India’s attractiveness as a destination for international investors has been increasing in the context of both its projected high growth as well as the ongoing shifts in risk among major economies and investment destinations. A previous Leader in the Sign of the Times demonstrated how India was improving its relative positioning in terms of risk-adjusted returns relative to other major markets, having not only improved returns during the past decade but, uniquely among major economies, having simultaneously reduced risk. In order for international policy makers seeking to build their relationship with India and also for international investors seeking to participate successfully in this market, they will need to form a clear view on the sectors that will drive India forward. This will require them to understand the value, growth and risk dynamics of India’s various industries, and how they are changing. The Modi government has developed an ambitious blueprint for the future of India encompassing increasing manufacturing, agricultural reform, and the growth of services, particularly in the digital space. However, the nature of Indian industry stands to be quite different from the rest of the world’s given that its mass industrialisation is occurring in the information and internet era, while all other major economies came of age in the industrial era . This more than any other factor needs to drive both policy decisions at home and abroad as well as investment allocations abroad. Any successful India allocation strategy will also need to tap into the country’s core macro-economic drivers, aligning with government priorities and recognising the local and global challenges facing potential target industries. This imperative is not lessened by the more free-market characteristics of India. Indeed, it may be even more critical for a successful investor to understand sectors where there is less government-led surety of outcomes. This month’s Sign of the Times examines the risks and opportunities facing major industries and their sub-sectors in India in the face of its unique transition, and attempts to provide a perspective on how international investors might participate in the most attractive segments of the country’s economy.
India is rapidly approaching a GDP per capita of US$2,000 and with industry now close to a third of total economic output, India today has clearly become a rapidly industrialising nation. China hit similar levels in the 1990s, Taiwan in the 1980s and Japan in the 1970s. Despite long efforts to develop heavy industries using top-down economic planning, the country spent many decades of its post-Independence existence as a largely agrarian economy, with agriculture being the largest contributor to GDP until as recently as the 1980s. Post economic liberalisation, India’s services sector leapfrogged its manufacturing and agricultural sectors, with its share of output increasing, from c.40% in 1990 to 58% today. The manufacturing sector, who’s share of output has increased at a significantly slower pace, will of course have to come back and create a bedrock of employment in the economy, but what the sector will look like is yet to be determined. Unpeeling the complexity of the situation with data reveals that certain sectors have emerged as the key drivers of India’s growth story to date. These fall into two categories. The first are a range of export sectors, driven by the country’s low cost, such as IT services and pharmaceuticals and the second are sectors driven by the growing domestic consumption, such as telecom, consumer, and financial services. The first category has benefitted from pursuing international customers, who have proven to be stronger and more reliable that domestic ones. The second category, on the other hand, has proven to be less reliable, particularly given that it is based on the growth of the Indian consumer, who still remains poor and dependent on the government’s ability to alleviate poverty and deliver on the infrastructure required for key services. Both categories however have seen the creation of national (and in some cases global) sector champions that have dominated their respective industries and in turn attracted the lion’s share of capital from both domestic and international investors.
However, the historic economic ‘model’ (if it can be called that at all) that has driven India’s growth since the 1990s is clearly not the one that will deliver the 8%+ GDP growth that the country hopes to achieve in the near future. While India’s core macro-economic fundamentals have been in place for some time - attractive demographics driving an increasing working population, a strong comparative cost advantage, rapid ongoing urbanisation, a stable government with strong democratic institutions, and the rapid growth and dissemination of technology - it has until recently lacked the economic policy and governance required to unlock the value of these assets. Since taking power in 2014, Mr. Modi and the BJP have sought to address this issue with a series of economic and structural reforms across taxation, financial inclusion, corruption and ease of doing business. Mr. Modi has also sought to jump-start growth through foreign investment, and his multiple ‘Invest in India’ tours around the world have made the country the world’s largest destination for FDI since 2015, attracting over US$50bn in inflows per annum since his election. These factors, combined with a reduction in India’s fiscal deficit and the continued growth of domestic consumption provide the backdrop for India’s 8% growth over the medium term. Foreign counterparties looking to secure their trading or investment position with the fastest growing economy in the world will not only need to consider the many factors explored in previous Sign of the Times , but also, critically, form a view on the sectors and themes within each sector that will drive the next wave of India’s growth.
