27 Jul 2017 19:16 IST

'Demographics is India’s advantage'

But we haven’t fully capitalised on it in the recent past due to weak governance

Attracting the foreign portfolio money required to fund growth poses no challenge for India, given the many favourable tailwinds, says Sukumar Rajah, managing director and chief investment officer for Asian equity at Franklin Templeton Investments. Apart from being the lead portfolio manager of Franklin Templeton’s India-related funds, Rajah is responsible for overseeing regional and multi-country funds and investment processes at Asia. BusinessLine caught up with him on a recent India trip to get his views on the FPI perception of India, the languishing capex cycle, and much more. Edited excerpts

India’s stock market valuation, at the Nifty price-earnings ratio of 25, looks expensive from a historical perspective. Is this a worry?

Profit margins in India are unusually depressed. Earnings growth in recent times has been challenged by a few factors. There are the write-offs in banks, which make up sizeable weights in the Indian benchmarks. There have been regulatory challenges in the pharma sector.

The IT sector, which was a big contributor to earnings, has gone into slowdown mode lately. Banking sector problems have also taken longer to resolve than we expected. These factors have delayed the recovery. But now we do see a meaningful recovery in some sectors, such as materials.

Eventually, bank write-offs will have to wind down. Therefore, earnings recovery will happen. In large-cap stocks, I don’t think valuation is much of an issue. The issue is primarily with mid and small-cap stocks where a lot of domestic liquidity has flowed in. Those pockets of over-valuation do need to correct.

What is the FPI perception on the achievements of this Government? Within India, the narrative is sharply divided.

The perception is that India’s long-term prospects are very good. There may be concerns in the short-term about valuations. From the market perspective, momentum in other emerging markets may be higher. But the majority view is that India is an attractive market for the long-term. Most FPIs also have a reasonable weight in India in their portfolios, relative to the benchmark. The problem really is that India’s weight in the global benchmarks is quite low. For higher allocations, this needs to improve. For that to happen, the free float of this market needs to expand.

The Government has cracked down on round-tripping of capital, renegotiated tax treaties and is a signatory to the anti-BEPS treaty. Will these actions impact foreign inflows?

I don’t see a challenge. The fact that the Current Account Deficit (CAD) has narrowed considerably means that India doesn’t require very high foreign flows at this juncture. If we did have a large opportunity for investment, the CAD would have widened sharply through the import of capital goods and so on.

The narrow CAD is partially a sign of weak demand, caused by the restructuring and rebalancing issues that we are facing. Once these are sorted out, investment demand will pick up. Globally, there is more money than available opportunities.

Lately, RBI has also adopted an inflation targeting framework with a 4-6 per cent range, mainly to ensure rupee stability. If the currency stabilises, the risk perception for India will come down. If risk perception falls, a reduction in cost of capital for the economy is inevitable. For India, finding foreign money to fund growth is not the problem.

You were one of the earliest investors in the Indian software sector, in the 1990s. Today there is a lot of despondency about whether the sector can sustain its growth rates.

There were certain levers that allowed the Indian software sector to grow at a high rate. The first lever was the trend of global IT services being increasingly outsourced to countries like India. India also rapidly gained market share within this pie. These two levers worked to deliver far higher growth rates for Indian software players, compared to the global growth in IT spending.

But now, India’s global share in key categories of IT spending is already high and the room to expand this is limited. This means that the growth in Indian IT companies has to converge towards the growth in global IT spends, which is in the single digits. Margins for Indian firms are under pressure too, because earlier they were competing with European or US-based firms and had a beneficial cost structure compared to them.

Now Indian software majors compete with each other, and global IT firms have set up shop here. Can they find new avenues to grow? It is possible. But it is not easy, given the manpower profile that they have worked with so far. The business has been built on bread-and-butter stuff, and to take on cutting edge tasks is quite different. Therefore, we (Franklin Templeton) are valuing these companies for much lower growth rates than we used to.

What are the macro trends in India that excite you as an equity investor?

Favourable demographics and the increasing size of the middle class population are the biggest drivers. When you have favourable tailwinds, it creates demand, income growth and higher savings. It is very difficult to fight demographics.

If you look at Japan, despite managing such a high standard of living, technological excellence and so on, they’re unable to grow the economy due to an ageing population.

India hasn’t fully capitalised on its demographic advantage in the last 10 or 20 years due to weak governance. Now, the governance framework is improving and we can get a higher benefit from demographics.

There’s a view that economic growth is not creating enough jobs. What is implication of this for consumption?

The perception seems to be that the Government should manufacture jobs. That’s not correct as such job creation cannot be sustainable. The Government should stick to improving governance. Job creation will automatically follow.

All available indicators tell us that governance is improving. My accountant was just telling me that all the interactions with the Income Tax department have moved online. That’s just one instance. I am quite confident that job creation will happen. There is a lag between governance improvements and job creation. It cannot happen overnight.

What are risks to this bull market? Typically, we focus on domestic factors but market crashes in India are often triggered by global events.

Global risks remain mainly geopolitical. The foreign policy of the US is a big a challenge. But that is getting contained lately with the EU and others taking a stance. A substantial weakening of the US economy is a risk too. But unless a big risk like a war manifests itself, we don’t really see a big correction like we saw in 2007-08 after the global financial crisis, when there was a synchronous decline in world markets.

Global equity markets are not all that overvalued. The bond markets are more frothy. People are over-invested in bonds and will face more challenges there. I am therefore positive about diversified global equity portfolios.

Emerging markets have underperformed in recent years and are therefore quite promising. China-related fears have abated a little too and a free fall appears unlikely.

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