After India's shares tumble, which new markets are proving the best?
Investors frustrated by returns in London have been looking ever further afield. Recent events in India show what may go wrong with such an adventurous approach. Iain Morse asks whether other emerging markets are similarly vulnerable
Saturday 22 May 2004
Did you think investing in India was a one way bet? Either side of last weekend, Indian share values went into freefall, twice prompting stock exchange regulators to suspend trading. By end of play on Monday the market was down 17 per cent but has since made back over half its losses. All this came on the back of a surprise election result, the ousting of the incumbent and capitalist-friendly Bharatiya Janata Party and its replacement by a less "progressive" coalition of the Congress and Indian Communist Parties. Last year, Indian equities rose by more than 70 per cent, and investors can be forgiven for asking whether such volatility is justified.
But despite India's sheer scale, both in terms of geography and population, its stock market remains puny by comparison with those of developed economies like the UK or Japan. "It's true that about 6,000 shares are listed on one or another of the country's stock exchanges," notes Richard Cardiff, manager of Fleming's Indian Investment Trust, "but only about 250 are at all liquid and tradable." These are captured by the Bombay Stock Exchange's indices. The BSE, which kept its name when Bombay became Mumbai, accounts for about two-thirds of equity trading in India.
Most overseas investors use the MSCI India index, which includes 48 shares. MSCI provide a suite of such emerging market indices, which tend only to include the most liquid and easily tradable large-cap shares in each country. At the end of May, before current market upsets, the 48 shares in MSCI India had a total market capitalisation of $49bn (£27.8bn). There are single stocks listed in the US, such as Microsoft, with a larger value.
Liquidity is another issue. There are half a dozen major stock exchanges in the subcontinent, of which the BSE is the most important, not to mention over a dozen local ones. Paper-based systems are still widely used, and some stocks are only actively traded on local exchanges. The 48 shares listed by MSCI have daily trading volumes ranging from as little as $100,000 up to $40m. Once again, it would not be uncommon to see a large cap US share hit $1bn in a day's trading. Many shares from the broader BSE universe don't even trade on a daily, weekly or monthly basis. "The listing rules are simply looser in India," says Alpesh Patel, managing director of Aranca, which outsources from the UK to India. "Many companies are listed but simply never trade."
This means that transaction costs, incurred on each purchase or sale of a stock, are quite high, averaging 0.84 per cent of deal value. But in a rarely traded, illiquid stock they can go much higher. "The key issue here is market impact," says Mr Cardiff. "As you buy or sell you can put up or push down the market value of the share you are trading."
The breakdown of the MSCI India index is also very different from that of a more developed economy. The largest sector, energy, accounts for 23.1 per cent of index value, reflecting India's need to import oil and generate electricity. But kerosene remains the most widely used source of energy, lighting and heating the homes of the poor. Financials come second at 17.2 per cent, and information technologies third with no less than 15.7 per cent. Included in these sectors are banks and insurance companies, but also software companies and offshore call centres.
Much of the $7bn that flowed into Indian markets last year went into these sectors. Foreign investors prefer industries they understand. "By now, we all know that India produces smart young graduates who work in call centres or do online software repairs," notes Hilary Cook of Barclays Stockbrokers, "but how much premium can you put on these types of business? After all, if call centres move to India so easily they can leave it as well."
What about the rest of the index? Consumer discretionary and staple items, with 10.3 per cent and 9.9 per cent respectively, serve the burgeoning domestic consumer market. But for a country which boasts the world's largest bicycle factory, industrials sit at just 6.2 per cent. In the absence of any effective free healthcare, that sector is more important with 7.5 per cent of the index. But India departs from other emerging economies in two very important sectors: utilities are just 3.4 per cent and telecoms a tiny 1.7 per cent of the index.
Here lies part of the reason why markets reacted so adversely to the prospect of Sonia Ghandi forming a Congress Party government, or the need for this government to have Indian Communist Party support. About a quarter of India's tax revenue goes either to paying for borrowing or a hefty annual defence budget. Privatisation of state-owned utilities and telecom monopolies were in the last government's reform pipeline, and government holdings in oil and gas were also slated for sale. Emerging market funds would have been their keenest buyers. But all the signs are that this process of privatisation will now slow, perhaps even grind to a halt.
"It suddenly looks as if it might take longer, many years longer, for the maturation of this market," cautions Phillip Ehrmann, head of the emerging market fund at Gartmore Asset Management. But that is not all. Current market volatility has hurt many investors. It is driven only in part by foreign money.
A far more important driver lies with insider trading, a massive problem in India as in other emerging markets like Russia and Brazil. Nobody, least of all emerging market fund managers, is keen to discuss this. But a recent report on global market competitiveness, commissioned by the International Monetary Fund, makes it clear that "insider trading is directly linked to market volatility".
That is not all. Exponents of India will tell you that, while China attracted $55bn of inflows last year, India needed just $7bn to sustain its bull market. But India, like China, has a huge pool of domestic, speculative cash held by the general population, often invested for the very short term. In other words, cash momentum drives volatility in this market; it can be very fickle.
CHINA: The untapped potential of a booming marketplace
Fears of an over-heating economy and the threat of increased interest rates have hit Chinese share values hard recently. The MSCI China index is down 7.8 per cent so far this month, and is not expected to recover soon. Behind this lie further doubts over the sustainability of massive structural change in China.