India’s Sectors of Growth
The previous Sign of the Times sought to demonstrate that, with increasing economic and political stability, India’s fundamental risk-return profile is improving at the exact moment when developments in other major markets are leading to increased risk, reduced returns or both. With India representing an increasingly attractive investment destination, investors seeking to allocate additional global funds to the country will need to carefully calibrate their strategy in terms of sector and asset selection. The same macro-economic fundamentals and structural reforms that are reducing risk for the country overall are also transforming its industries, and investors will need to form a perspective on relative sector attractiveness. Importantly, the shifting drivers of growth are impacting the high value points within sectors themselves too, and so sub-sector strategies and themes are also becoming more important.
Weighing the relative risk versus reward in various major sectors is a good place to start. The chart below captures a quantitative and qualitative assessment of sector risk and growth profiles, and aims to show the relative attractiveness in terms of risk vs. the expected growth outlook for India’s major sectors over the next four to five years, while overlaying other qualitative factors such as industry size, and the relative appropriateness for foreign investment.
Based on the above, five sectors clearly stand out at a macro level as potentially the most attractive for international investors given their value creation potential and levels of relative risk: information technology, financial services, consumer, healthcare and manufacturing. Real estate (and the related construction industry), while also a high growth sector, remains plagued by low transparency, frequent incidences of corruption and a lack of enough credible market participants across the value chain. Further, opaque rules and documentation of property ownership as well as the political and ethical challenges associated with the slum clearances that often accompany major developments in urban areas continue to pose risks beyond the appetite of most international investors for now despite the fact that this is a critical issue and will need radical solutions to tackle it. Telecoms, on the other hand, is projected to slow down significantly going forward, reducing the returns investors can expect to achieve. So the focus for investors that care about governance related risks and attractive returns are the five target industries above. Each of these are in effect ‘mega-sectors’ containing a number of scaled sub-sectors, with significant variances in structure, growth, profitability and overall attractiveness among them. For each of these five ‘mega-sectors’, the five to ten-year value creation prospects of the sub-sectors can be understood based on their size, growth potential, valuation and risk. Fast forwarding to the conclusion, given the significant variances in sub-sector industry structure, competitive dynamics, levels of regulation and maturity, investors will need to utilise a number of different investing approaches across public and private markets as well as direct and indirect investments to fully participate in the India growth story at the sector level.
Context. India’s IT industry has been a critical driver of the country’s growth over the past decades, and today generates US$187bn of revenue or c.8% of India’s GDP, employs approximately one-fifth of India’s organised private sector labour force, and contributes c.50% of India’s annual services exports. In this process, India has not only created the first set of home-grown global market leaders (with the top five Indian IT companies accounting for c.US$50bn of revenue and c.1 million employees), it has also become an operating hub for large global IT companies like Accenture, Cognizant and CapGemini amongst many others.
Growth Outlook. Importantly, the growth of Indian IT services has created a robust and entrepreneurial technology ecosystem with over 16,000 firms, which includes a number of promising start-ups across all types of emerging digital technologies such as cloud computing, data analytics, internet-of-things (IoT), virtual and augmented reality, artificial intelligence, amongst others. These technologies are the driving force of the larger global disruption across virtually every sector. While e-commerce is at an early stage and still looking for a business model that works in the Indian context, India’s digital solutions sector has boomed. India’s exports of digital solutions have grown at a CAGR of 68% over the last three years (from US$4bn to US$16bn), while traditional IT services exports have decelerated significantly to 6% growth over this period. These emerging digital technologies are the primary drive force of both innovation and growth for India’s IT industry evidenced by their share in India’s IT exports increasing from 4% in FY2014 to 14% in FY2017, are expected to further increase to 38% by 2025 and hold the key to the shape of many other industries too.
Potential Investor Strategies. Global spending on traditional outsourced IT services is expected to decrease by over 25% over the next decade and India’s ITES giants will accordingly see those parts of their business become commoditised (and less profitable), decelerate, and possibly eventually shrink. Recognising this, most of these companies are looking to build (or buy) digital capabilities. However, with 1m employees among just the top-five companies and large ‘legacy’ businesses, overall earnings for these large IT bellwethers will lag far behind overall industry growth, with a new generation of smaller, entrepreneurial companies likely taking the lead in creating value from emerging digital technologies. Investors seeking to participate in the growth of the next wave of Indian IT will need to look beyond India’s public markets to investments in innovative, high-growth private companies through VC/PE investments. As the rapid global rise of India’s large IT companies has shown over the past two decades, given the abundant human resources and a robust entrepreneurial ecosystem, India will likely create a new generation of global tech leaders in emerging digital technologies.
