The Long View: Notes from the Road in India
The Edinburgh-based Global Emerging Markets team recently visited Mumbai as part of a trip through India, Sri Lanka and the Middle East. Mumbai is the second-most populous city in India behind New Delhi, according to the United Nations. It has become a center for financial services in the country and was host on this occasion to a conference run by a local bank, Kotak Mahindra. The bank was founded as a finance company in 1985, became a bank in 2003 and has been run since its inception by the eponymous Uday Kotak.
Trust is a Key Component
In a speech to welcome delegates, the chairman talked about the development of the mutual fund industry and the need for financial services to earn the trust of the people, many of whom were putting their money into markets for the first time. For us, trust is a key component of trying to understand the financial services industry, because trust that can take many years to build can be destroyed in an instant, as more developed markets proved in 2008.
While regulation in the industry is required to tame “animal spirits,” it seems almost impossible to regulate for every eventuality. In an industry where people are paid substantial sums of money to conjure intangible products from thin air, the regulator inevitably winds up playing catch up with the latest innovation.
In many industries we believe innovation is key, but in financial products it tends to make us nervous as the core services that customers need have not changed since the advent of modern banking in Italy in the 12th century. The rise of computers, however, has meant that the only limit to creating new financial products is the imagination of the user and the tolerance of his or her compliance department. This helps to explain why there are now more indices in the world than the stocks they supposedly represent.
Do Politicians Make Good Bankers?
India, unlike most parts of the world, has not had a full-blown banking crisis with runs on banks since banking laws were liberalized in the 1990s. This, in part, seems to have been driven by a lack of bankruptcy law that meant the proverbial can was kicked down the road. Recent changes to establish a bankruptcy procedure have forced many banks to acknowledge these historical issues. We do not like state-owned banks because we have found time and again that the motivations of politicians do not make for sound lending decisions and so it is now that we believe the state-owned banks in India carry a disproportionate share of the bad loans.
The banking sector has been a big beneficiary of some of the changes under Narendra
Modi, India’s prime minister, as rules around financial inclusion have forced some of the informal economy into the light. Most of the companies we met mentioned demonetization, where large value notes were invalidated with little notice to force cash into the banking sector.
As a result of this and falling interest rates, growing savings in the country have been followed by rapid growth in mutual funds. This has helped to propel a rally that unfortunately has left many companies too expensive to own at this time.
Putting a Price on India’s Consumption
Consumer staples companies selling the kinds of things that people need or use on a daily basis, such as shampoo, toothpaste, hair oil or bread have the advantage of pricing power, which is really the ability of a product to maintain price in the face of inflation. In India, inflation often eats at the returns shareholders are hoping to make.
One threat that most consumer companies face is the rise of the Internet, and there has been much debate about whether the unlimited shelf space that this provides is a threat to the dominance of well-established brands. In India, e-commerce is on the rise, and given the lack of penetration of formal retail it is entirely possible that the large box format supermarkets that the developed markets are familiar with will not develop in the same way. Hindustan Unilever, for example, has used the strength of its distribution network to bring the Kirana (small independent) stores online, creating a potentially disruptive distribution channel.
In order for existing enterprises to take advantage of the opportunities that digital channels create, they will have to make substantial changes to information technology platforms that were never designed to work in this way. IT services companies like Tata Consultancy Services (TCS), Cognizant and Infosys all provide the means by which companies are able to do this. We think about their role much like the providers of picks and shovels to the prospectors in the gold rush in California in the 1850s.
Governance, Alignment and Discipline
Our trip once again underlined the importance of a philosophy of backing companies with strong corporate governance. There will be times when the wisdom of crowds does not prove to be so wise and it is for that reason that we believe a philosophy of this kind is so important. The two certain ways to lose money involve buying poor-quality companies or overpaying for a decent business. These mistakes become easier to make during periods of over-optimism. We believe there is plenty of opportunity in India but that the path is inevitably a bumpy one. This should give the patient investor the opportunity to buy when others are less optimistic about the future.
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Originally Published at: The Long View: Notes from the Road in India