New Reforms — But Will India Embrace Foreign Investors?

India and its 1.2 billion people can be a daunting place to invest, considering the country’s tumultuous politics, shifting views of foreign investment and wavering economy.

But recent government reforms are giving hope the Indian economy will grow and take investors along for the ride.

Bombay Stock Exchange, Mumbai
Sajjad Hussain | AFP| Getty Images
Bombay Stock Exchange, Mumbai

In mid-September, the government side-stepped India’s fractious parliament and implemented reforms that allow for greater foreign investment in the retail and aviation sectors. There is hope the government will allow more foreign investment in the insurance sector.

The government also showed willingness to tackle the nation’s growing fiscal deficit by cutting subsidies for diesel fuel.

“This is seen as a positive, and a bold step,” D K Aggarwal, chairman and managing director of SMC Investments in Mumbai, said of the subsidy cut. “The general perception of policy paralysis — that has been kind of vanishing — and people are realizing the government is willing to take the reform process forward.”

The opening up of foreign investment — and the subsequent flow of investor funds into the country — will have implications throughout India, affecting companies ranging from materials maker Grasim Industries to fast-moving consumer goods companies like ITC Ltd., which will benefit from lower inflation. Even blue-chip U.S. companies like Wal-Mart are poised to benefit as they can potentially make inroads into the huge marketplace, dominated by a young working population. (More:India Declares, 'We're Back in Business')

India’s markets rose in the aftermath of the reform news as foreign institutional investors poured $3.5 billion into Indian stocks in September, the largest amount since February, according to theSecurities and Exchange Board of India.The BSE Sensex is up 21.4 percent through Sept. 28 while the MSCI India Index is up nearly 24 percent.

In another positive for India stocks, a government committee in late August recommended postponing tax reforms that had been proposed at the beginning of the year — and would have hurt U.S. equity funds, according to a September report by WisdomTree Research.

The flow of investor money into the stock market, and the Indian economy, is already boosting the value of the Indian rupee , which had declined precipitously along with the Indian market last year amid more global market concerns. The rising rupee should in turn be good news for India’s 7.55 percent inflation rate, as India is a net importer, particularly of commodities such as crude oil, diesel fuel and other raw materials.

A stronger rupee makes those commodities less expensive,which should help lower prices for consumers. Lower inflation could also prompt the Reserve Bank of India to cut interest rates — now at 8 percent — and that could kick-start capital expenditures by industry, igniting growth, Aggarwal said.

Economists remain wary that India’s inflation can be quickly tamed, however. HSBC wrote in an Oct. 1 note that “price pressures remain firm,” citing the fuel price hike, and prospects for food inflation as a result of a weak monsoon season in the country.

To side-step inflation worries, Sunil Asnani, co-manager of the $657 million Matthews India Investor , said his firm selects stocks that are able to do well even when inflation is present.

“We are over-weight in consumer stocks,” Asnani said. “A lot of them have significant pricing power and are able to pass on price rises over time.”

Some of Matthews’ top consumer discretionary holdings as of the end of June included battery maker Exide Industries and media company Jagran Prakashan, as well as more defensive consumer staples companies Emami, a consumer products company, and ITC, a consumer products company that also has businesses in hotels, paper and packaging, agribusiness and information technology. (More:A Fast Food Nation Turns Health Conscious)

Matthews also believes inflation will come down over time through investment in infrastructure, because inefficiencies in the sector can lead to higher prices. Companies in areas where the power grid is deficient, for instance, supplement themselves with more expensive generator power, he said.

As a result, Matthews invests in materials and industrials companies likely to benefit from increased investment in India’s infrastructure. As of the end of June, commercial vehicle maker Ashok Leyland and logistics company Container Corp of India were its key industrial holdings.

A stock market not vulnerable to global volatility

Matthews’ central strategy is to take advantage of India’s dependence on its domestic economy, considered a plus by many investors who are seeking an emerging market not correlated to world-wide swings.

Indian stock dealers keep a watch on share prices at the Bangalore Stock Exchange.
Manjunath Kiran | AFP | GettyImages
Indian stock dealers keep a watch on share prices at the Bangalore Stock Exchange.

Most developing markets like South Korea or Taiwan are export-oriented, leaving their economies more vulnerable to global conditions, while two-thirds of India’s economy is driven by domestic consumption.

“The reason we like many stocks in India is they are largely dependent on domestic factors, independent of what’s happening elsewhere in the world,” said Asnani.

Matthews India Investor also is tilted toward more small and mid-cap stocks — which tend to be more domestically focused — giving it an average market cap two-thirds lower than its open-end mutual fund competitors, according to Morningstar , the Chicago research firm.

One reason for the small to mid-cap tilt, Matthews believes, is the currentMSCI India Index followed by many index funds, is weighted toward larger companies, “many of which reflect the India of the past rather than the India of tomorrow,” he said. Smaller companies tend to get less attention and as a result, have lower valuations, and the potential to get bigger over time, said Asnani. (More:10 Hot Indian Startups)

U.S. investors interested in a similar approach will have a hard time buying smaller cap stocks without the help of a mutual fund. That’s because most Indian companies that trade in the U.S. are larger firms that can afford the compliance costs of multiple listings. Indian companies trading as American Depository Receipts include pharmaceutical company Dr. Reddy Laboratories , HDFC Bank , and IT giant Infosys.

Investors have no shortage of mutual funds to choose among. Before investing in an India-only fund, investors should check the portfolio of their diversified emerging market fund. The average emerging market fund has about 7.5 percent invested in India, but several have bigger stakes, according to Morningstar.

Virtus Emerging Markets Opportunities had nearly a 26 percent stake and Wasatch Emerging Markets Small Cap had a 14.3 percent stake as of the end of June, while Oppenheimer Developing Markets had a nearly 13.5 percent stake as of the end of August, according to Morningstar.

But any fund heavily weighted in India now could shift their holdings over time and have a below average weight in India down the road, said Bill Rocco, senior mutual fund analyst at Morningstar. Rocco emphasized the firm’s view that “it’s generally not a good idea for individual investors to focus on a particular emerging market because they think that market will outperform for one reason or another.”

However, for an investor who wants more India exposure, there are 11 open-end India mutual funds and another 10 exchange-traded funds tracked by Morningstar.

One ETF with a more open-fund approach is the $1 billion WisdomTree India Earnings . Instead of tracking an outside index like the MSCI India Index, WisdomTree tracks an index created by the firm that includes small and mid-cap stocks.

The WisdomTree index is rebalanced at the end of August each year to cut the weighting of stocks that have out-performed, and boost the weighting of those that have under-performed. The index’s energy weighting rose 1.9 percent this year to 20.8 percent of the portfolio, while the health care weighting fell by 1.1 percent to 6.1 percent of the portfolio.

Despite India’s complex economy, and slowdown in growth, Jeremy Schwartz, WisdomTree director of research, thinks investors should take a look at India now. He cites low valuations in India’s stocks, and argues that while India’s growth has slowed, its growth prospects are better than those in the developed world.

“I think it’s a good time to be looking at India,” Schwartz said.