Context. The healthcare sector has long been a mainstay of international investor focus in India and it is set to continue to be one of the key priorities of the BJP government in a country that has long struggled to deliver health services to its 1.3bn citizens. India today spends only 4.7% of GDP on healthcare, less than half the average of industrialised countries , with the majority of spend being made out of pocket by patients themselves, due to the low levels of public investments, poor insurance coverage and a severe shortage of healthcare delivery infrastructure. In the face of these challenges, investors have historically focused on sub-sectors that competed in international markets, such as generic pharmaceuticals, or at the ‘premium’ end of the domestic demand spectrum, such as private hospitals and clinics.
Growth Outlook. The healthcare sector as a whole by most estimates is set to grow significantly, from US$110bn in 2016 to $280bn in 2020, a CAGR of c.20% , driven by deepening healthcare demand from consumer affluence, changing lifestyles and greater awareness. However, some of the key sub-sectors of past years are facing increasing challenges. Generic pharma, for example, is subject to increasing competitive pressure driven by both new low-cost market entrants and channel consolidation in the US. Similarly, while the demand for private healthcare services is expected to continue to grow, the country faces a significant constraint with regards to the availability of qualified physicians. Policy makers and entrepreneurs should turn to technology to help overcome these challenges: the rapid growth of smartphone and internet penetration is enabling new technologies and business models such as telemedicine and remote monitoring to address some of India’s core healthcare accessibility challenges, bridging the current gaps in affordability, accessibility and the quality of care.
Potential Investor Strategies. Investors will need to be more selective about participating in the traditional focus areas of Indian healthcare. In pharma, smaller and more focused companies with differentiated portfolios and more innovative drugs promise to deliver better returns than their larger and diversified peers, who have seen average EBITDA margins decline from 30% to 25% over the past three years , but require a higher degree of expertise to access and diligence, particularly given that a number of these companies remain private. Acquisitive strategies by Indian sector leaders targeting international players will provide one avenue for investors savvy in judging who to back and which strategies make sense. In the healthcare services space, in the absence of clear policies that drive mass market growth, companies focusing on specialised or premium services should continue to perform well, such as medical tourism which is expected to grow to US$8bn in 2020. Finally, digital health represents a small but growing opportunity for investors. While most companies in the space were founded within the past five years or less, a number of these are scaling rapidly and shifting from start-up to growth mode. Accessing the opportunity over the medium-term will require a private investing strategy until the first wave of successful companies are able to prove their business models, scale and list on public markets.
Context. A robust financial system that can promote domestic savings in financial instruments and efficiently channel these savings into productive investment is critical for India to sustain and accelerate its overall economic growth . The government appears to recognise this and is moving aggressively through initiatives such as the ‘demonetisation’ scheme, its financial inclusion initiatives and a new bankruptcy code to address the non-performing assets (NPAs). Other major changes, including the consolidation and potential privatisation of the public-sector banks, appear to be inevitable given the challenges these banks currently face.
Growth Outlook. India’s financial services sector is in the midst of several simultaneous structural changes. Firstly, India’s previously ‘under-banked’ population is rapidly and en-masse being brought into the formal financial system through ambitious government schemes which have resulted in 296 million new bank accounts (primarily in rural and semi-urban areas) with c.US$10bn of aggregate deposits, and the proliferation and rapid growth of microlending institutions. Secondly, India’s public sector dominated banking system (public sector banks account for two-thirds of total deposits in the country) is gradually ceding ground to well-capitalised and better-managed private banks and non-banking financial companies (NBFCs) which are disbursing credit at a significantly faster rate than their public-sector counterparts. Thirdly, the financial sector is also being disrupted by technology companies and aggressive government policies to reduce the cash economy (primarily in order to curtail corruption and illicit wealth accumulation), with the immediate beneficiaries being online payments companies, such as PayTM (India’s largest online payments company) which has rapidly grown to 200 million users and is expecting to reach 500m users in the next 3-5 years. Finally, the penetration of other financial products such as insurance and corporate bonds, which has long lagged behind in India compared to other major markets, are witnessing rapid scaling, driven by a combination of government policies and international investment.
