A week in India

After spending a week in China I was privileged to be able to follow that with a week in India. While the comparisons between the two giants will probably be the subject of another article, let me focus on my perceptions of India.

First of all I think that the markets are no where near topping out. The government and assorted intelligentsia are determined to uncover some sort of scam behind this near 60 per cent market rise, they cannot imagine that the market could have risen on its own steam, and given the past history of stock market scams in India one can hardly blame them for lacking belief.

The hedge fund community seems to be in the cross hairs of the regulators, being an animal they have little understanding of and even less faith in. While the regulators are right to be strict and watchful, their obsession in trying to uncover a scam when nothing improper seems to be going on can backfire.

Hedge funds are here to stay, they are the direction in which the fund management industry globally is evolving. Post-2000, hedge funds have raised more money than the traditional long only mutual funds and thus as a class of investors cannot be ignored.

Despite the steepness of the market rise, most sentiment indicators still show little euphoria with limited equity flows into mutual funds, little IPO activity and quite balanced sectoral performance.

As for the fundamentals, here also things look okay. It would not be a stretch to say that India will be able to grow its GDP at between 6-7 per cent over the next five years with inflation at around 4-5 per cent.

With the broad economy growing at between 10-12 per cent, the private sector will grow faster, say at 15 per cent, this 15 per cent top line growth for India Inc. should translate to earnings of between 20-25 per cent per annum.

If India Inc. as a whole were a stock how much would you pay for an earnings stream of 20-25 per cent, it is free cash flow positive, has a positive EVA spread and rising ROE's? Despite the cyclical mix of companies in India Inc., I would argue paying 13-14 times(current P/E) for the above earnings profile is certainly not outlandish.

It is tough to understand why regulators are so worried about the markets. The valuations are not outlandish, sentiment indicators not yet flashing red nor is the personality cult associated with previous market tops apparent.

As far as industries are considered, one gets a real sense that the auto ancillary industry is currently where IT was seven to eight years ago. Currently exports are only $ 800 million (only $ 320 to OEM) and reaching $5 billion over the coming six to seven years does not seem impossible.

There is substantial over capacity at the global OEM level, the cost of manufacturing cars keeps rising due to safety/emission norms and to maintain demand, OEM's have to resort to severe discounting. They need to constantly drop component costs, and their existing vendor base is unable to respond.

Keeping with the above, more than half a dozen global auto majors have now opened procurement offices in India over the past three years. The indigenous development of new car/SUV platforms in India by Telco and M&M has also raised the technology bar for the Indian vendor base as far as design/development and quality is concerned.

The fact that Telco is currently working on five new vehicle platforms, and Maruti and Hyundai are planning new small car platform developments in India will only further increase the skill level of the domestic vendors. It is not inconceivable that in a few years time a handful of Indian vendors will transition to Tier 1 status and be significant vendors to global platforms.

As for the two-wheeler industry, the consensus is that for upto 250 cc engine platforms (over 90 per cent of two-wheelers sold globally are 250 cc and under), there was a limited technology gap between Bajaj/TVS and the Japanese.

There will be a huge export story in two- wheelers developing over the coming years which the market has not fully latched on to. The price-performance equation the Indians can deliver in this space is unmatched.

As far as IT is concerned, Bangalore is clearly carving a global niche for itself. I was surprised to meet so many professionals who had returned to India after spending more than 10 years overseas. All mentioned the ability to do cutting edge work in India as the enabler of their move back, the family and social reasons had always been there.

The reverse brain drain is a huge positive for the country though still in its infancy, and marks the transition of the IT industry to the next level in terms of skill sets. It would not be an exaggeration to say that within a few years, outside of Silicon Valley, no other location will be able to touch Bangalore in terms of breadth and depth of technology skills.

Already SAP has more than 10 per cent of its global development team sitting in India doing the same high-end work as Waldorf in Germany; for Oracle the figure is also 10 per cent of global development as well as 10 per cent of their total global workforce due to a lot of BPO work.

In the case of Texas Instruments nearly 25 per cent of their global development team sits in India. One heard similar numbers for I2,Sun, Dell and other tech majors. For all of them, India was their largest development centre outside their home country and the fastest growing. What was interesting was that all these players spoke about the quality and productivity of the Indian workforce, not just cost.

The ability to get these high quality and diverse skills in large-scale was the other key attraction. No one complained of infrastructure which was a change. Clearly the benefits of the telecom policy are apparent.

I still remain baffled as to how for white collar workers our productivity levels are on par with the best, but for blue collar manufacturing, we seem to be below world averages. Is the lack of an exit policy the cause or the poor quality of pre-university education? This just seems odd.

Not in a single meeting was the upcoming elections raised as a risk factor to future prospects, nor did anyone talk much of government policy. The delinking of the economy and politics seems quite advanced.

Surprisingly, no one really spoke of infrastructure challenges, power was seen as the only unresolved burning issue, but even here the Delhi distribution experiment was cited as a template for the way forward. I was quite surprised at this complacency on infrastructure; India still has no 24/7 cities (in terms of power/water), even Africa has 5. The decay of the urban centres is apparent and will only get worse with growth.

Even on the fiscal side complacency ruled, many could not see the damage a 10 per cent fiscal deficit was causing, they seem to have forgotten the crowding out issues, lack of funds for infrastructure and internal debt dynamics. Low interest rates seem to have dropped all these issues off the radar.

The mindset of the Indian companies was very different from a few years ago. Many talked of becoming global industry leaders. All the BPO players were putting up facilities in other low cost locations. They clearly wanted to become multinationals and drive industry evolution and not lose their lead.

Even in IT services most companies already had some presence in China and all the talk was on the established superiority of the offshore model. In auto ancillaries, the desire to set up base overseas was very evident, as was in two-wheelers.

Getting close to your customer was of paramount importance. The real challenge for India Inc. will be how they manage this transition away from an India centric workforce and production base.

India clearly is happening, there is a strong sense of things coming together, but the challenges of the fisc and infrastructure (especially power) remain. They are interlinked and cannot be wished away if we truly want to break out.