GSAM’s Khemka: The Indian elections – prospects and challenges

Prashant Khemka, CIO emerging markets and fundamental equity at Goldman Sachs Asset Management assesses the impact of the Indian elections.

We’ve seen a lot of interest in India in the last few months, in the run-up to the elections. Why is this election, in particular, garnering so much attention?

Over the last three and a half years, India has seen a significant slowdown in business confidence, capital spending and, as a result, economic growth. Based on the latest opinion polls, current expectations are that the largest opposition coalition – the National Democratic Alliance (NDA) led by the BJP party – will come to power with a sufficient number of seats to form a strong, stable government. The BJP is considered to be a business-friendly party and so the market is expecting a pick-up in business confidence and, importantly, capital spending. As a result, economic growth is expected to accelerate from the current sub-5% level, which feels like a recession in India, to 7-8%, which is considered to be India’s long-term potential growth rate. That’s why this election is so critical.

Opinion polls are saying that the BJP is very likely to win, but what is your expectation as to how strong a coalition they can form?

There are 543 seats in the Lok Sabha, the lower house of parliament, so to have a majority, any party or coalition needs to win at least 272 seats. India has been governed by a coalition for the last 25 years, so no single party is expected to win 272 seats on its own. Therefore, what’s under debate is the party that will win and how strong a coalition that party will be able to form. I would say that any party that wins more than 200 seats on its own is in a strong position to form a stable coalition government, as their dependence on smaller coalition partners would be low.

Over the last six months, projections for the number of seats the BJP may win have risen steadily and, with more and more parties joining the BJP in pre-poll alliances, projections for the number of seats the NDA coalition can win have also risen. Latest opinion polls suggest that the BJP can win around 225 seats, with the NDA pre-poll coalition projected to win around 275 seats overall. If these numbers were to materialise, there will be no dearth of additional political parties eager to join the coalition, prompting reasonable expectations of a strong, stable government.

Assuming we do get a strong election outcome, what are your expectations for India’s economic growth and corporate earnings?

We would expect economic growth to accelerate back to its long-term trend rate of 7-8% and the demand environment in the corporate sector to improve markedly, with a pick-up in sales growth, profit margins, cash flows and earnings growth. This would kick-start the investment cycle and represent a complete reversal of what we’ve seen over the last three years, which has been characterised by a significant slowdown in capital spending and investment. What India needs to revive economic growth is a decisive leadership who can implement decisions in a quick and efficient manner. The good news is that this is not an insurmountable challenge. We would expect corporate earnings growth, which has fallen over the last three years to the high single-digits, to accelerate back to at least the mid-teens long-term trend rate and potentially to as much as 20%.

Given that the equity market is currently trading just below its long-term average, would you expect to see any multiple expansion immediately after the election results?

On a 12 month forward basis, the Sensex is currently trading just below its 20-year average of 15.5x. However, given where we are in the cycle – at the early stages of what could be a strong and sustained earnings growth cycle after three years of single-digit earnings growth – we believe that the market should be trading on a higher-than-average multiple. Between May 2009 and October 2010, following the last elections and before confidence in the government was shaken by several scandals, the market was trading at around 17x. We would expect the market to re-rate back to the 17-18x range after the upcoming elections.

It’s worth noting though that the current valuation discount is much starker in the mid and small cap space than in the large cap space. The BSE Mid Cap Index is trading at a 25% discount to its long-term average on a price/book basis and the BSE Small Cap Index is trading at a 33% discount[2]. Having been penalised the most severely during the downturn, we would expect small and mid caps to benefit the most during any market recovery.

So, given the multiple expansion possible immediately after the elections, should investors use that opportunity to sell, rather than buy, Indian equities?

After several years of very mediocre earnings growth and market returns, some investors will no doubt be tempted to take profits immediately after the elections. However, if we are at the beginning of a sustained cycle of strong earnings growth, as we believe we are, long-term investors should be rewarded. We see immediate upside of 15-20% as the market re-rates to 17-18x, but the better corporate environment is likely to drive stronger earnings growth, which gives us more confidence in the sustainability of this growth cycle. Between 2003 and 2008, when corporate earnings growth accelerated to 25% per annum following three years of single-digit growth, the market went up sevenfold. We are not saying that that will repeat, but – in the absence of things going drastically wrong – we think it would be far too early to sell Indian equities immediately after the elections.

For investors based outside of India who may be investing in currencies other than INR, would we expect the INR to be an incremental source of return?

Absolutely, as all these things are correlated. As the economy improves, we believe the currency markets will start gaining confidence in the longer term competitiveness of the country relative to other countries. Over long periods of time, countries that are more competitive tend to have appreciating currencies. The INR was at its peak in 2007 when markets felt that the competitiveness of the Indian economy was improving. In our view, if the post-election environment normalises or better, markets will expect faster economic growth and increasing competitiveness and so the currency will appreciate, offering non-India domiciled investors an additional source of return.

How are you positioning your portfolios for success in light of the upcoming elections and expected results?

Since inception, we’ve employed a consistent investment philosophy and our alpha has all come from stock selection. In the run-up to the elections, we haven’t changed our philosophy or skewed the portfolio in any one particular direction; rather, we maintain a balanced portfolio of companies that we think will outperform for stock-specific reasons. We have invested in more domestically-orientated companies recently though, as the likelihood of a strong government and improving corporate environment has increased. For example, we have added names in the industrials, capital equipment, financials and consumer discretionary sectors. We also continue to have around half of our portfolio in mid and small cap names – significantly more than other managers do – because we continue to find a lot of alpha generation opportunities in that space.

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