully against the dollar.

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This is critical, as a depreciating rupee was leading to higher inflation and worsening of fiscal deficits. Further, the Indian central bank -- which I consider to be one of the best central banks in the world -- was avoiding rate cuts due to inflation.

Higher interest rates have impacted growth in the real estate and infrastructure sector in India. With the current rupee appreciation and an expected decline in crude oil prices due to a global slowdown, inflation should moderate going forward. This will give some breathing space for the Reserve Bank of India, and I personally expect interest rates to decline over the next three to four quarters. With a decline in interest rates, the infrastructure and real-estate industry should witness renewed robust growth, along with growth in other industries, such as automobiles.

I also mentioned collapsing economic growth at the beginning of my article. As the chart below shows, India's first quarter growth was the worst in 13 quarters.

I am of the opinion that GDP growth in India has bottomed out at these levels and should be relatively robust going forward. The reforms push and expected cut in interest rates should be the key triggers to boost growth in the foreseeable future.

Besides the liquidity factor, the recent surge in Indian equity markets has been largely due to the reform measures, which can boost GDP growth. I can say with some conviction that Indian equities are discounting relatively better growth and not just trending higher due to excessive liquidity.

Coming to the reform measures, the opening up of the retail sector in India is expected to benefit the country in more ways than one. Before discussing the benefits for India, I have to mention here that the Indian retail sector is pegged at $500 billion and is expected to reach $1.3 trillion by 2020. Therefore, companies like Wal-Mart (NYSE:WMT) have a significant market to tap.

The first benefit from the retail foreign direct investment (FDI) would be job creation on a large scale. The retail FDI plan has the potential to create 10 million jobs, with over 4 million jobs in the small and medium industries and another 5-6 million jobs in the logistics sector over the next three years. Job creation would have an immediate impact on growth, as it can boost consumption.

Further, the FDI rules require foreign investors to bring in a minimum investment of $100 million. Of the total investment, at least 50% should be invested in back-end infrastructure. Therefore, opening up of the retail sector will include investment in processing, manufacturing, distribution, design improvement, warehouse, logistics and storage. Ideally, this should boost overall infrastructure growth in the country. The FDI in the aviation sector should also help some of the ailing airline players in India to infuse much needed equity.

The disinvestment of public sector units is another key reform agenda, which will help improve government finances and maintain the fiscal deficit target at 5.1% of GDP. The government is looking at disinvestment of INR25,000-30,000 crore in 2012-13 by selling its stake in several government owned companies. With equity markets trading at relatively higher levels and investor confidence reinstated, the government should not find it difficult to raise money from government sector IPOs. Besides the disinvestment measures, the recent hike in diesel prices should also help in improving government finances by reducing the subsidy burden.

Going forward, one can expect further reforms and populist measures with the election just around the corner. I personally expect the government to be doing more in the infrastructure sector and the agriculture sector. The agriculture sector employs over 50% of the work force in India, and doing something beneficial for the sector is the key to capturing a significant vote bank.

Coming back to the equity markets, the NIFTY index has run up by 18% in the last four months. Markets have been discounting the impact on GDP resulting from new reform measures. Also, the global liquidity glut has also supported markets at higher levels. Even after the recent rally, the NIFTY does not look to be terribly expensive in terms of PE valuation. The markets are currently trading at a PE of 19.2, compared to a historical average PE of 18 for the index.

However, I do expect global markets to correct over the next three to six months. I had discussed the rationale behind this in one of my earlier articles. The Indian equity markets are still very much coupled with global equities, and Indian stocks should also correct in the near-term.

Therefore, for investors considering exposure to Indian equities, the next three to six months might present good buy opportunities. I would personally look at considering exposure to Indian stocks through the following ETFs and stocks.

iShares S&P India Nifty 50 Index Fund (NASDAQ:INDY) - The fund seeks investment results that correspond to the price and yield performance, before fees and expenses, of the S&P CNX Nifty index. The fund is a good way to consider exposure to the largest Indian companies across sectors. The expense ratio for the fund is 0.92% with holdings of 50 large cap Indian stocks.

iShares MSCI India Index Fund (BATS:INDA) - This is another good alternative for investors. The ETF seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the MSCI India Index. The difference compared to INDY is that the MSCI fund has exposure to 74 stocks (more diversified) with a relatively lower expense ratio of 0.65%.

iShares MSCI India Small Cap Index Fund (BATS:SMIN) - The ETF seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the MSCI India Small Cap Index. With the fund having exposure to relatively small Indian companies, the risk related to exposure is high compared to INDY and INDA. However, investors can consider some exposure to this ETF, as returns can be superior over the long-term. The ETF has holdings of 120 stocks with an expense ratio of 0.74%.

ICICI Bank (NYSE:IBN) - For investors betting on the Indian banking sector, IBN is an excellent long-term investment option. With a high probability of interest rates trending down from current levels, IBN is a good investment option to consider. IBN is one of the largest private sector banks in India, providing a wide array of banking and financial services. The services include commercial banking, retail banking, project and corporate finance, working capital finance, insurance, venture capital and private equity, investment banking, brokering and treasury products and services. Besides this, it also provides NRI banking, international banking, rural and agri banking, Internet banking, mobile banking, and phone banking services, as well as dematerialization services. The stock is currently trading at a TTM PE of 16.1 and offers a dividend yield of 1.4%.

Tata Motors Limited (NYSE:TTM) - TTM engages in the manufacture and sale of commercial and passenger vehicles primarily in India. It also markets its commercial and passenger vehicles in Europe, Africa, the Middle East, Southeast Asia, South Asia, Russia, and South America. The Indian automobile market has immense potential with a burgeoning middle class, and TTM is well positioned to capitalize on this growth. The stock currently trades at a very attractive TTM PE of 6.3, and can give investors robust returns in the long term.

Disclosure: I 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.