article 02-25-2014

What Columbus Missed: Royce Rediscovers India

In 1492, Italian explorer Christopher Columbus set sail to discover India. He missed his mark, however, landing in America instead. The rest, as they say, is history—with the exception that more than 500 years later India is still worthy of discovery for many Western investors.

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Portfolio Manager and Director of International Research David Nadel discusses:

An Introduction to India

In 1492, Italian explorer Christopher Columbus set sail to discover India. He missed his mark, however, landing in America instead. The rest, as they say, is history—with the exception that more than 500 years later India is still worthy of discovery for many Western investors.

India is the world’s largest democracy and Asia’s third-largest economy. With its rapidly growing middle class, India is also the world’s third-largest economy measured by purchasing power parity, and with a median age of just 25 years old, it will also soon have a fifth of the world’s working-age population.1 India’s median age is 10 years younger than the U.S.’s and nine years younger than China’s.2 This demographic dividend sets the stage for growth.

Gross Domestic Product (GDP), 2012 by Purchasing Power Parity (trillions of international dollars)3

I recently visited the country to meet with 14 local companies to try and unearth some promising investments. This was our second visit together in three years, and my third in total. Investors’ attitudes toward India tend to alternate between extremes of worship and despair. We think a calmer middle ground is warranted for this market (any many others).

As of December 31, 2013, India is the fifth-largest country allocation of the Royce International Smaller-Companies Fund (click for a prospectus). Let’s discover why we are somewhat more bullish than most.

India is the world's largest democracy, Asia's third-largest-economy, and the world's third-largest economy measured by purchasing power parity.

Royce International Smaller-Companies Fund's Portfolio Country Breakdown as of 12/31/13

Countries % of Net Assets (Subject to Change)*
Japan 12.8
United Kingdom 12.5
Hong Kong 10.4
France 9.3
India 5.1

*Securities are categorized by the country of their headquarters

India and the BRICs: Unloved, Underinvested

Over the past decade, the emerging markets (EM) have been responsible for the bulk of real GDP growth globally and now collectively account for more than half of the global economy. Yet the BRIC stock markets (Brazil, Russia, India, China) have dramatically underperformed global equities for nearly three straight years. And within the Indian market, there has been an epic level of bifurcation between large- and small-caps. While the S&P BSE Sensex Index of India’s 30-largest companies recently touched an all-time high on January 23, 2014, Royce’s market-cap range as represented by the S&P BSE Small Cap Index was trading at press time some 55% below its 2008 high. Given this yawning gap in performance, we see the greatest opportunity and valuation cushion among India’s small-caps.

While investors hoping to gain EM exposure have bid up the prices of large-cap multi-national corporations (MNCs) based in the U.S. and Europe, they have curtailed direct investment in EM companies. Foreign Direct Investment (FDI) for India contracted 30% in 2012 over 2011, returning to 2010’s level of $25 billion, and has contracted still further in 2013, while investment by Indian corporations has likewise slowed for more than a year.4

For bottom-up stock pickers like Royce, we like that most of the Indian smid-cap companies with which we met are managed as much for returns as they are for growth, an unusual calculus in the emerging markets.

Yet even as most investors are running away, our investment view on India is cautiously optimistic. Its current account deficit has improved to just 1.2% of GDP, and its unemployment rate (4.7%) and even budget deficit (5.3% of GDP)a have likewise shrunk to manageable levels.5 More importantly, for bottom-up stock pickers like Royce, we like that most of the Indian smid-cap companies with which we met are managed as much for returns (return on capital, return on equity) as they are for growth, an unusual calculus in the EM. Corporate India has generated the highest ROE (return on equity) among the BRIC economies, and among the highest ROE in all of Asia.6

Fastest Growing Middle Class

India’s middle class is the fastest growing among the BRIC countries, and has expanded by 35% in the past decade.7 At current rates of growth, India in just eight years will have as many households with disposable income of $10,000+ as the U.S. or the eurozone.8 By 2030, India is expected to have more members of the middle class than any other country, including the entire EU.9 Put another way, India’s middle class is expected to outnumber the entire U.S. population by sometime before 2025.10