Despite this the market's fundamentals for long-term growth remain in place. These include the one billion hard-working Chinese, who have produced growth in China's gross domestic product of over 7 per cent a year for the last four years. The mainland Chinese savings ratio is a massive 40 per cent of incomes. We buy low-cost manufactured goods from China on credit. They save and invest into real estate, one-year deposit accounts and shares. If you need evidence of the buoyancy of the Chinese equity markets, just consider recent initial public offerings on the mainland stock exchanges. China Life was four to five times subscribed. PICC, another financial services company, raised $400m (£225m).
All this is being driven by fundamentals that won't change for years to come, according to Shifeng Ke, a director at Martin Currie Investment Management. "Workers in China used to be given free housing but now must buy their own, and the rate of urbanisation is growing rapidly," he notes. "Now ordinary Chinese have enough money for discretionary spending, buying cars and spending on leisure. Only 20 per cent of China's GDP is in exports, as domestic consumption is becoming more important."
All this may be true, but there are still some very real risks and restrictions to investing in China. The equity market on the mainland is not directly accessible. Its exchanges list "A" shares which can be bought only by Chinese residents and a handful of authorised foreign investment companies. As a proxy to the mainland, Hong Kong and Taiwan are far easier to access.
But mainland "A" shares consistently trade at higher average price-earnings ratios than those in Hong Kong and Taiwan for structural reasons. China has too much liquidity for too few shares so demand drives the market. The problem is that it creates valuation bubbles which collapse as quickly as they arise.
This makes picking a unit trust with diversified exposure to greater China - the mainland, Hong Kong and Taiwan - the best option for investment. Gartmore's China Opportunities fund returned a breathtaking 76 per cent gain last year. Invesco Perpetual's Hong Kong and China fund lagged on a gain of only 54 per cent. HSBC's Hong Kong Growth fund returned 35.26 per cent.
RUSSIA: The value of an economy founded on oil
Russia has been the least hard-hit of the major emerging markets, down only 0.5 per cent for the month to date, because it is so closely tied to the oil price. "It has huge reserves of oil and gas," says Mark Robinson, manager of JP Morgan Fleming's Russian Securities investment trust. "Its oil companies directly own these reserves, so buying their shares gives investors ownership of reserves that is not available so directly through Shell or BP."
Oil prices currently hover around $40 per barrel and show no signs of falling. This is good news for Russia, which hasabout a third of world oil reserves. Oil and gas shares account for around 65 per cent of the value of all shares listed on Russia's stock exchange. Banks, telecommunications, and utilities account for much of the rest, but Russia is really about oil.
And while other commodities are cyclical, oil is not. It is controlled by a cartel, the Organisation of Petroleum Exporting Countries (Opec), which agrees how much oil members will pump. Russia does not belong to Opec, so has no official say in these agreements.
Right now, Opec shows no signs of wanting to collapse its members' revenues. But even if it did, this might not have too bad an impact on the Russian oil industry. The lifting price for Russian oil, the cost of getting it out of the earth, is $1 to $1.50 per barrel, and the industry would break even at a barrel price of $14.
But the Russian stock market is volatile, like those of other emerging economies. "Invest for the long term," cautions Lev Snykov, a Moscow-based analyst for Nikoil, one of Russia's largest private wealth managers, "and don't be put off by short-term volatility." Beyond oil and gas lies the promise of a fast-developing consumer economy. "Looking ahead we expect to see shares in banks, consumer durables, retailing and utilities becoming more important," says Mr Robinson. "In ten years these sectors will be transformed. A lot of future value is locked up here and will be released to patient investors."
How best to invest? You could approach Nikoil direct. The group manages over $300m (£170m) of private money and a good place to start is its website, www.nikoil.ru. JPMF's Russian Securities is an investment trust which can bought through an execution-only stockbroker. Baring's New Russia Fund is an OIEC, similar to a unit trust, but listed in Luxembourg.
BRAZIL: Stability brings hopes of growth
Down a fifth so far this year, Brazilian equities have been battered as much by the expectation that US interest rates will rise as anything else. But after more than doubling in 2003, there is still plenty of room for investors to take profit and wait for the next wave. "The country is a mixture of first and third world," says Philip Ehrmann, head of emerging market funds at Gartmore. "A lot of multinationals are present there, but also rural backwardness and patches of extreme poverty."
President Luiz Inacio Lula da Silva, elected 18 months ago, is widely credited with bringing stability and fiscal discipline. An ex-Marxist, with time spent in jail for his politics, Mr Silva has brought an unprecedented degree of political unity: the expectation is that this will bring greater economic stability.
Even so, the Brazilian market is very concentrated. The oil giant Petrobas accounts for 28 per cent of the stock market index, the iron-ore manufacturer CVRD for a further 17 per cent, and local telecom companies for another 10 per cent, a total of 55 per cent. "This makes the market inherently volatile," says Mr Ehrmann.
Large parts of the economy are not represented by public companies. Surprisingly for a developing country, power and water are privately owned. The government-controlled state pension fund also has decisive shareholdings in many domestic companies. And the government has a controlling share in Petrobas. Vast tracts of arable land and rainforest are in the hands of wealthy local elites.
Despite all this, Brazil manages GDP growth of 3 per cent to 3.5 per cent.
But, as always, the question for private investors is how best to get exposure to this market. The answer is likely to be one of a handful of Latin American funds or "BRIC" funds, playing Brazil with Russia, India and China. Providers include Gartmore and Aberdeen.
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