Potential Investor Strategies. At an industry level, investors will need to focus on the transition from the public sector to the private sector. With that comes a plethora of opportunities as institutions shed assets, change ownership, recapitalise, restructure, create new businesses, launch new products, find partners, expand geographically and harness technology. The biggest driver of change is that India’s public-sector banks are sitting on deteriorating balance sheets (with gross NPAs currently at 11% of loans outstanding and expected to increase up to 15% by next year ), and so the stage is set for innovative, well-managed and well-capitalised private sector players to grow and take market share across a number of different financial products. The public markets appear to have clearly recognised this significant difference in growth potential, with private banks trading, on average, at a c.400% premium to public sector banks . Given the comparably low entry barriers in most financial services categories (other than banking, where licenses are difficult to acquire), the key challenge for investors are high valuations and identifying unique business models which can take scale.
Context. India needs manufacturing for the simple fact that no other sector has the same potential to create hundreds of millions of jobs for its burgeoning labour force. The world has no other proven method to absorb large scale urban migrants and labour transitioning away from agriculture and one that can lift hundreds of millions of people out of poverty. But global manufacturing needs India too; while many low-cost regions such as Indonesia and Bangladesh are ramping up to address the manufacturing demand shifting out of China as it continues to develop as a middle-income country, only India has the scale required to create the necessary supply on a global level. The country has accordingly begun building strong manufacturing capabilities across a number of sectors, including automotive, chemicals, machinery and equipment, amongst others.
Growth Outlook. India is viewed by many as the country that is most likely to replace China as the world’s factory over the course of the next decade . The country has a large, skilled, English-speaking workforce, a relatively low-cost structure – India’s wage rate is one fifth of China’s – and a government that is determined to build out the country’s industrial base. Despite being hampered by poor infrastructure (and high logistics costs), and myriad regulatory challenges at the state and national level, the sector is expected to grow by at least 11-16% (in nominal terms) per annum for the next decade, and could expand at a significantly faster rate under the right policy framework . India’s organised corporate sector will continue to outpace India’s sub-scale units which still account for 30% of manufacturing output (and almost two-thirds of manufacturing employment). India will be the first emerging market to industrialise in the era of artificial intelligence, rising automation and 3D printing which is disrupting global manufacturing. India’s challenge will be in building a scaled industrial base, which simultaneously can provide mass employment and operate with globally-competitive technologies and processes.
Potential Investor Strategies. Large scale industrial investments in India traditionally require an extremely long-term horizon to ensure return on capital, due to the issues outlined above. A more near-term way to play the sector is to identify the sectors which are likely to benefit from both India’s large domestic market and export potential; that are able to leverage India’s low-cost base while mitigating the cost implications of the infrastructure bottlenecks; and able to use technology and management expertise to build strong brands and market leadership at home and eventually abroad. The automotive industry, which now accounts for nearly half of India’s manufacturing GDP, provides the most compelling example: the same company, Tata Motors, now build’s the iconic Jaguar and Land Rover designs and vehicles and also a US$2,000 car. Other industrial leaders are learning from this, and the next wave of innovation in manufacturing in India may well come in sectors such as electronics, industrial machinery and capital goods.
Context. Unlike China in the past decades, a significant part of India’s growth story has been driven by domestic consumption. However, India is a far poorer country, and its consumption is dominated by basic items – food, shelter, energy – and is dominated by ‘unorganised’ firms, which are sub-scale and inefficient. Since liberalisation, the sector has been undergoing three fundamental shifts: First, as incomes grow (particularly in the richer states), the consumption basket is shifting from essentials to discretionary items like electronics, appliances, apparel, etc. Second, this combined with urbanisation and other trends is driving a now accelerating shift towards organised (and branded) consumer firms. Finally, and more recently the rapid spread of smartphones and high-speed mobile networks is driving the rapid growth of online commerce which in turn is disrupting entire consumer categories.
