Ibus6007 Research Paper Matthew Bright

IBUS6007: INTERNATIONAL BUSINESS SPECIAL PROJECT RESEARCH PAPER

Asset allocation and investment strategies in emerging equity capital

markets: India Is a global macro strategy the best investment proposition for emerging markets? India: a snapshot.

Matthew Bright

Presented to the Faculty of Economics and Business

in partial fulfilment for the requirements of a Master of Commerce degree by coursework

The University of Sydney Sydney, Australia November, 2010

Keywords: Emerging markets finance, India, ‘the new normal’, asset allocation, macro investing, asset management / investment management.

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Is India best suited to a global macro strategy as an investment proposition?

India: a Snapshot*1

Abstract:

This paper considers India as an emerging economy after a strong short-term rebound from a macroeconomic shock and with sound long-term growth prospects.

The focus of research houses towards the end of the decade has been on the prospective outlook for emerging economies with projections decades ahead considering the prospects of developing middle classes, infrastructure development and changes in consumption patterns.

In the background of this recent research focus, twenty years of emerging markets finance scholarship has considered the perils and predilections towards investing in foreign markets with their inherent information asymmetries, pricing inefficiencies, valuation difficulties, internal complications of corruption and poverty and other “third-world problems”.

For investors to gain exposure to asset classes in emerging markets, typically a global macro approach is required to develop profitable positions. Investors simply must take into consideration all of the wealth of statistics available to them and apply their own risk premiums to countries and assets.

This paper is interested in the interaction between macroeconomic figures, equity market performance, the relationship between international investment and market performance and the internal drivers of markets for goods as a country, India, matures.

1 I would like to thank the following academics and universities for whom resources were available in the form of cases and course curricula on Indian business, including individuals such as Vikas Kumar at The University of Sydney, Professor Bruce McKern at Stanford Graduate School of Business and The University of Sydney and Jitendra V. Singh at The Wharton School, University of Pennsylvania; and academic institutions offering courses on emerging markets strategy: Harvard University Department of Economics; and courses on emerging markets finance: Yale School of Management, New York University, Darden Graduate School of Business at the University of Virginia and Duke University’s Fuqua School of Business.

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1. Introduction

Current trends in emerging markets finance involve critical structural changes in the global

economy, where domestic consumption in emerging markets is evolving towards self-sufficiency

and decreased reliance on international exports to the developed world.

For India, its domestic-orientated economy and the long-term consequences of economic reform

bode well for domestic equity capital markets and the stability of foreign direct investment. This

paper considers the short-run economic performance of India as an example of an emerging

economy in a single-country setting, in examining how projected long-term growth can lead to

investment opportunities for firms now in respect of a macro investing strategy.

Time constraints limit the scope and methodologies to literature review in emerging markets

finance, Indian business and third-party proprietary research from financial houses and

consultancies on the Indian economy.2

2. Background: theoretical review, framework and research context

2.1 Emerging markets finance research in context

Over some twenty years of emerging markets finance literature, there has been ample research in

market integration and liberalisation, abnormal distribution and inefficiencies in market

microstructure and asset pricing. The literature is predominately finance-specific and

contextually, tends not to integrate topic-specific concepts of international business. Event-

specific articles often consider large macroeconomic shocks such as market failures and region-

specific financial crises.

2 A more thorough analysis would take into consideration raw data or up-‐to-‐date reports from economic database and research agencies such as the Centre for Monitoring Indian Economy Pvt Ltd. (CMIE). The author’s resources were limited to publicly available information, information acquired at no cost from helpful third-‐parties by direct approach and the resources of The University of Sydney.

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2.2 Putting international business into perspective

Indian scholars Jones and Khanna (2006) put international business scholarship into perspective

in urging for the need to explain how history matters in international business. The pair cites the

decline in the teaching of history in business schools as a possible reflection of the growth in

discipline-based teaching at the expense of the more topic-based IB department3. The core of

their argument is that a dynamic view of events in history allows us to examine long-run events

of interest, but that much of the conceptual underpinnings of current emerging markets literature

such as ‘the effects of Foreign Direct Investment on variable x’ is seriously limited in scope,

search and result. Accordingly, the author’s approach in this paper has been to integrate

concepts related to Indian business, economic and market conditions and suspended concepts

explored on a rolling basis, rather than commencing with an iron clad archetypal question.4

2.3 Investing in emerging markets

Macro investing

Macro forces have historically explained the majority of equity returns for securities in emerging

markets (Cleary, 2010). A global macro strategy directs efficient capital allocation to compelling

opportunities in international economies using macroeconomic principles to identify asset

mispricings (subject to liquidity constraints and market participant behaviour). De Brouwer

(2001) calls this a ‘top down’ approach.