Shares of Global Middle Class Consumption, 2000-205011

Comparisons of India’s economic miracle to China’s are inevitable for Westerners, who have even coined the phrase “Chindia” to combine the two powerhouses. However, the face of economic growth is quite different in the two countries. For one, India is not a command economy but rather a democracy with a much smaller government. State-owned enterprises (SOEs) comprise only 14% of India‘s market cap versus 73% of China’s.12 Government services are spartan, at just 15% of GDP.13 The government’s revenue-collection capacity is limited, with only 3% of Indian citizens paying income tax.14 India’s business leadership is more independent of government than is China’s, and Indians have excelled at industries that do not require heavy government support, such as pharmaceutical manufacture and information technology.b Half of the world’s FDA-approved pharmaceutical facilities are in India. IT services behemoth Infosys was famously founded with $250 and today commands a market cap of $30 billion.c

India is more service based while China is more manufacturing based15
GDP by Industry (%)

India’s development has been largely fueled by a game of rural catchup, in our view creating a potentially more sustainable growth model over the longer term.

The second, and more important, difference versus China is the composition of that middle class growth. In contrast to China, where the middle class expansion has been driven disproportionately from cities (arguably creating an unstable socioeconomic divide between cities and the countryside), India’s development has been largely fueled by a game of rural catchup, in our view creating a potentially more sustainable growth model over the longer term.d While urban India is still wealthier than its countryside—the 100 biggest cities account for 43% of GDP with just 16% of the country’s population—its rural economy is advancing more rapidly.16

India's "Rural Revolution"

India’s “rural revolution” can be traced to a number of sources, including government policy. Whereas farming comprised nearly two-thirds of rural employment in 2000, now it is closer to 40%, replaced by more stable and less seasonal jobs in various services.17 Annual growth in rural wages rose at an annual rate of 16% in seven years, almost double the pace of inflation during this period.18 Rural land is now used for a broader range of purposes beyond farming, even as farming yields themselves have improved. Accordingly, land values have advanced five to 10 times and more in the last decade, unlocking massive collective spending power.19 With so much pent-up demand, the rural Indian consumer product market is expected to triple to $650 billion over the next decade, making it roughly the size of Switzerland’s entire economy.20

The penetration of mobile phones in rural India provides an inkling of future growth and demand when it comes to consumer products we in the U.S. often take for granted.e Starting in 2001, mobile phone subscriptions grew exponentially in just 10 years, reaching 900 million subscribers (about 86% penetration).21

What's next in India's consumer story? Consider these penetration rates:22

Less than 5% Less than 15% Less than 35% Less than 50% Less than 70%
Car Refrigerator Treated Tap Water Television Electricity
Laptop or PC Washing Machine Cable Toilet Bank Account
Air Conditioning Motorbike   Bicycle  

As India’s middle class growth has deepened, consumer spending on basics like food has been replaced by outlays on discretionary services such as private education, healthcare, and travel. Eighty-five percent of rural households surveyed have increased expenditures during the last several years on these three categories.23 Life expectancy has advanced six years to 66 in the last 15 years, and the Indian private care and healthcare market is expected to grow at a remarkable 15% rate per annum through 2020.24 Travel comprises 11% of the consumer spending bucket today versus just 3% 10 years ago.25

Demand for such services is likely to grow robustly, in our view. Barely 10 million Indians travel abroad annually (just 0.8% of the population), versus 70 million Chinese (5.2%) in 2011.26 Royce International Smaller-Companies Fund (click for a prospectus) currently holds Thomas Cook India (TC on the BSE), whose CEO we met at their colonial-era headquarters in Mumbai. One of the most trusted brands in Asian travel, Thomas Cook India has operated in the country for more than 130 years and generates 20%+ pre-tax ROE, with scope for improvement. Indian-born uber-investor Prem Watsa, whose Fairfax Financial has compounded book value at 25% per year from 1985 through 2010 and which many regard as Canada’s answer to Warren Buffett’s Berkshire Hathaway, recently acquired the majority shareholding of TCI from its former U.K.-based parent company.27

