Emerging Markets: Investing in India

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Narendra Modi, India's newly elected prime minister, is experiencing a moment reminiscent of the early days of Barack Obama's presidency, some watchers of Indian politics say. There is a general feeling of optimism that Modi can get things done despite a slow, choked bureaucracy and improve the country's economic fortune.

Moreover, Modi's Bharatiya Janata Party won the majority for the first time in 30 years. "He has great political capital, and there are incredible expectations for him. All of these people have projected their hopes and aspirations onto him," says Sandeep Dahiya, an associate professor of finance at Georgetown University.

Indian stocks rose to all-time highs on June 6, with Reliance Infrastructure and engineering company Larsen & Toubro among the top performers. In May, the MSCI India index gained 7.35 percent over the prior month. After such a big rally in Indian stocks, the question for investors is: Can Modi meet those expectations? Financial institutions and companies considering expanding overseas are watching closely to see if his record of improving the business climate in Gujarat as chief minister will carry over to the national economy.

Nicholas Smithie, chief investment strategist at Emerging Global Advisors, says Modi is more likely to tackle major obstacles such as a poor infrastructure than previous prime ministers. "The difference in this case is that this time, there was a landslide majority for the first time in 30 years. It's a mandate to change the status quo," Smithie says.

Health of the economy. India is facing dual headwinds of slowing growth and high unemployment. India's gross domestic product grew 4.7 percent in the 2013-2014 fiscal year, missing the official government estimate of 4.9 percent. Smithie says the GDP needs to grow faster to employ the country's large population of young people. "India has to grow at 6 percent to produce enough jobs to get new entrants employed," he says. By contrast, China's GDP grew 7.7 percent in 2013.

Unemployment is fairly high in the 15-to-19 and 20-to-24 age groups across sexes, according to the Indian government's 2009-2010 data. Urban men ages 20 to 24 had an unemployment rate of 9.7 percent. That cohort matters because in contrast to many western nations, India is a nation of young people. In fact, 28 percent of India's population is 10 to 24 years old, according to 2013 data from the Population Reference Bureau, a nonprofit based in Washington, D.C.

[Read: The Economy of Pot.]

"The big challenge is for India to get its growth mojo back. You just can't have those unemployed and millions entering the workforce," Dahiya says.

The hope is that Modi will make this issue a priority. Sumit Ganguly, a professor of political science at the Indiana University School of Global and International Studies, says Modi's record in Gujarat shows that he isn't overly concerned with economic inequities, but that doesn't mean he won't address unemployment. "He may address it by focusing on employment generation. If he can get [domestic investors] to invest, that generates a lot of employment, and then you don't need redistributive policies," Ganguly says, referencing taxes on the wealthy and expansion of current social safety nets.

Investing in India. Investors have been rewarded for investing in India over the past year. The MSCI India index gained 19.6 percent over the past year through May 30, compared with a 9.4 percent return for the MSCI Emerging Markets index during the same period.

Investors may have already priced in Modi's election, but investments in India are still relatively cheap compared with other emerging market countries, Smithie says, noting that investor-friendly reforms are further along in India than in other popular markets like the Philippines or Mexico.

He recommends pursuing riskier corners of the Indian market, such as infrastructure and small-cap stocks, as opposed to more conservative consumer stocks, since those companies exhibit slower earnings growth. "There are some fine consumer companies, but there is not the same earnings growth. With population growth and economic growth there will be a gradual increase, but it lacks the oomph that cyclical sectors have," Smithie says.

For exposure to small companies, the Market Vectors India Small-Cap Index ETF holds more than 85 stocks in a range of sectors. The fund has seen a year-to-date gain of 76.6 percent and a two-year return of 42 percent as of June 9. Its top holding is Apollo Tyres, a tire manufacturer headquartered in India that derives the majority of its revenues from that country. For investors looking for a bit more diversity, just 14.27 percent of the SPDR S&P Emerging Markets Small Cap ETF's portfolio is in India. That fund has risen 11.7 percent so far this year through June 9.

[Read: Emerging Markets: Investing in The Philippines.]

For investors looking for large-cap funds, JPMorgan India Equity Growth Fund counts bank stocks such as ICICI Bank and HDFC Bank among its top holdings, as well as Larsen & Toubro and Indian conglomerate Reliance Industries. So far this year, the fund has gained 19.4 percent, versus 19 percent for the average large-cap fund, according to Morningstar.

It is important to note that with any emerging market investment, the trade-off for growth is more risk. Investors should be wary of investing too much of their money (more than 5 percent, some experts say) in a general emerging market fund, let alone an India-specific fund.

Industries to watch in India. Georgetown's Dahiya says information technology, long viewed as India's most progressive business sector and among the most attractive sectors to global investors, has grown largely because it is "too new for [the government] to mess up." It helps that the industry does not have to comply with regulations of massive factories.

"IT services aren't likely to see a slowdown, but it has become bigger. It will never have the growth it did before when it had a small base," Dahiya says.

George T. Haley, professor of marketing at the University of New Haven, says the textile industry has the potential to be bigger in India than China, but current regulations give companies incentives to stay small. "The textile industry needs some help. Get rid of that limitation, and the GDP could grow 2.5 percent. There is no reason for China to be doing better than India in textiles when China has more expensive labor," Haley says.

A slow-moving bureaucracy in India hasn't helped industries grow, but Ganguly says Modi has the political capital to put an end to some of the most onerous regulations and taxes.

[See: 14 Legal Secrets for Reducing Your Taxes.]

Ganguly says he expects retrospective taxes on capital gains, like the 2012 tax that hit Vodafone to the tune of $2 billion, will be finished under the new prime minister. "I don't see political resistance, as this was the product of the previous regime. This thing is dead in the water," Ganguly says.

Faster growth may come in other areas. Experts say investors should watch three major sectors: pharmaceuticals, defense and infrastructure, and construction and manufacturing.

John Clancy, president of Radius, a firm that offers international business software and services, says, "The infrastructure takes a decade to build, but the spending will start immediately."

Investors should also watch companies that have indicated an interest in expanding in India but have held back, as well as companies already located there, as they have the greatest advantages.

Clancy says that for now, investors should look at companies already involved with or based in India.

Two examples of companies in the growing pharmaceutical industry are GlaxoSmithKline Pharmaceuticals Ltd. and Dr. Reddy's Laboratories. GlaxoSmithKline's Indian subsidiary, GlaxoSmithKline Pharmaceuticals Ltd., is one of the oldest pharmaceutical companies in India. Another homegrown drugmaker, Dr. Reddy's Laboratories, based in Hyderabad, recently announced plans to automate more of its manufacturing.

Clancy says this is the moment international corporations have been waiting for -- a turning point that assures them India's policies will foster economic expansion. "Companies outside of India see this massive economy, and now there is an opportunity for them to get in," he says.



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