Growth Outlook. The entire consumer sector is witnessing a step change in consumer patterns with the most notable shift being towards discretionary items such as restaurants, packaged foods, personal care, branded apparel and jewelry. The organised segment, including large and mid-sized consumer goods firms, organised retail chains across discretionary categories and scaled and profitable e-commerce platforms, is expected to grow at 20%+ driven by the sharp shift away from unorganised firms, macro trends including urbanisation and increasing disposable incomes, the spread of internet penetration. The sector as a whole continues to face challenges primarily due to the infrastructure and distribution bottlenecks and regulatory issues at the state and national level (though the recent implementation of the nationwide GST should ease issues considerably for pan-India firms). The other issue for investors to consider is the relatively low entry barriers and the considerable churn of brands and firms in India’s ever evolving consumer landscape. India’s economic (and therefore consumption) patterns vary widely by region, and therefore will continue to leave room for small, innovative niche players to emerge and dominate micro-categories.
Potential Investor Strategies. India is growing from a very low base given GDP per capita stands at US$1,709 and more than 50% of the country’s wealth is concentrated in the hands of just 12m individuals. The rapid growth needs to be balanced with this realization. However, the seeds of a growth story that may finally deliver returns to investors is beginning to take root. Since Mr. Modi took office in 2014, Indian consumer stocks have increased by c.38%, making the sector one of the most important drivers of the country’s public markets growth over the last three years. This growth, however, has been priced into sector valuations – the sector trades at a PEG ratio of 1.56 – and is hypercompetitive and often leads to volatile returns within categories. Therefore, investors looking to participate in the sector will need to formulate sector strategies that incorporate careful category and business model selection, identifying companies that possess the standard prerequisites of any strong customer franchise: brand, distribution, and good unit economics. Scaling Indian brands globally and bringing in global brands into India will also continue to be effective strategies to build defensible business models. These companies will likely be valued at a premium today, but will also be best-positioned to become market leader and deliver value to investors. Returns can be expected to be realized from the long-promised consumer and retail story over the next decade or so.
Stepping back, a few key points stand out. Firstly, each of the five high growth industries contains a number of subsectors that reveal massive differences in terms of their relative growth outlook and risk profiles. Second, there are some core themes that are driving the growth opportunity across these sectors. Some of these such as India’s demographic dividend and its growing middle class are well understood, while others, such as the role of Indian cross-border companies, with the first generation of national champions looking to grow their businesses internationally, remain less well explored. Third, and perhaps most importantly the analysis shows that within nearly every sector, the most attractive sub-sectors from an investment perspective are the ones with the highest degree of technology enablement, e.g. digital health in healthcare, fin-tech and e-payments in financial services, e-commerce in consumer.
This phenomenon is not unique to India, of course; the spread of digital technology is a truly global theme. However, technology has the potential to have a much larger impact on India relative to developed and other rapidly developing countries. India, due to its size, demographics and history has faced a series of structural challenges that have hindered development and left the country struggling at times to adequately feed, house and provide for its own people. India today, for all its recent progress, still ranks only 131st on the World Bank’s Human Development Index, somewhere between Tajikistan and the Congo and as recently as 2012, 304 million Indians (nearly 24% of the population) lived without electricity. And while this gap has been steadily closing, with currently only c.5000 of India’s 500,000 villages completely without electricity, the challenges for India of moving up in the rankings are extraordinary. The country’s need is a very basic one for more roads, water lines, power generation, schools, universities, hospitals, clinics. Solving for this will require an estimated US$4.5 trillion of infrastructure spending alone over the next 25 years, not to mention the cost of developing the accompanying human capital requirements . Technology and innovation, and the impact these have on productivity, has the potential to in many cases short-circuit the otherwise slow and costly process of ‘upgrading’ India.
For India, technology can be the bridge to cross its sizable gap across nearly every sector: in healthcare telemedicine and remote monitoring can extend medical services to regions without sufficient physical primary care (and provide for better utilisation of India’s limited number of physicians), in financial services mobile banking drives financial inclusion and grows the size and potential of the industry without requiring a costly and sprawling network of bank branches, and in manufacturing India can simultaneously become a hub for labour-intensive low-cost mass-scale manufacturing (for textiles and apparel for example), and for high-tech and scaled industrial automation in electronics and machinery. With technology overcoming physical and structural bottlenecks, and creating growth opportunities in nearly every industry sector, the India growth story is really a technology story: innovation, in the form of digital technology and the new business models it is enabling, is underpinning India’s 8% growth outlook; without it, the country’s physical constraints would continue to prevent it from realising the full value of its macro-economic growth drivers.
