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Three Unintended Consequences Of A Tumultuous 12 Months

23 September, 2011

Given the nerve-jangling events – both inside and outside India – over the past year, it is easy to get mired in a funk about what the future holds for us. However, the extent to which the world has been upside down over the past year gives us hope for the future, not just because it is always darkest before the dawn. Here are the three unintended consequences of a turbulent 12 months, which will shape investment returns in India for many years to come.

1.   MNCs’ Laser-like Focus On India

As it has become obvious that India will be, for some time to come, a hotspot of consumer demand in an increasingly sclerotic world, MNCs of all shapes and sizes have become laser like in their focus on India. Their annual management conferences are being held in India and they are increasingly allocating more capital and more senior bandwidth to this country. As a result, FDI flows into India remain robust ($17 billion over the previous six months) even as the FII flows dwindle (around $0.5 billion over the previous six months).

The impact of this MNC interest in India is likely to be profound and long lasting. In fact, in a recent note on the Indian consumer durables sector, my colleagues highlighted that with the exception of one or two domestic brands, such as Onida and Videocon, almost everyone else has been wiped off the table by the superior technology, lower cost of capital and powerful marketing practices of the Koreans, the Japanese and, now increasingly, the Chinese.

I can also see the dynamic play out in the passenger car space as Indian auto firms, (Maruti, Tata Motors, M&M) run into intense competition from the Japanese, the Europeans and the Americans. Once again, the triple combination of superior technology, lower cost of capital and well-drilled marketing practices will be difficult for the Indians to deal with.

There is a real risk that the Indian FMCG sector might go the same way as MNCs (Nestle, Unilever, Procter & Gamble, Danone, GSK) commit capital and senior management bandwidth to India in a manner they haven’t done before. Marico’s recent profit warning might be the first of a string of such warnings from homegrown FMCG firms.

2.   The Rise Of Alternative Arms Of The Government

In the wake of multiple scandals over the past 12 months and in the face of its bewildered reaction to anti-corruption movement, the Executive arm of the Indian Government seems to have been weakened meaningfully. This has allowed other arms of the Indian Government – the Judiciary, the CAG, the RBI, the Competition Commission, etc. – to spread their wings and seek to enlarge their legal ‘territory.’ Plenty has been written elsewhere on the Supreme Court, the CAG and the RBI. Hence, I will only focus on the one institution that is yet to show its full deck of cards – the Competition Commission of India.

By choosing to fine as high profile a firm as DLF in its first ruling, one cannot but feel that the Commission is seeking to send out a message that it means business. Newspaper reports suggest that the cement industry is also under investigation. If the Commission’s logic is to investigate industries where there is (a) surplus capacity, (b) market share dominance by a few large players and (c) little evidence of local price-based competition, then I reckon that the Commission might also show an interest in airlines, truck tyres, residential real estate and cigarettes in the months to come.

3.   The Demise Of The Politically Connected Firm

While the recent spate of corruption scandals has soured investor sentiment regarding India, it has had a salutary effect – forcing investors to focus on fundamentally high quality companies. In my previous columns, I have highlighted the strong positive correlation between companies with high accounting scores and high investment returns. Moreover, my colleagues have shown in our published research that for the first time in five years, I now have a situation where politically well-connected companies are no longer outperforming the broader market. To be precise, over the past 12 months, the most ‘connected’ 75 firms in the BSE500 have underperformed the index by 18 percentage points.

Investment Implications

The laser-sharp focus that large MNCs now have on India is likely to have adverse impacts on return ratios across a range of listed sectors, notably, consumer electronics, FMCG, auto and stockbroking. In fact, in a recent study of cross-cycle ROAs in India, I showed that across the last six years, the only large sectors which have been able to protect their ROAs are banking and mining & mineral products, both of which are sectors where foreign entry is restricted by regulatory barriers.

However, there is a flipside to this MNC focus on India – acquisitions. It seems likely that in sectors such as FMCG, stockbroking, consumer electronics and media, Indian assets will garner overseas acquisition interests. The better-quality, listed stockbrokers, the non-news arms of the media companies, the homegrown FMCG companies, some of the smaller Indian auto ancillary firms – there are a number of attractive takeout targets at present.

The only word of caution in this regard is valuations – in the FMCG space in general and in the broader ‘aspirational consumer’ space where a number of firms are trading significantly north of 25x forward earnings. While our demographics are attractive and consumption is the one bright spot in our fraying GDP story, there are only so many pressure cookers and so many pairs of underwear that the average Indian middle class family can buy.

Moving on to the politically connected firms, I continue to urge investors to be cautious about specific firms in power, capital goods, infrastructure, construction, metals & mining, telecom and real estate space. While political connections might deliver short-term benefits, in the longer run, such connections are open to investigative scrutiny and hostage to the vagaries of the election cycle.  

Finally, the Competition Commission is likely to become a share price-driver in the year ahead. The powers that be in New Delhi are concerned, I think, about the operation of cartels in key segments and their impact on the economy and with structurally high inflation threatening to become a permanent part of our economic landscape, I expect some fireworks in specific sectors, such as airlines, cement and real estate, in the year ahead.

 


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Three Unintended Consequences Of A Tumultuous 12 Months

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