Emma Wall: Hello, and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Kunal Desai, manager of the Neptune India Fund.
Hi, Kunal.
Kunal Desai: Hi, Emma.
Wall: So, last time we spoke was July 2016. Quite a lot has changed both for the Indian backdrop, the economy, the macro and indeed, the market. Namely, that Modi is significantly further along in his tenure as Prime Minister and had the chance to implement some of the policies that he was promising last time we spoke, what are the most important of those in your mind?
Desai: So, I think, kind of, over 12, 18 months or so we have seen this acceleration in that reform agenda. And really, I would point to two things which I think were most important. One being this new Goods and Services Tax bill, which is essentially looking to unify the patchwork of taxes and levies that exists across India into one unified VAT system. And that's really in process at the moment. Companies are working their way around the changes in terms of increasing their tax compliance.
The second which is something which came very recently would be recapitalizing the banking sector. So, one of the challenges that India has faced has been a lot of build-up of problem assets in the corporate sector. And a lot of the state-owned banks weren't able to give new credit to these problem projects because of the haircuts involved and the impact that would on their capital base. What we've now seen over the last few weeks is actually the government recapitalize these ailing state-owned enterprises, which I think will give a real big boost in terms of economic development and also growth going ahead.
Wall: And looking at the stock market, it is up significantly this year. What have been the key drivers of that performance?
Desai: So, I think, from India's macro perspective, it continues to have very strong resilience. And I think global investors, when you are scarring the world and you are looking at the macro scorecards of emerging market economies, India continues to screen very favorably. Its external vulnerability continues to fall, growth is accelerating, inflation is soft, the fiscal deficit is under check. So, I think, that's been something which has helped investors look at India favorably and gives them support and stability in a market when you have global issues and global concerns. So, that's the first element.
I think the second most significant element has been a remarkable shift in terms of domestic equity participation. So, Indians today are buying India funds or accessing their own market. And this has really been driven by policy, by incentives, demonetization, which was a reform which happened this time last year, really is trying to move or channel people's savings away from physical assets towards financial assets and within financial assets towards the equity market. So, from a flow perspective, this has certainly helped the market and as a result, it registered very, very strong growth this year.
Wall: So, a lot of that performance has been done, as you suggest, to demand rather than underlying fundamentals, which is something that we did talk about when you were here before about earnings. They haven't come through as expected. Is this something that is going to change soon, because otherwise I think Indian equities begin to look a bit expensive?
Desai: I completely agree. I think when we look over the next 18 months to two years, the reason why I'm so positive on the market today isn't so much the macro noise which has driven the market over the past three or four years, but is that India now moves from a macro story to a micro story. And rally the reason for that is India's position on its own capital cycle is at a point which is very rare for any emerging market economy. And what I mean by that is, firstly, excess capacity exists in India today. It's at about 72% utilisation.
Secondly, demand is now coming through. When we look at the lead indicators of demand, be it job creation data or passenger vehicle data, et cetera, we are now seeing demand crystalising and coming through. So, as a business, increasing demand into your business which has excess capacity goes straight to your bottom-line, operating leverage, rising margins, rising earnings. But at the same time, companies are still showing balance sheet restraint.
They are very, very careful about all these incremental cash flows they are getting, not really putting it back into the ground by way of more capacity. So, when you think about what that means for a business, when you look at it on a return on invested capital basis, operating leverage is pushing that numerator higher, but the invested capital base is still staying low.
So, I think, interestingly, I was in India over the last couple of weeks and probably the most often asked question was when does the CapEx cycle come to India, when does the investment cycle take place.
And I think that's probably the wrong way to look at it, because first, I imagine, over the next 18 months to two years you will see return ratios pick up and companies enjoy their supernormal profitability that they once did and that's what will give the companies the confidence then to go down to that virtuous CapEx cycle. So, really for me, the most interesting part for India over the last five years is the next 18 months.
Wall: Kunal, thank you very much.
Desai: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
