India’s economy and markets, in recent years, might have been overshadowed by other emerging markets. Yet, from the perspective of Vinay Agarwal, director at FSSA Investment Managers, there are many positive aspects of this market and there are good reasons why investors need to keep India in mind.
What would you tell global investors who are keen to invest in India?
In our view, several aspects make India an attractive market to invest in over the long term. Firstly, the majority of listed companies are privately owned rather than being state-owned. As minority shareholders, we find it easier to feel aligned with private owners who don’t have the national service obligations of state-owned companies.
Secondly, most sectors in India are significantly under-penetrated. Even the market leaders in these sectors are relatively small in size. These leaders have a long runway of growth ahead of them as penetration rises. Management teams are also conscious of the need to earn high returns on capital due to the high cost and historical scarcity of capital.
As we also constantly engage with management teams across markets, we find that managers here are always willing to learn. They are keen to engage with all stakeholders to improve their business franchise and their governance standards. Due to these reasons, we believe India offers a much larger universe of high-quality, investible companies than other regional markets. It has always been one of our favourite markets to invest in.
Which part of the Indian market do you think foreign investors lack understanding of?
The majority of Indian companies are family-owned businesses. There are several advantages of this ownership structure, led by their ability to take a long-term view and act countercyclically.
However, the cultural nuances of a family-owned business in India may not be apparent for foreign investors to understand. For example, it is important to understand that most families are large and there are complex relationships at play among various members across generations.
In smaller companies, this may lead to an impression that governance standards are low. But, we have seen that well-managed, family-owned companies are able to take a long-term view, while also grasping the advantages of introducing capable professional managers, high-quality boards, reputed auditors and other best practices. Spotting the cultural markers of which families are likely to strengthen their management and governance practices over time and which ones will get left behind is often not apparent to foreign investors.
Another misconception about the attractiveness of India’s investment universe arises from the fact that from a top-down perspective, India always appears to be in chaos. There are diverse political interests perpetually in a tug-of-war, geo-political issues and economic disruptions. However, from a bottom-up investor’s perspective, we have observed that the leading Indian businesses have thrived despite these challenges.
Over the last two decades, there have been several disruptions in India. These include droughts, the global financial crisis; several corruption scandals leading to a change in government; demonetisation and the introduction of a new tax regime, a crisis among non-bank finance companies and most recently, Covid-19. The leading Indian companies have only become stronger during this period as they have gained market share from their weaker competitors and grown their profits consistently. As the economic environment improves after the pandemic, these companies have the potential for exceptionally strong earnings growth for years to come.
Given the rise in ESG interests among investors in India, do you see a rise in companies adopting ESG standards?
As the Indian economy has grown significantly in recent decades, the social licence to operate for businesses across sectors has become more critical than ever before. This encompasses a range of issues, from the environmental impact of their businesses to their relationship with their labour force and the role they play in their communities.
We have observed that companies in India are increasingly realising that without this social licence to operate, their businesses are not sustainable over the long term. The improvement in ESG (environmental, social and governance) standards is being driven by several stakeholders. These include:
Generational change within promoter families: A new generation of owners with global exposure have taken on leadership roles in many family-owned businesses. This generation of owners have studied abroad or worked at global firms. They have introduced best practices in their companies using their learnings from developed markets.
Regulatory changes: Mechanisms to protect the interests of minority shareholders have been strengthened consistently. Minorities have the right to reject certain related-party transactions and a compulsory reverse-bidding process is required for the privatisation of a listed company. Governance standards have also improved significantly after regulations were introduced mandating a minimum level of female representation on a company’s board, periodic auditor rotation and increased disclosure levels.
Owners have also witnessed that in recent years, some of the largest business groups which had a poor reputation for corporate governance have failed to survive. They are aware that they need to consistently improve their ESG standards to ensure the sustainability of their business over the long term.
What are the greatest barriers to ESG adoption in India?
We have observed that most Indian companies intend to treat all stakeholders fairly. However, they are often unaware of best practices. This is especially the case with small and midsized companies, which may not have much global exposure. Management teams are keen to engage and learn about ways in which the sustainability of their business can improve.
For example, several Indian consumer goods businesses deal with the issue of environmentally harmful plastic packaging. We introduced a global bio-degradable plastic packaging solutions provider to a leading domestic consumer staples company in India. The company has started a pilot programme and is currently in the process of obtaining regulatory approvals before adopting these solutions on a larger scale.
Similarly, our engagement on a range of issues from reducing water consumption to using more sustainable raw materials has been well-received by management teams. They have shown a willingness to adopt effective solutions.
Where can we find good companies in India to invest for the long term? How has the second wave of the pandemic impacted business sentiments in key sectors?
The pandemic has provided an unprecedented opportunity for investors to identify high-quality companies. By looking at whether a company’s management treats all of its stakeholders equally, we can distinguish the good companies from the others. Stakeholders do not just mean the majority shareholders, but also minority shareholders, employees, the tax authorities, local communities and the environment. Organisations that have shown that they proactively take care of their stakeholders during difficult times have sent a reassuring message.
India has seen a resurgence of Covid-19 infections over March to May 2021. However, businesses were better prepared to deal with this, compared to the initial disruption they faced in March 2020. They have well-established systems to manage their supply chains, work from home, and ensure safety protocols are followed at their manufacturing plants. Many Indian corporates have also played a leading role in providing vaccination for their employees and local communities.
We noted some key trends across our investment universe during this period.
Accelerated market share gains by organised sector companies:
Smaller companies in the unorganised sector with limited capital availability and weak IT systems struggled to cope with the extended national lockdown last year. This allowed industry leaders to gain significant market share across sectors.
For example, Metropolis Healthcare, a leader in the highly fragmented diagnostics industry, witnessed 41% growth in its revenues and an almost tripling of its profit in the most recent quarter. Consumers are shifting rapidly from small local laboratories to those of established brands like Metropolis with higher-quality standards and accreditations. We have seen a similar trend of organised sector companies gaining market share from their unorganised sector competitors across industries.
Price hikes to pass on the impact of rising inflation in raw material and labour costs:
In industries ranging from electrical products to IT services, customers have accepted significant price increases. KEI Industries, a manufacturer of electrical wires and cables, raised prices of its wires used in household applications by 35% over the last six months. The CEO of Mphasis, a fast-growing IT services company, told us that unlike previous years in which they witnessed pricing pressure from their large corporate clients, most customers have been willing to discuss price hikes due to wage inflation.
Investments in capacity expansion:
There hasn’t been much corporate capital expenditure (capex) during the last decade in India. Recently, sharply rising commodity prices have led to large capex announcements by several commodity producers. Thermax, the largest manufacturer of boilers used across heavy industries, indicated a significant improvement in customer enquiries across sectors such as oil & gas, steel and cement after years of weak industrial demand.
How has your portfolio allocation changed over the second Covid-19 wave? Have you increased or reduced exposure to certain sectors? And added and removed companies?
We invest in companies which are run by management teams that we feel closely aligned with as minority shareholders, are market leaders in under-penetrated categories with significant growth potential, earn high returns on capital employed and have demonstrated a strong track record of consistently gaining market share.
As businesses struggled with the initial disruption of Covid-19 and markets turned volatile last year, we had the opportunity to invest in high-quality businesses that we were watching from the sidelines as they became available at more attractive valuations. We also used the opportunity to increase our holdings in our existing investments. In the second wave of Covid19, companies were better prepared with strong systems to ensure business continuity, and valuations remained relatively unchanged. We did not make significant changes to portfolio allocation during the second wave.
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