Outsourcing has hit the news big-time recently, with the main focus being the dangers it poses to American jobs. The much larger part of the story, however, is what it represents at the other end: The emergence into economic growth of 2.3 billion people in India and China, fully three times as many as currently live in the developed, economically productive world. Whether or not you're exposed to potential job loss from outsourcing, it's worth trying to figure out how to make money from this enormous change.
China's a tough market for a foreign investor. The country is still nominally communist, without most of the personal freedoms we take for granted; this means that a small foreign investor with no political pull is especially likely to be at the end of the line if times get tough. Times are bound to get tough at some stage. The country has been growing at nearly 10% per annum recently, which sounds wonderful until you look at what's been fueling that growth: A lot of it is real estate speculation, often in the state sector, fueled by easy bank credit. The big banks are all state-owned, so there aren't the usual checks and balances against lending to companies that won't repay, particularly if those companies are themselves controlled by the state and have powerful friends near the top of the system.
Finally, there is a multitiered stock market, with many of the more attractive companies reserved for domestic investors. Most of the Chinese companies that foreigners are allowed to buy are themselves majority-owned by the state, so there's no protection at all against mismanagement, which, in an era of easy money, is frequent. On top of that, China isn't cheap.
India: The promise land?
India, on the other hand, is a little easier. Admittedly, the economic growth rates aren't quite as exciting -- around 8% in gross domestic product (GDP) in the year to March 2004, of which about 1.5% was due to a very favorable monsoon in India's still predominantly agricultural economy. In the year to March 2003, when the monsoon was poor, the economy managed only 5% growth.
Yet, India has one enormous structural advantage: It is coming to capitalism not from a true command economy, but from a Third World state socialism that was undoubtedly very inefficient yet still allowed small business to flourish and personal freedoms to survive. India's moves towards capitalism, therefore, are slower than those in China, because the political system delays and dilutes them. However, they work with the grain of the society that already exists, not against it.
India began to reform its socialist system under the Congress party in 1991, and progress accelerated with the arrival of Prime Minister Atal Bihari Vajpayee in 1998. The country's very complicated system of national elections (it's the world's largest democracy by a considerable margin) swings into action in April and May, and Vajpayee is expected to win a new term of office. Even if he doesn't, the commitment of the previous Congress government to reform is likely to continue in a new Congress-dominated coalition, so momentum towards the free market might well slow but it is unlikely to cease. Rapid progress in reform is not necessary; with the Indian labor cost advantage being so great, and the momentum built up by the economic opening so solid, it would require a massive effort of misgovernment to halt progress at this stage.
The important thing is not the pace of Indian economic growth, but the fact that it's now considerably faster than population growth, and likely to stay that way. As each year of 5%-8% economic growth succeeds, more and more Indians are dragged out of subsistence agriculture into the cash economy, and more and more young Indians are able to get an appropriate education. Thus, the investable sector of the Indian economy, in which an internationally competing work force produces internationally competitive goods and services, will grow for many years at a much faster rate than the economy as a whole.
Risks
There are the usual political risks. An India-Pakistan war would clearly hurt, but is perhaps less likely than it seemed a year ago (the two countries are currently playing each other at cricket!). However, one advantage of emerging-markets investing is that it exposes you to a set of risks that is largely different from and uncorrelated to those of investment in the U.S. In that sense, to expose 10% of your portfolio to the possibility of an India-Pakistan war may be a conservative strategy if the other 90% is exposed to the problems of the U.S. budget and trade deficits.
However, one caveat remains: India is one of the most corrupt societies in Asia, and that corruption is not yet showing definitive signs of improvement. It is neither a regional nor an ex-British Empire problem; Malaysia, for example, is only moderately corrupt, and international investors have made good money there for 30 years. In India, the huge "permit raj," erected by the Congress governments of 1947-1991, bred a culture in which the only way to deal with government was to bribe officials. Such a culture is not eradicated in a decade, and it makes India a very difficult place for foreign companies to do business.
The stock market
The Indian stock market has been strong in the last year. The Mumbai Sensex stock index has fluctuated in a range between 3,000 and 6,000 since 1997, peaking at over 6,000 in early 2000 and at the end of 2003. It is currently somewhat below its peak, at around 5,600. At these levels, there is no sign of a Nasdaq-type overvaluation, and there's some possibility that you are still close to the ground floor of a lengthy revaluation of the entire market.
