Alquity’s Mike Sell: Growth, reform and why now is the time to buy Indian mid-cap, July 2019

Alquity Indian Subcontinent fund manager Mike Sell has a concentrated portfolio, which focuses on the domestic story in India. We sat down and had a chat with him following the recent elections and the changes taking place in a country which is expected to be one of the biggest drivers of global growth in the next couple of years.

Why have medium-sized companies underperformed in India recently?

Whenever mid-caps underperform, as they did in 2018, they normally rebound quite strongly the following year, but they have yet to do so in 2019. The reason for that is the Indian market is in a funk about growth - being backward looking rather than forward looking, but we are really bullish on the outlook for mid-caps in India. Going into elections you always have a growth slowdown as people defer spending and, in the rural areas, people stop working and go to election rallies for a month.

What is the outlook for growth in general?

In the last quarter growth was 5.8%, which is the lowest it has been for some time. But we would expect 6-7% in the future. If you look at the leading indicators, like auto-sales or tractor sales, they’ve all been really weak in the last 3-6 months and the Indian market is taking a backward approach to growth and not taking into account the fact that it has had three interest rate cuts – which should ultimately benefit growth. We expect at least two more cuts will come and we think growth will come through in the aftermath of the election.

The Indian market is driven by the retail investor and they wanted the sugar rush from the budget, in terms of lots of growth and handouts. But the Indian government was really good and refused to oblige – which is great for India’s long-term deficit. It just slowed confidence in the short-term.

People have also missed the structural improvement in India in general, with inflation falling to 3% (having peaked at 12% in 2014). The oil price is the only real threat to that structural growth, and that would impact all of Asia. Public debt has come down dramatically and the budget deficit has improved.

We think this shows all the stars are aligned. Growth in India is not far away and mid-caps will feel the full force of that growth – we think now is the time to buy mid-caps given these prospects and just how cheap these stocks are at the moment.

Before Prime Minister Narendra Modi was re-elected earlier this year you said the market had not priced in his re-election. On reflection has that proven to be the case?

We thought he would win with a reduced majority and it turned out he actually increased his majority. There was a significant rally when that happened, with a 10-15% increase in mid-caps. The market has since come off because growth has not come through yet. That bounce was lost pretty quickly, and it is returning to the doldrums we saw pre-election.

What is on Modi’s agenda for structural reform following his re-election?

He hasn't said anything as its not popular, but he has already started working on labour reforms by putting them all under one single code, which means he can simplify it. Effectively it means it is easier for companies of all sizes to hire and fire people – it is a slow burner.

The second area is land, which he has also made no mention of, but India definitely needs reform there. In Modi’s first term, when it came to reform you had euphoria, followed by stagnation in markets. Then finally we saw an acceleration as people realised what he had achieved.

The third area is infrastructure. We’ve seen an acceleration in road construction with 27 kilometres of railway built per day (versus 12kms in the previous government) and India’s metro system is growing again.

What Modi did in his first term, such as streamlining the GST (goods and services tax) system and making compliance easier, is also continuing to have a greater impact on the economy.

What is the shift from the informal to the formal sector for the retail market and how is it benefiting India?

On the tax side, if you were a small entity you did not pay the state taxes or income tax, it was all cash in hand – that was a huge part of the Indian market. Under GST, almost everyone is registering for that and paying VAT, and they want to do that because you can claim back the VAT on your imports.

There is also a move to make sure minimum wages are introduced across the country. The result is a level playing field which means a lot of companies in the mid-cap space are no longer at a competitive disadvantage, while also putting more money in the consumers' pocket. To put it into context, over 80% of the US is formal/organised retail companies, compared to only 7% in India. It will be a huge generational shift.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Mike's views are his own and do not constitute financial advice.