Risks inherent in emerging markets

It is understood that common investment issues in emerging markets include information

asymmetry, agency conflict, adverse selection and moral hazard (Sammut, 2010). Non-market

3 Jones and Khanna cite a personal communication from IB scholar, Hennart, on the basis of such an interpretation of a business school’s IB department. 4 Such a concept was explained to Vikas Kumar, Department of International Business, The University of Sydney. A question was put forward in the research proposal, as something of a ‘buoy’ and in order to provide a research proposal which other students could critique, in keeping with the IBUS6007 course mandate.

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issues include difficulties in information access, weak contract enforcement, poor investor and

intellectual property protections, corruption and political instability (Mobarak, 2010).

Inter and intra-day volatility was compared in India for 13 years and found to be low compared

to other emerging markets (Raju and Ghosh, 2004).

Valuation Challenges in Emerging Markets

Assuming market efficiency, in asset pricing, valuation models will consider a risk-adjusted

discount, being the sum of a risk-free rate and an equity risk premium for a given market or

security. Some universal principles hold true, including the basics of discounted cash flow value.

Valuation uncertainty lies with risk premiums. Hence, practitioners and scholars alike have

devised modified Capital Asset Pricing Model (CAPM) frameworks incorporating country risks

into valuation (the international cost of capital, effectively). Considerations associated with

country risk include a country risk premium, a shift in the exchange rate and models such as the

Goldman Model take into account the sovereign yield spread. To incorporate cash flows

properly, there is the temptation to use macroeconomic factors to construct scenarios (including

forecasts for GDP growth, foreign-exchange rates, interest rates and determine how they drive

each component of cash flow). Espinosa (2005) suggests using estimated country betas in the

CAPM.

The principles of corporate finance in this area involve capturing and countering firm-specific

parameters (EPS volatility, long-run growth rate, systemic risk) with long-term yield parameters

(long-run treasury yields, interest rate volatility) and factoring in growth assumptions without

being unrealistic. The sheer number of variables computed in developing modified valuation

models and then applying them mechanically often leads to wrong results and can lead to bad

decisions (Li, 2005).

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Typically a Sharpe ratio is used for portfolio management and measurement and Value at Risk

(VaR) is calculated for maximum loss over a target horizon based on horizon and confidence

level.

Asset Allocation and Investment Strategies in Emerging Markets

Stock selection in emerging markets takes into account fundamental factors, expectations and

momentum. A macro investing strategy takes into consideration a country’s fundamentals in

devising investment positions for various market instruments.

As a driver of investment strategy, valuation makes a huge contribution to asset allocation.

Kargin (2002) discusses the failure of complex, country-specific models specifically for value

investing in emerging markets. Market volatility may only bring moderate returns and

undervalued stocks may be undervalued for region-specific reasons, not easily understood by the

geographically removed investor due to information asymmetries.

General value investment principles that measure value such as low price/earnings (P/E), high

book/market (B/E) equity or high cash flow/price (C/P) may uncover opportunities in emerging

markets. Fama and French argue that the value premium is compensation for risk missed by the

CAPM and that value stocks tend to have higher returns than growth stocks in markets around

the world.

3. Methodology undertaken: data, method

Data was obtained from reliable third party sources, due to time and resource constraints and the

author’s extensive research in third party proprietary research from credible sources. The

acceptability of such methodology was assumed by the author on the basis of other successful

student-authored papers being developed in such a manner (such as Barnett-Hart, 2009).

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An extensive literature review was conducted involving emerging markets finance, Indian

business and asset management and asset allocation. A general within-country analysis allows

for an isolated view of a country and its internal drivers.

4. India as an investment opportunity

4.1 Key macroeconomic indicators in India

Research houses have focused on the macroeconomic developments underpinning India’s

development. McKinsey Global Institute (MGI) makes logical sense of how India’s

macroeconomic climate interacts with a macro investing strategy with the following modified

flow-chart:

Figure 1: Modified ‘Bird of Gold’ structure

In developing this model based on its own 2007 ‘Bird of Gold’ model, revised with Oxford

Economics (OE) projections as an input, MGI proposed that India would continue to grow at an

annual rate of 7.4% through 2030 (based on a growth rate of 8.0% between 2009 and 2018,

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stabilising to 7.0% between 2018 and 2030). MGI projects GDP growth to reach 9.1% in the

medium term, before slowing down to 7% between 2020 and 2030.