As far as currency is concerned, the Indian rupee is managed against the dollar, and has risen by about 12% against the dollar in the past year. Historically, the rupee has been a weak currency because of India's lack of foreign exchange reserves, but that is not currently a problem. Certainly in the long term, if India's economic growth keeps up, the stock market will enjoy a sustained, long-term price rise accompanied by an increasing inflow of foreign capital. In spite of its size, India is still not well studied by the institutional investor community.
How to get in
While there are a number of companies, such as Coca-Cola (NYSE:KO) and IBM (NYSE:IBM), that have big operations in India, the country still represents only a modest part of their overall operations. Hence, there are two ways to play India (unless you want to get involved in the arcana of Indian clearing systems and tax regulations, which I don't recommend.)
One is to buy American Depositary Receipts (ADRs) of the major Indian companies, listed on the New York Stock Exchange or the Nasdaq. These can be bought and sold in exactly the same way as any U.S. share, but represent either one share or a multiple of shares of a major Indian company. Currently, ADRs are traded on 10 Indian companies, though this selection can be expected to expand rapidly as investment in India opens up further. Information on ADRs can be found on the website adr.com, which is maintained by J.P. Morgan Chase, the leading ADR depositary.
A particular potential problem with ADRs is that they often trade at a premium or (less frequently) a discount against the value of the underlying share, reflecting the differing relative supply/demand in the U.S. investor universe vs. the Indian domestic investor universe.
For example, the leading Indian software and services company, Infosys Technologies (NASDAQ:INFY), traded recently at $81.85 in New York, with a trailing 12-month price-to-earnings ratio of 36 -- by no means excessive for the sector. However, since two ADRs represent each share, the share price equivalent of the ADR price on that day, in Indian rupees (Rs.), was Rs. (81.85*2*43.37), or Rs. 7,116 -- a 44% premium to the day's Mumbai closing share price of Rs. 4,938. For the major Indian financial house ICICI Bank (NYSE:IBN) -- of course a less "sexy" share internationally -- the ADR traded at a premium of 15.1%.
Because of the ADR premiums over the underlying share price, it may well make sense to acquire Indian exposure by investing in a closed-end mutual fund dedicated to Indian investment (because of the remaining restrictions on foreign investment in India, there are currently no open-ended mutual funds dedicated to this.)
There are two such funds worth considering. One is the Morgan Stanley India Investment Fund (NYSE:IIF) trading recently at $25.44, a premium of 9% to net asset value (NAV) and a market capitalization of $499.1 million.
The other is The India Fund (NYSE:IFN) managed by Advantage Advisers, trading recently at $26.27, also a premium of 9% to NAV and a market capitalization of $724.3 million. IIF's ratio of fund expenses to net assets, according to the Closed-End Fund Association, was 1.56%, while IFN's was 1.76%. (Yes, the cost of operating in foreign countries -- with different accounting and tax systems, not to mention languages -- is high.)
One additional wrinkle is that, like ADRs, closed-end funds can trade at both a premium or a discount to NAV and tend to trade at a discount when the sector in which they invest is unfashionable. At the end of 2002, both IIF and IFN traded at discounts of around 15% to NAV. Hence, they have benefited both from the rise in the Indian stock market and the elimination of this discount, more than doubling in price during the last 15 months.
IFN has since Sept. 2003 operated an "interval fund" mechanism, whereby every six months it offers to buy shares in the fund at a discount of 2% from NAV. This will tend to eliminate the possibility of a large discount to NAV, but could make the fund shrink in size.
The funds tend to invest in the same blue-chip Indian companies. IIF's three largest holdings as of Dec. 31, 2003 were State Bank of India (OTHER OTC: SBKIY), the country's partially privatized largest bank; Bhahrat Heavy Electricals, an electric power equipment company; and Infosys.
IFN's three largest holdings as of Dec. 31, 2003 were Reliance Industries (OTHER OTC: RLNIY), a diversified chemical company; Infosys; and Hindustan Lever, the Indian affiliate of Lever Brothers, which is active in soaps and cosmetics.
Both closed-end funds have advantages, and you may want to diversify by splitting your investment between them. Either way, you should look at India for part of your long-term investment portfolio and as useful risk diversification from the U.S. market.
Now what?
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