Room for growth: India has the lowest private consumption rate per capita among the world's 10 largest countries28

10 Most Populous
Countries
Population
(millions)
Private Consumption
(U.S. trillions $)
Consumption Per Capita
(U.S.' 000)
U.S. 313 10.7 34.2
Japan 126 3.6 28.1
Brazil 197 1.3 6.8
Russia 143 0.9 6.0
Mexico 115 0.7 5.8
China 1348 2.6 1.9
Indonesia 242 0.4 1.8
Philippines 95 0.2 1.7
Pakistan 177 0.2 1.0
India 1241 0.9 0.8

We believe credit growth is set to advance rapidly in India over the next several years. As a percentage of GDP, household debt and mortgage penetration are only approximately 12% and 10% in India, respectively, versus roughly 95% and 80% in the U.S., respectively.29

India has among the lowest household debt of any country as a percentage of GDP30

Non-performing loans are actually lower in India, as is public debt as a portion of GDP at 66% for India.31 Fewer than 20% of rural Indians have loans at all.32 Shriram Transport Finance (SHTF on the BSE), founded in 1979, is India’s number one lender to the used truck market, with a 25% national share. Royce International Smaller-Companies Fund (click for a prospectus) currently holds shares, as we are attracted to its under-banked market, its fragmented customer base of more than one million serviced by loan officers embedded in the local communities, its conservative balance sheet (Tier 1 capital is 30% above the requirement), and its high returns (pre-tax ROE has averaged 30%+ over the last 10 years).

Trade Integrating India Globally

Today, foreign trade comprises nearly half of GDP versus just 16% 20 years ago.33 The U.S. is India’s third-largest trading partner, surpassed only by China and the Gulf Cooperation Council (i.e., the United Arab Emirates and Saudi Arabia). Cross-border mergers have further integrated India into the global economy, whether India is the acquirer (e.g., Tata Steel’s $13 billion acquisition of Corus and Tata’s $2 billion acquisitions of Jaguar/Land Rover) or the target (e.g., Vodafone spent $11 billion for Hutchison Telecom; BP invested $7 billion in Reliance).

Meanwhile, India is asserting itself more as an exporter. Family-controlled Bajaj Auto, for example, exports 1.6 million motorcycles and three-wheelers a year, mostly to the MENA (Middle East and North Africa) region.34 One company riding Bajaj Auto’s coattails as a supplier is FAG Bearings (FAG on the BSE), India’s number two manufacturer of ball bearings and a long-held investment in Royce International Smaller-Companies Fund (click for a prospectus). Founded in 1962, FAG Bearings has generated 30%+ pre-tax ROE and has compounded revenue growth at 20% over the past decade without the benefit of acquisitions.35 Another export-oriented holding is Ipca Laboratories (IPCA on the BSE), which has compounded revenue growth of 20%+ for the last five years—with 20%+ ROIC—by selling anti-malarial medications to Africa and cardiovascular drugs to Europe.36

Interestingly, India’s manufacturing base hasn’t grown much as a percentage of GDP (15% currently) since the 1960s.f But of course it has grown rapidly on an absolute basis, and we have not been hard pressed to find high-quality, export-driven manufacturers in which to invest. Family-controlled Graphite India (GRIL on the BSE) runs a tight ship manufacturing graphite electrodes, a global oligopoly market serving the electric arc furnace production of steel. AIA Engineering (AIAE on the BSE) is the global number two manufacturer of chromium grinding balls used by the mining and cement industries, and like Graphite India is a holding in Royce International Smaller-Companies Fund (click for a prospectus). AIA has averaged revenue growth of 30% and ROE 20%+ for more than a decade,37 reflecting the benefits that accrue to companies whose product sports a low cost of ownership (inconsequential percentage of customers’ costs) but a high cost of failure (customers don’t want to risk a costly plant shutdown by using cheaper grinding alternatives).