Against these economy-wide projections and measures, at the consumer level projected utility

growth and forecast changes in consumption preferences will drive firm profitability by

investment category and allow investors to access growth through equity capital markets.

Figure 2: McKinsey & Company analysis of India’s growth potential

Source: McKinsey Global Institute, ’India – the Growth Imperative’ research report

As a model of emerging economy growth, India has a robust future for Foreign Institutional

Investor (FII) to channel capital flows into opportunities from labour and production factors.

India’s demographics and urbanisation are favourable and its emerging middle class will drive

growth. MGI, 2007 estimates that India’s middle class will rise tenfold from 50 million to 583

million by 2025.

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How Demographic Change Will Impact the Financial Sector

Projected increases in domestic savings will alter consumer behaviour in holding financial assets.

Goldman Sachs projects that the distribution of household savings into financial assets will

greatly increase household flow into equity assets and decreases in bank deposits.

Figure 4: Projected changes in household asset ratio skew

Source: Goldman Sachs, ‘India – The Assurance of Domestic Demand’

Against this background of increased household wealth and inflows to equity capital markets, it

is worthwhile considering consumption categories and patterns in India.

Figure 5: Evolution of Indian consumption categories

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Historically, consumption categories have been dominated by goods (necessaries), but Goldman

Sachs projects a greater apportionment to services (necessaries and luxuries) in the next decade.

Figure 6: Projected changes in consumption bundles

As a demographic shift occurs, it makes sense that for liquid foreign capital allocation, equity

capital markets would be the logical arena for FIIs to capitalise on domestic consumption by

accessing financial instruments destined for price appreciation as consumer spending evolves.

4.2 India’s place as an emerging market in the ‘new normal’

India emerged from the global financial crisis (GFC) having expanding real GDP by 6.7% in

FY2009 (Roach, 2010), having posted impressive country output of 6.4% in 2008 and 5.7% in

2009 (IMF, 2010), amongst the highest of not only Developing Asia, but all developed countries.

Industrial production is at a two-year high after having drastically decreased from 13% in early

2007 to approximately zero in 2009 (Roach, 2010); The country generated a domestic savings

rate of 32.5% in 2009 (Roach, 2010). Inflation has returned to pre-GFC double-digit levels at

around 10% and India’s growth is projected at 9.7% in 2010 and 8.4% in 2001 (IMF, 2010).

Real GDP is projected to grow by 9.2% in 2010-2011 (CMIE, 2010).

Exports to developed markets such as the US and Europe have drastically decreased, whilst

exports to other emerging markets such as China have dramatically increased (Roach, 2010).

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Key bellwethers of the Indian economy typically are manufacturing output and investment

levels, both of which have sharply increased (Khari, 2010). India’s growth in the recent period

has been driven by high domestic demand, productivity, credit growth ad high levels of savings

and investment (CSFA, 2009).

India’s post-GFC position is consistent with the country’s model espoused by Das (2006), as a

stable, consumption-driven country largely insulated from global events. Taylor’s L. K. Jha

Memorial Lecture (2010) is a good summary of the resiliency of emerging markets, including

India, over this period.

The General Regulatory Environment

Much has been written on how India’s institutional evolution through measures of reform and

liberalisation which occurred on a rolling basis in the early and mid nineties have positively

impacted the Indian economy and in particular enabled some more sophisticated and liquid

capital market development, including the development and empowerment of the Securities and

Exchange Board of India (SEBI) to regulate capital markets (salient examples include McKern et

al, 2009, Khanna and Palepu, 2005 and Zattoni, Pederson & Kumar, 2009).

The literature on India’s banking system is extensive, including on its nationalisation and

liberalisation (as an example, Chiarlone and Gosh, 2009). The topic of FDI in India has been

very well researched (such as Beena et al, 2004) and is not further discussed here.

5. Accessing macroeconomic growth through financial markets and instruments

5.1 Macroeconomics and Capital Market Behaviour in India

Montiel (2003) observes that short-run macroeconomic stability can be seen as an important

determinant for long-term growth performance in emerging economies. The snapshot of India’s

economy, post-GFC, shows a country’s robust performance after an exogenous shock. A model

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of macroeconomic shocks and financial stability demonstrates the systemic effects of what

should occur with asset prices under such conditions.

