There are lots of events that mark 1994: the North American Free Trade Agreement was established, Silvio Berlusconi and Nelson Mandela were elected to lead their respective countries, and OJ Simpson captured the world’s attention in a white Bronco.
While it may not have grabbed as many headlines, it was also the year that Indian equity expert Vipul Mehta started running an India-focused strategy, the India Magnum fund for the State Bank of India Funds Management and Morgan Stanley Asset Management. The country had opened up to foreign investment a few years earlier, changing its economy for ever.
‘The Indian market has come a long way in the last two-and-half decades in every aspect,’ says Citywire AAA-rated Mehta.
‘From significant growth in size and the number of participants in the markets; from sophistication of the systems to incrementally increasing transparency; from breadth in terms of investable opportunities to the returns delivered and global recognition – India has emerged as an attractive destination for all types of investors and in all probability it is only the beginning of the story.’
Mehta joined Nomura Asset Management in Singapore 12 years ago and as head of investment for Asia ex-Japan, has been managing the Nomura Funds Ireland-India Equity portfolio since its inception in March 2005. The Ucits version was launched in January 2007 and as of March 2017 the overall strategy had $2.7 billion in assets, with the Ucits fund accounting for $62.9 million.
Over five years, the fund’s performance is more than double that of the MSCI India NR USD benchmark, returning 98.7% in the 60 months since the end of April, versus 44.9% from the benchmark. The average manager in the Indian equities sector tracked by Citywire returned 84.1% over the same period.
Over three years, Mehta has almost tripled the benchmark’s 27.9%, returning 84.4%.
The strategy’s concentrated portfolio of 25 to 35 stocks has been outperforming significantly since the beginning of 2014. According to Mehta, the seven years prior to that was a ‘mixed bag’, impacted by a couple of bad periods, such as the US taper tantrum in 2013 which wiped out previous outperformance.
‘Since then we have exercised much higher conviction in our stock picking and significantly, being benchmark agnostic, had much higher active shares in the portfolio, which helped to deliver consistent outperformance,’ he says. ‘Higher concentration in stocks where we had much higher conviction resulted in a much better outcome.’
THE MODI EFFECT
India’s economic trajectory has shifted again since Narendra Modi took office in 2014. His policies to promote foreign investments and infrastructure, revamp the tax system and reduce corruption have attracted more money to the country and its market has pushed forward with every economic reform.
However, such surges can be double-edged. Following the most recent market rally, in the wake of a major victory in an important state election, a number of Indian equity managers increased their cash reserves due to the rich valuations of Indian companies. According to an April report from Morningstar in India, cash levels at equity mutual funds reached their highest level since 2012 due to concerns that stocks were overpriced.
Mehta acknowledges that valuations are high but remains unfazed. His approach is to keep the fund fully invested as much as possible as he does not believe in holding large amounts of cash.
‘We evaluate companies and our positions, not only in terms of absolute valuations but also various other factors. If these other aspects justify a premium valuation, we are willing to pay up a bit.’
He also believes that stocks are expensive for a reason and they could be well worth their price tag.
‘Given the opportunity in the Indian economy and the likelihood of economic growth picking up, we believe the phenomenon of higher earnings growth with superior returns on equity will continue and premium valuations will prove sustainable,’ he says.
This is especially true with sectors associated with consumption, he says, such as consumer staples and discretionaries and their derivatives.
‘With support from macro dynamics, good managements are likely to drive superior returns, so these stocks should trade at a premium.
‘Conversely, in India, cheap stocks, especially those associated with the government, have traded cheaply for a long period of time and we don’t see a big re-rating in the offing,’ he says.
MEHTA’S HIGH-CONVICTION APPROACH HAS BEEN REWARDED ACROSS BOTH 3 AND 5-YEAR TIME FRAMES
Stock selection is especially key to investing in India as this market is still finding its way, says Mehta.
‘India is a land of large inefficiencies, and its stock markets are still evolving, which accounts for the vast investment opportunities. Private sector financials is a case in point, which has taken huge market share from the public sector. One of the biggest opportunities arising in India could be the new policy on affordable housing. If that is executed well, it could be a game-changer for the Indian economy,’ he says.