Pivotal Elections: Reform, Redux?

From 1993 through 2007, India’s economic growth averaged a remarkable 6.5% real per year, more than twice The U.S.’s pace over those 15 years.

From 1993 through 2007, India’s economic growth averaged a remarkable 6.5% real per year, more than twice the U.S.’s pace over those 15 years.38 With the benefit of hindsight, the 1991 economic reforms are credited with helping to stoke this period of extraordinary advancement, which lifted more than 200 million Indians out of poverty.39 These reforms aimed to return India closer to its free-market roots, phasing out the comparatively isolated and bureaucratic License Raj period of 1947-1991, which has been called “a surreal mix of Soviet stupidity, British pedantry and Indian improvisation.”40 The ’91 reforms not only transformed India socioeconomically, but also restructured business arrangements that had become too cozy—of India’s 20 largest companies in 1990, for example, only five survive today in their original form—and proved that India’s government could be effective under the right leadership.

India GDP Annual Growth Rate 1992-200241

India is facing pivotal elections in May, and another period of economic reform and liberalization may be needed to return to higher growth, which has decelerated since 2010’s 9.3% growth rate. India’s economy is expected to expand by “only” 4-5% real this year, a multi-decade low (albeit a respectable achievement by Western standards).

Rajan and Inflation

Reserve Bank of India (RBI) Governor Raghuram Rajan, the equivalent to U.S. Fed Chair Ben Bernanke or Janet Yellen, has been widely embraced by the investment community for championing transparency, the curtailment of regulations, and helping to arrest the slide this past summer in India’s currency, the rupee. One of Rajan’s key challenges is taming India’s surging inflation. Rajan recently increased the repo rate to 8.0%, the central bank’s third increase in five months.42 India’s core inflation, which excludes volatile food and fuel prices, has moderated to 2.6% while wholesale price inflation spiked to 7.5% and consumer inflation spiked to a dizzying 11.5%, in part driven by rupee weakness.43 Rajan’s policies will also of course impact the rupee, historically a far weaker currency than the U.S. dollar.

Indians in general have a strong savings culture, with consumer savings accounting for about 30% of GDP versus about 4% in the U.S.,44 and about half of India’s savings are held in hard assets, principally gold.

With all that gold squirreled away across India, perhaps there’s another Kerala-like gold treasure just waiting to be discovered.g But at Royce, we’ll continue to focus on what we do best in India and around the globe: attempting to find high-quality smaller companies for our portfolios.

Endnotes

a India’s budget deficit has been a persistent problem and has exceeded 7% of GDP in 12 of the last 15 years.45

b Several of India’s 55 billionaires hail from these two sectors. Further, many are self-made entrepreneurs, including the Ambani family ($27 billion, Reliance Industries) whose patriarch rose from a gas station attendant; Dilip Shanghvi ($14 billion net worth, founder of Sun Pharma); Azim Premji ($14 billion, Wipro); Shiv Nadar ($9 billion, HCL Technologies); Sunil Mittal ($6 billion, Bharti Airtel); and Uday Kotak ($4 billion, banking).46

c China’s business leaders frequently owe their success to government ties, and many subsequently serve in government to return the favor; interestingly, the collective wealth of the 50 richest members of China’s National People’s Congress is nearly $100 billion (versus less than $2 billion for the 50 wealthiest American Congressman).47

d India has 53 cities with a population exceeding one million inhabitants, compared to 160 such cities in China.48

e The rapid penetration of mobile phone in rural markets has been a boon to farmers; immediate communication means access to transparent pricing, which has all but eliminated the middlemen who used to be wedged between farmers and farm markets, allowing the farmers to realize their full profit margins for the first time.

f The perception of India as an agrarian economy is outmoded; agriculture accounts for only 17% of GDP versus 56% for services and 27% for industry.49

g Two years ago, a massive treasure was discovered in Kerala, near India’s southern tip. A remarkable $20 billion worth of gold and jewelry had been buried in an ancient temple.