Figure 7: SEBI adaptation of trickle-down effects of a shock to a country and its financial markets

Source: Government of India Committee on Financial Sector Assessment (CSFA): India’s Financial Sector, p32

Bridging theory and actual occurrence, the short-run performance of India’s capital markets and

asset prices over this period provide a positive example of behaviour under external duress.

India’s domestic equity markets grew sizeably over 2003-2009 from a capitalisation of less than

US$300 billion to over US$1 billion (Deutsche Bank, 2009). Historically, Indian equities have

been considered to be expensive based broadly on Price/Earnings ratios (CSFA, 2009), including

one a one-year forward basis or according the Greenspan formula (as discussed in detail below

the diagram).

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Figure 8: SEBI model of equity valuations in India


Foreign Institutional Investors (FIIs) have broadly achieved positive net investments in Indian

equity markets, reflecting the country’s sound macroeconomic fundamentals and positive

corporate earnings. The close correlation of fund flow and P/E is an interesting phenomenon.

Figure 9: SEBI model of Net FII Inflows relative to P/E Ratio


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If one considers the close relationship between Net FII inflows and P/E ratios, the relationship

can be seen as a sort of Internal Rate of Return (IRR) for the Indian corporate securities market.

It is also interesting to observe that over a blended, relatively stable decade, how a

macroeconomic shock like the Global Financial Crisis tests a country’s model and fiscal policies

through shock and recovery phases. India’s performance demonstrated a rapid rebound of public

markets, asset price recovery and sustained earnings multiples through the period.

Figures 10 and 11: Bombay Stock Exchange Sensitivity Index (red) behaviour in GFC

Source: Bain & Company, India Private Equity Report 2010, p25

Coming out of the GFC, investment in India has been quick to rebound. During the period of

January to June, 2010 FIIs invested US $6878.50 million in equity investments in the secondary

market. The primary market for IPOs has rebounded, backed by foreign underwriters such as

Goldman Sachs and Deutsche Bank, with issues including power companies such as Power Grid

Corporation of India Limited and Jindal Power Limited, state banks such as State Bank of India

and infrastructure developers including Ramky Infrastructure Limited.

The Outlook For Foreign Institutional Investment

At the same time as equity markets gain momentum, currency stability is allowing for efficient

institutional asset allocation without fluctuations distorting capital flow into markets.

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Figures 12 and 13: Stock market and exchange rate performance during and beyond GFC

Source: Deutsche Bank

Key facts such as India’s equity market capitalisation exceeding the value of its banking sector

and its corporate bond market being so under-developed also bode well for foreign investors in

equity markets as equities are the choice assets to gain exposure to corporate earnings.

International Asset Allocation

Figure 14: Emerging Markets Net Private Capital Inflows / GDP

Source: IIF Research Note

A general recovery in private capital inflows into emerging markets is currently taking place. As

the West emerges scathed from the GFC, the investment community is adapting to the emerging

markets’ increases in domestic consumption and decreased export to developed markets, in asset

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allocation priorities are shifting in favour of something of a towards emerging market mandates

(as considered in greater length by Kang, Nielsen, Fachinotti, 2010).

As a discrete case, cumulative fund flows to India highlight the sheer rise in FII over the first

decade of the new century.

Figure 15: FII flows to India (cumulative since Jan 2000)

Source: Chakrabarti, 2009, SEBI.

Research indicates that the vast bulk of Indian FII inflows are channelled into the equity markets,

with which capital market indices are very highly correlated, to the extent of market volatility

causing sell-offs in Indian stocks and exchange rate volatility (CSFA, 2009).

Figure: 16 Relationship between FII inflows and BSE 500 Index performance


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Some Problems

A liquidity puzzle exists in India that constricts investors in channelling funds to productive uses

across the entire economy. Allen and Chakrabarti et al (2007) observe that the size of the formal

financial sector in India, measured by market capitalization and volume of bank credit, is small

in relation to the size and needs of the economy and that alternative financing sources persist

beyond the firm start-up stage.

Without a foreign footprint, foreign investors are typically limited to closed-end or open-end

funds, where foreign-domiciled investment managers make decisions on behalf of the limited

scheme.

