India, Mumbai, Delhi, Indian stock market, long-term investor

Albert Einstein is said to have called compound interest the eighth wonder of the world and Warren Buffett holds it as one of the biggest factors behind his incredible investment success. Compounding should certainly be a big consideration for any investor – and for most companies.

Many fund managers speak of firms that can compound their growth rates consistently over time, and investors in India believe that the Asian country has the best compounders in the world.

"Stocks in India can compound between 15 and 20 per cent every year for donkey’s years," says David Cornell, chief investment officer at Ocean Dial, a UK-based asset manager.

Simon Finch, from another UK-based manager, Ashburton, agrees: "That demonstrates to us that this is a market you can invest in, not trade in and out of".

Investors in India, though, must be able to stomach volatility. Performance can be lumpy, with big up years but just as big down years, and year-to-date has been tough thanks to the strong oil price, which has been a major headwind.

As a result, we’ve already found that some Indian funds have struggled. However, Cornell notes that it’s been the best-performing stock market on the planet over the past 30 years. "It’s compounded at 9.9 per cent in dollar terms every year for the last 30 years."

And while past performance is no guarantee of future returns, there are reasons to believe this may continue. Factors contributing to this year’s weak market performance are not India related. In fact, Prime Minister Narendra Modi has been busy pushing through reforms aimed at clamping down on corruption and improving tax revenues and access to financial services.

Growth in the fourth quarter of 2017 came in at a strong 7.2 per cent, with Q1 beating that at 7.7 per cent. meanwhile, India is in a "demographic sweet-spot", according to Finch, with around 65 per cent of the population 35 years old or younger. With Modi on a job creation drive and almost three-quarters of the population living rurally, there’s ongoing urbanisation, too.

Drilling down to the individual stock level, there are concerns, including corporate governance. Many companies are run - and majority owned - by families, who may not have minority shareholders’ best interests at heart. Cornell says, contrary to popular belief, the larger companies tend to have the worst governance.

In contrast, if you look to the mid and small-cap part of the market, you’ll find young entrepreneurs who have been educated in the UK or US and realise that growing the multiple of the business and enhancing the value for minority shareholders does wonders for the family’s wealth, too. "There’s a shifting attitude that you don’t see in the top 100 names," adds Cornell.

Finch is another who likes strong corporate governance, making sure he invests in those who treat minority shareholders on an equal footing to other stakeholders.

7 Indian stock picks

But there are plenty of positives. Cornell describes India as "a stock-picker’s paradise", with more than 5,500 listed companies and a huge range of investable sectors in the country. He likes companies with a strong balance sheet that pay both tax and dividends.

Cornell says mid-cap India is the engine room of the country, especially considering the large-cap names generate around half of their revenues from overseas. However, it’s easy to find global leaders in very niche industries in the smaller part of the market.

Essel Propack, for example, is the world’s second-largest toothpaste tube maker and is branching out into making ketchup bottles for the elderly. It’s tiny, at US$250 million market cap, but has facilities all around the world.

Mortgage penetration in India currently amongst the lowest in the world, meaning there’s plenty of upside here. Combine this with wage growth outpacing house price inflation, lower interest rates and higher mortgage-related tax breaks and “this is the best time to buy a house in India for over two decades," according to Nitin Bajaj, manager of the Morningstar Bronze-rated Fidelity Asian Values fund.

As a result, all three managers like non-banking financials, with housing or mortgage finance companies top of the list.

Bajaj picks out LIC Housing Finance, the second-largest Indian corporation in its industry, behind HDFC. He believes LIC should be able to compound its loan book at 15 per cent per year.

Meanwhile, its loan book is very interest rate sensitive, meaning its net interest margin has shrunk while Indian interest rates have been falling. Now, rates are on the up, meaning LIC’s net interest margin should begin to expand.

With a price/earnings ratio currently at low levels, too, it’s a simple investment case for Bajaj. You’re "paying nine or 10 times earnings for a business that can compound at 15 per cent-plus for the next five years".

Cornell likes Dewan Housing, a mortgage financing company that operates in off-the-radar tier two and tier three cities that is tapping into this big structural growth trend. It is ICG’s largest holding.

Finch, meanwhile, likes companies that lend to consumers who want to buy white goods like fridges, dishwashers and air conditioning units. He also like auto ancillary companies like the recently listed Sandhar Technologies, as well as Endurance Technologies.

Cement is also a hunting ground for IGC, and has been for a while. His latest buy was Sagar Cement, whose boss is the world’s leading expert on cement and has acted as a sounding board for Cornell while looking into the sector.

Bajaj also points to state-owned enterprise Power Grid, India’s national grid, which he says has three significant advantages over its competitors. It’s another that has been, and can continue to, compound at 12-15% per annum.

These are the know-how of having done what it does for such a long time; the ability to borrow at beneficial interest rates due to its Government ownership; and they don’t need to hire new workers when bidding for new lines of work due to the broad scope of their current operations.

 

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David Brenchley is a reporter for Morningstar UK.

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