Conclusion. India’s Opportunity to Leapfrog the Rest of the World
It is no coincidence that India’s emergence as a global economic power is occurring alongside the ongoing global shift from the industrial to the information and internet age. India, through a combination of structural factors, geography and history was unable to industrialise alongside other major economies during the industrial age. The fact that it is doing so now places it in uncharted territory, with its industries developing without the problem of replacing legacy infrastructure in the way that developed countries are having to do so now. Indian companies and entrepreneurs today can leverage technology and develop new business models for creating, delivering and consuming products and services using a blank slate. With this advantage, India can create a future that leapfrogs the status quo of the West. These new companies can use technology to define how people communicate, secure healthcare, get educated and skilled, get financed, work, access information and entertainment and ultimately pervade all aspects of people’s lives. In each case, technology enables India to avoid the path that the developed world has taken and to move straight to the future that the world is now trying to create, without the massive transition cost of building and then replacing old infrastructure. In the absence of this significant economic and social transition cost, India has the potential to secure a first mover advantage, becoming a country in which the world gets to test and apply its technologies in an unprecedented scale and in which innovation breeds best in class companies which seek to create new solutions to problems rather than borrow old ones from rest of the world. Therein lies a massive, as yet untapped, opportunity for India: to become not just one of the world’s leading adopters, but also one of the leading creators of innovation and technology. The size of that prize is tremendous: Seven of the ten most valuable companies in the world today are technology companies, five of which were founded within the past 20 years, and their combined market capitalisation is greater than the total value of India’s equity capital markets. Innovation and technology clearly have the potential to catapult India into a global economic power position and its companies into the top tier of global value creators.
The importance of technology for India and the broader opportunity it represents therefore have important implications for India’s government, its priorities and the shape and execution of its reform roadmap. With technology being the key enabler of growth, the government’s core policy focus needs to be the promotion of technology and innovation and its application across all industry sectors and society as a whole. While the BJP’s digital initiatives to date, such as the Digital India campaign promoting connectivity, digital literacy and e-governance have been ambitious, an even more aggressive approach is required if India is to achieve its potential. This would entail building widespread technology infrastructure and implementing government policies to attract large scale domestic and international investments that enable India to build the future rather than transition to the past as a precursor to the future. This is a critical juncture to enable India to make a leap to become a leading nation. India had the natural and human resources to be a global leader during the agricultural age, controlling up to one third of global GDP before the start of the Industrial Revolution. Today, at the dawn of the information age, India again has the opportunity for global leadership. It is an opportunity that it should not let slip by.
1 See the August 2017 Sign of the Times: India’s Rising, Risk Falling
2 See the August 2015 Sign of the Times: India Has to Create Big Waves to Succeed for a further explanation of the transition from the industrial to information era and implications for India
3 See the May 2017 Sign of the Times: 12 Certainties with the Potential to Transform India by 2025
5 Our sector risk assessment is based on an assessment of three qualitative factors: (i) management and governance risk; (ii) execution and operations risk; and (iii) regulatory and policy reform risk, and one quantitative factor: valuation assessed by evaluating current valuation multiples in public markets (and for subsectors in private M&A deals), in the context of the sector and sub-sector level growth. Each of these risk factors is given a score from 1 (for low risk) and 5 (for high risk) and given equal weightage in the risk score
6 See the October 2013 Sign of the Times: Transforming India’s Slums: A Critical Step in Creating the New India
7 Source: Gartner, NASSCOM 2017 Strategic Review
8 Source: OECD average: 9.7%
9 Source: Frost and Sullivan, Deloitte, TechSci Research, LSI Financial
10 Based on the top ten listed Indian pharma companies by revenue
11 See August 2016 Sign: Financial Reforms in India: Restructuring the Nation’s Financial Machine for Double-Digit Growth
12 Source: Credit Suisse equity research
13 Private sector banks trade at a price-to-book ratio of 2.5x vs. 0.5x for India’s public sector banks, Source: CapitalIQ
14 Source: 2016 Deloitte Global Manufacturing Index
15 Source: International Labour Organisation
16 See August 2014 Sign: Unleashing India’s Industrial Potential: Building a Globally-Competitive Manufacturing Base
17 Source: Global Infrastructure Outlook