A FLOOD OF NEW MONEY
India has been a favorite within emerging markets this year. The IMF predicts the country’s economy will grow at 7.2% in 2017 and 7.7% in 2018, making it the fastest-growing major economy in the world. This has attracted a lot of foreign money, especially through ETFs, such as the $4.9 billion iShares MSCI India index and the $1.6 billion WisdomTree India Earnings ETF.
‘There is a huge amount of money flowing into the Indian equity markets, a phenomenon you would normally associate with a decent bull run in the overall markets or sections of the market. This is especially true of retail flows but this time round there are a few differences,’ Mehta says.
Along with more money coming in from foreign investors, local fund managers have also seen a boost but Mehta hasn’t dropped his guard.
‘First, alternate avenues of investment have dried up, especially real estate and to an extent, gold. Second, the flow of money from domestic retail investors is significant through mutual funds, which is a very good sign. There is, however, an unprecedented rush of money and though the metrics are very favorable for the long term, we are cognizant that this could reverse too,’ he says
The reversal of flows is always a concern for emerging market managers. When faced with global turmoil, investors have historically cut and run and India is no exception, says Mehta.
‘Fundamentally we think that the biggest risk is the Fed hiking rates a couple of more times than expected, or crude prices going to $100, but both scenarios are unlikely.
‘Domestically, political instability would be the biggest concern,’ he says.
Despite the current negative view towards Indian financials, the sector is Mehta’s biggest overweight, although this is down to individual stock picking, he says. At the end of March, financials made up 42.4% of the fund versus the benchmark’s 22.1%.
India’s financial sector is made up of state-owned banks, private sector banks and non-bank financials, the latter which do not lend money like traditional consumer banks. State-owned banks have recently come under pressure due to bad loan ratios.
‘All the portfolio’s overweight in the financial sector comprises private sector entities, which account for about a third of the financial system and are very efficiently managed and therefore able to capture share from inefficiently run, non-performing, asset-laden and capital-starved public sector banks. Also increasing penetration and growing opportunities continue to present an environment for sustained growth,’ he says.
A number of Mehta’s top holdings include financials, such as India’s largest private sector player HDFC Bank, Yes Bank and loan firm Housing Development Finance.
Outside of finance he also likes auto manufacturer Maruti Suzuki. ‘This company has been a stellar performer for us. Continuous gains in market share and favorable top-down dynamics in terms of consumption growth have resulted in a virtuous cycle,’ he says.
So which sectors is Mehta giving a wider berth?
India’s $150 billion IT industry is one example. This sector has been pushed into a corner recently between the pressure to transition in an age of automation, Donald Trump’s crackdown on immigration and rumors of mass layoffs.
Mehta has moved away from the industry and was underweight the benchmark by 8.5 percentage points at the end of March.
He says: ‘The IT sector in India faces a number of structural as well as cyclical headwinds and Infosys is probably even more challenged with other issues. Structural challenges include the inability to penetrate effectively into new geographies, while new technologies are shrinking the opportunity space for Indian IT companies. Cyclical headwinds include a slowdown in spending in a number of verticals, rising costs and increasing regulatory threat, not to mention a weakening US dollar, at least as of now.’
Emerging markets have come a long way in the last 20 years but they are still prone to shocks. Mehta is no stranger to reversals of favor and tries to protect his portfolio from such swings. His team stress-tests portfolios to ensure they are resilient to external events.
‘Fundamentally, our portfolio is very domestically oriented and based on certain assumptions of the macro and micro economy.
‘We carefully monitor these metrics and would be very wary if our assumptions didn’t play out as we expected, he says.’
Last year, President Modi caught Indians by surprise. On the evening of November 8 he announced that starting the next day, most of the country’s paper money would no longer be worth anything.
For an economy where 90% of business is transacted in cash, the demonetization policy was a major shock.
People would have a month to take their cash to the bank and exchange it for newly-minted bills in a move that Modi hoped would stop corruption.
Whether or not the currency cull was effective remains to be seen in India’s upcoming data set, but one of the drawbacks for Mehta was having to abandon a stock that up to November seemed to have a promising future.
‘We ditched Bharat Financial Inclusion, a micro-finance company, after the demonetization event in India,’ he says.
‘Micro-finance business in India involves transactions in hard currency and with demonetization, availability of currency dried up, particularly in rural areas. Borrowers would find it much more difficult to repay loans, resulting in bad debt, so we eliminated the position. However, in hindsight, we underestimated the ability of the system to recover from the impact of demonetization.’