6. Asset Management

Figure 17: Growth of the Mutual Funds Industry in India

Source: Chakrabarti (2009), adapted from Association of Mutual Funds in India

6.1 Current Issues in Asset Management

As the asset management industry evolves towards a more crowded, complicated industry, key

items on the agenda for asset managers include seizing financial opportunities associated with

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demographic retirement shifts, reinventing the wholesale approach to fund structuring, business

development for the next wave of growth and driving scale to generate operating leverage

(McKinsey, 2010). Global regulatory reforms such as the closure of proprietary trading desks at

investment banks are seeing new players move into the space and niche players disappear after

years of negative returns.

6.2 Asset Management in India

Internally, pre-GFC the Indian asset management industry had grown rapidly at 47% year-on-

year since 2003, but Assets Under Management (AUM) are a mere 8% of GDP, compared to

79% in the US and 39% in Brazil (McKinsey, 2008), suggesting a dynamic opportunity pipeline.

New equity inflows and new fund offers have contributed heavily to industry development, with

growth equal between the retail and institutional segments (McKinsey, 2008). Amongst the

country’s demographic opportunities in the real economy, growth drivers will lie in distribution,

consumer understanding, and investor education (SpencerStuart, 2009).

Chakrabarti (2009) examined the asset management industry in India, including a history of

mutual funds in India, regulations and regulatory change, current industry structure and product

offerings. He observes that in spite of the mutual fund sectors recent growth nationally, Indian

population participation is still very low at approximately 3%, but still higher than retail equity

ownership, which is around 2%. Corporate assets account for over half of total assets under

Management (AUM). Performance is rather negligible in domestically founded funds, relative to

major stock market indices, but market efficiency would appear to be present, with a low number

of outliers in the risk-return profile. FIIs are seen as a discrete category of the market and are

regarded in the market as “hot money” that quickly withdraws at the hint of trouble, with

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potentially destabilising consequences. FII equity investments and stock market performance are

very closely linked.

Mutual funds AUM is expected to grow 40% CAGR to be a US $302 billion industry by 2012

(KPMG, 2008). New trends in the asset management business include the arrival of real estate

securisation in the form of Real Estate Investment Trusts (REITs) and employee pension fund

development and its flow-on effects (Chakrabarti, 2009). Goldman Sachs is currently

underwriting the offer public offering of UTI Asset Management Company, India’s second

largest mutual fund.

Equity funds product development tends to focus on equity-long positions across sectors and

market caps. In accessing equities, FIIs equity funds will typically apply a proprietary investment

strategy in line with the fund or company mandate.

Investment Funds, Inception, Operation and the Indian Regulatory Framework

The asset management business officially evolved in India from the SEBI (Mutual Fund)

Regulations 1993. Historically, product marketing has not generally been aimed at Indian

investors and foreign funds have typically not elected to mobilise Indian investment with

offerings to access investment from Indian residents (SEBI, 2004).

Knowledge barriers may necessitate that investors can best access Indian ECM through open or

closed-end funds managed by third-party asset managers. Risks include liquidity and redemption

risks, geographic or sectoral concentration risks, currency fluctuations and foreign markets risks.

Integration of the geographic region and global capital markets, may dictate diversification

benefits and fund profitability, as explored in the close-end funds example by Bekeart and Urias

(1995).

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Such an example is the open-end Goldman Sachs India Equity Fund launched in 2008, with the

mandate to achieve long-term capital growth from actively managed Indian equity securities.

The key metric for fund performance is the fund’s Net Asset Value (NAV) calculated on a daily

basis.

Discussion and key findings

The asset management industry in India is evolving with new product creation occurring

concurrently with demographic change and regulatory changes such as pension development.

FIIs have a strong grasp of India’s macroeconomic fundamentals and how access to equity

markets can shape investment strategies in line with fund mandates. India’s economy has

positively weathered a stress test through a challenging period and the snapshot of its economic,

taken into consideration with research houses’ long-term projections make it a positive candidate

for investment allocation from FII funds into equity markets.

Recommendations and Further Research

This paper is a good point of departure for a more extensive analysis of investment strategies that

can be applied to India based on the country’s macroeconomics forecast and growth projections.

A more extensive paper would consider the linkage between financial assets and consumer

demand for real goods and services, exploring asset allocation strategies and developing models

to overcoming the challenges of fundamental analysis in emerging economies. Further research

would also explore best practice valuation methodology used for Indian securities by

practitioners of corporate finance.

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References

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Ibus6007 Research Paper Matthew Bright

Economy & Finance

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