Important Disclosure Information

David Nadel is Director of International Research and a portfolio manager of Royce & Associates, LLC, investment advisor to The Royce Funds. He is the portfolio manager of Royce International Smaller-Companies Fund (RIS), Royce European Smaller-Companies Fund (RES), and Royce International Premier Fund (RIP). He also assists on Royce Global Value Fund (RGV), Royce Global Dividend Value Fund (RGD), Royce International Micro-Cap Fund (RMI), Royce Global Value Trust (RGT), and Royce Value Trust (RVT). The thoughts expressed in this piece are solely those of Mr. Nadel and may differ from those of other Royce investment professionals, or the firm as a whole. Mr. Nadel’s thoughts and opinions are given rendered as of the date of each posting and may change without notice. This piece is not intended to be investment advice or a recommendation to invest in any securities, region, or country. There can be no assurance with regard to future market movements. Data from third-party sources used in the preparation of this piece may not have been independently verified by Royce, and Royce does not guarantee its accuracy. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Fund may invest a significant portion of its assets in foreign companies, which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund invests primarily in micro-cap, small-cap, and/or mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The S&P BSE Sensex Index measures the performance of the 30 largest, most liquid, and financially sound companies across key sectors of the Indian economy that are listed on the Bombay Stock Exchange. The S&P BSE Small Cap Index is a composite small-cap index designed to measure the performance of the full small-cap universe of companies listed on the Bombay Stock Exchange. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

Percentage of Fund Holdings as of 12/31/13 (%)

RIS RES RIP RGV RGD RMI RGT RVT
Infosys 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Thomas Cook India Ltd 0.70 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Fairfax Financial 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Shriram Transport Finance 0.71 0.00 0.00 0.00 0.00 0.00 0.00 0.09
Bajaj Auto 0.00 0.00 1.65 0.00 0.00 0.00 0.00 0.00
FAG Bearings India 0.81 0.00 0.00 0.00 0.00 0.85 0.00 0.05
Ipca Laboratories 0.71 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Maharashtra Seamless 0.63 0.00 0.00 1.36 0.00 0.00 0.00 0.16
Graphite India 0.68 0.00 0.00 1.27 0.78 0.65 0.00 0.03
AIA Engineering 0.86 0.00 0.00 0.00 0.00 0.77 0.00 0.00

There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future.

1 The Economist, http://www.economist.com/news/briefing/21577373-india-will-soon-have-fifth-worlds-working-age-population-it-urgently-needs-provide
2 "India, Unlocking the Demographic Dividend," Henry McVey, November 2012
3 World Bank, http://databank.worldbank.org/data/download/GDP_PPP.pdf; The Geary-Khamis dollar, commonly known as the international dollar, is a hypothetical unit of currency that has the same purchasing power parity that the U.S. dollar had in the United States at a given point in time.
4 OECD, http://www.oecd.org/daf/inv/FDI%20in%20figures.pdf
5 Bloomberg, http://www.bloomberg.com/news/2013-12-02/india-s-current-account-deficit-narrows-to-lowest-since-2010.html; Financial Express, http://www.financialexpress.com/news/unemployment-rate-jumps-to-4.7-as-slowdown-bites/1171982; Trading Economics, http://www.tradingeconomics.com/india/government-budget
The Economist, "Adventures in capitalism,"October 22, 2011
7 Edelweiss, "Rural India: Transcending boundaries," October 2010
8 Euromonitor, http://blog.euromonitor.com/2013/09/special-report-rising-middle-class-threatens-global-food-security.html  
9 Brookings, http://www.brookings.edu/~/media/research/files/papers/2010/3/china%20middle%20class%20kharas/03_china_middle_class_kharas.pdf
10 "India, Unlocking the Demographic Dividend," Henry McVey, November 2012
11 OECD, http://www.oecd.org/development/pgd/44798225.pdf
12 "India, Unlocking the Demographic Dividend," Henry McVey, November 2012
13 The Economist, http://www.economist.com/blogs/banyan/2013/08/indias-economy
14 BBC, http://www.bbc.co.uk/news/magazine-22772391
15 Data as of December 31, 2011. India Central Statistical Organization, Instituto Brasileiro de Geografia e Estatistica, China National Bureau of Statistics, Haver
16 The Economist, "Concrete jungles," September 29, 2012
17 Edelweiss, "Rural India: Transcending boundaries," October 2010
18 livemint.com, http://www.livemint.com/Specials/H6IUUYlYHJLPyViYh2ZtgJ/Labour-market-The-rural-wage-boom.html   
19 BBC, http://www.bbc.co.uk/news/world-asia-21171262
20 Edelweiss, "Rural India: Transcending boundaries," October 2010
21 Asymco, http://www.asymco.com/2012/07/26/cracking-the-india-code/
22 Edelweiss, "Rural India: Transcending boundaries," October 2010
23 Edelweiss, "Rural India: Transcending boundaries," October 2010
24 "India, Unlocking the Demographic Dividend," Henry McVey, November 2012
25 Edelweiss, "Rural India: Transcending boundaries," October 2010
26 Edelweiss, "Rural India: Transcending boundaries," October 2010; The Guardian, http://www.theguardian.com/world/2012/aug/17/chinese-foreign-travel-surges
27 Fairfax Financial Holdings Limited 2010 Annual Report, http://www.fairfax.ca/files/doc_financials/AR2010.pdf
28 Data as of April 26, 2012 for the year 2011. United Nations World Population Prospects, International Monetary Fund
29 Thomas White International, http://www.thomaswhite.com/global-perspectives/banking-sector-in-india-counting-on-credit-growth/; "India Mortgage Sector," Credit Suisse, May 2013
30 Economics In Pictures, http://www.economicsinpictures.com/2012/02/household-debt-as-percentage-of-gdp.html  
31 The Times of India, http://blogs.timesofindia.indiatimes.com/cursor/entry/gdp-decline-in-growth-may-have-bottomed-out
32 Edelweiss, "Rural India: Transcending boundaries," October
33 The Economist, http://www.economist.com/node/21563415
34 India Infoline, http://portal.indiainfoline.com/datamonitor/Others/Automobile-Manufactures-Association/Bajaj-Auto-Limited/International-Business-of-Bajaj-Auto.aspx  
35 Capital IQ, https://www.capitaliq.com/CIQDotNet/Financial/IncomeStatement.aspx?CompanyId=9429928
36 Capital IQ, https://www.capitaliq.com/CIQDotNet/Financial/IncomeStatement.aspx?CompanyId=4481217
37 Capital IQ, https://www.capitaliq.com/CIQDotNet/Financial/IncomeStatement.aspx?CompanyId=24629985
38 The Economist, http://www.economist.com/news/briefing/21582257-most-dramatic-and-disruptive-period-emerging-market-growth-world-has-ever-seen
39 AEI, http://www.aei.org/events/2013/10/18/why-growth-matters-understanding-the-growth-vs-social-agenda-debate-in-india/ 
40 The Economist, http://www.economist.com/node/21532448
41 Trading Economics, http://www.tradingeconomics.com/india/gdp-growth-annual 
42 The Wall Street Journal, http://online.wsj.com/news/articles/SB10001424052702303277704579347834014875334?mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702303277704579347834014875334.html 
43 Reuters, http://www.reuters.com/article/2013/12/16/us-india-economy-inflation-idUSBRE9BF0CP20131216  
44 The Economic Times, http://articles.economictimes.indiatimes.com/2012-06-13/news/32215516_1_savings-rate-sector-savings-retail-credit; Trading Economics, http://www.tradingeconomics.com/united-states/personal-savings
45 Reserve Bank of India, 2012
46 Forbes, http://www.forbes.com/india-billionaires/list/ 
47 The Economist, http://www.economist.com/news/china/21586883-wealthy-politicians
48 The Economist, "Stirring the pot," January 11, 2014
49 "India, Unlocking the Demographic Dividend," Henry McVey, November 2012

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