Watch out for this India vs. China Megatrend - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Watch out for this India vs. China Megatrend 

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In this issue:
» Can Indian beat China at manufacturing?
» Should you worry about 'Goodwill'?
» Promoter pledging should be on your watch list
» OPEC plans to bust the US shale boom!
» And more!

Our readers and subscribers are well aware of how we are admirers of Warren Buffett's principles of investing. Now, just the other day, we had talked about how it is Diwali crackers and lanterns, Ganesha idols, smart phones, Bangalore Silk saris and cheap generic pharma APIs are all a grim reminder. They remind us of the fact China supplies over 90% of these goods consumed in the largest quantities in India. We would like to believe that the 'Make in India' campaign will the tilt the balance in favour of Indian manufacturers overnight. And that will lead to a Megatrend which can unleash huge wealth building opportunities. But one cannot forget that China's manufacturing Megatrend started nearly three decades ago. In pursuit of its reforms agenda of 1979, China has followed a more-exports-at-any-cost policy to boost its economy. The Chinese government's support to manufacturing in the form of affordable cost of funds, cheap inputs and world-class infrastructure gives it huge advantage over Indian manufacturers. And the cost arbitrage is not going away in a hurry. Will India's manufacturing Megatrend ever take off then?

Well, there is no denying that India's chronic infrastructure and logistics deficit makes it tough for manufacturing companies to achieve just-in-time production. Add to that, archaic labour laws. Little wonder then that despite the government ambitious 'Make in India' promises, Indian companies continue to look for greener pastures overseas. Tata Motors in fact announced a new manufacturing capacity in China days after the government's 'Make in India' pitch.

The Modi government wants to radically simplify and deregulate Indian manufacturing. It wants to change bureaucratic mindsets, cut paperwork and remove the notorious legal and infrastructure hurdles. However, the gap to be bridged with China is enormous for India to make any mark in global manufacturing. Bilateral trade with China crossed US$ 65 bn in 2013. But while India exported US$ 15 billion worth of goods to China, it imported 3 times over (US$ 51 bn)! The quality of trade also goes against India. India exports raw materials such as iron ore but imports manufactured goods.

But does that mean India can make no headway in the pursuit of indigenous manufacturing? To start with, China's traditional cost advantage is now under pressure. Under pressure from the US, China has had to appreciate its currency by 30% since 2006. Its labour costs are also on the rise. Together these are eroding Chinese exports' cost competitiveness. Not to mention the concerns over quality and the treatment meted out to workers. Therein lies an opportunity 'Make in India' must tap. India's labour costs remain among the lowest in the world. According to the US Bureau of Labor Statistics, average labour compensation in India's organised manufacturing sector grew by just 5% YoY, each year, since 1999. Against this the hourly wage growth was 20% YoY each year in China during the same period. As a result, the wages in India (US$ 1.5 an hour currently) are half of that in China (US$ 3 an hour). India's nearly 500 million strong workforce is also a big positive. Comprising of both unskilled and skilled workers, channelized well, the workforce can help India leverage the cost advantage.

So India's manufacturing Megatrend is certain to impact sectors ranging from engineering to textiles to pharma, banking and retailing. A close watch on this trend is necessary to spot companies that can be the biggest wealth creators over the coming decade. And the best way to do that is to be on the ground, meeting companies and managements that are taking the 'Make in India' challenge very seriously. Well, 'The India Letter' team has hit the ground running in this endeavor to select stocks that are certain to ride, what we call, The Golden Decade Megatrend. And we are quite certain that at least a handful of these companies will feature amongst the biggest wealth creators in the coming decade.

How soon do you think will the 'Make in India' pursuit bear fruit? Let us know your comments or share your views in the Equitymaster Club.

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02:40  Chart of the day
Talking about trends, corporate profit to GDP is a very good indicator of the productivity of an economy. Besides a healthy corporate profit to GDP ratio also indicates that the GDP growth is sustainable. If and when, India's manufacturing Megatrend takes off, this is one indicator investors can certainly watch out for. As the chart shows, low investments in manufacturing constantly brought down India's corporate profits to GDP ratio since FY10. In FY14, the ratio was at a decade low (4.2%)! Any improvement in the ease of doing business in India can therefore mean a huge upside for this ratio. And while it may take a while for the ratio to go back to FY08 levels, manufacturing led corporate profits are bound to be sustainable too.

As Indian companies build capacities for growth, interest and depreciation costs may cap profitability temporarily. However, investments in the best companies at good valuations, at this phase can yield very rich dividends later.

Have corporate profits bottomed out?

Now that we've had a look at the concerns about profit growth, let us examine the valuation angle. The most common yardstick to gauge valuations is the P/E ratio. While investors have no influence over the 'E'; they do have a choice when it comes to the 'P'. Paying a high price for earnings growth can be risky, especially if the company is growing via acquisitions. By this, we are not just referring to the business challenges of the acquisition. We would like to highlight the importance of 'Goodwill'.

You see in an acquisition, when a company pays a price that is higher than the target firm's book value, the amount of premium is called 'Goodwill'. It is carried on the balance sheet as an asset. How will this affect you as an investor? Well the risk comes not from the Goodwill itself but from the chance of impairment. This means that if the acquisition turns bad, the company will have to write off the Goodwill. This would crush earnings (E) for that year and send the stock price (P) on a free fall. Thus, we see that it's important not to overpay for the stock of a company with a lot of Goodwill on its balance sheet.

The biggest example is Facebook's buyout of WhatsApp earlier this year. The company paid an astounding US$ 19 bn for WhatsApp. Out of this, about US$ 18 bn is Goodwill. It has revealed that for the first half of 2014, WhatsApp made a loss of US$ 232.5 m on sales of just US$ 15.3 m! We would certainly not like to be a shareholder of Facebook!

Back home, there are plenty of corporates with Goodwill heavy balance sheets. Tata Global Beverages (TGB) instantly comes to mind. The company had made a historic and expensive acquisition of Tetley in 2000. The Goodwill arising out of the acquisition has since then dampened the return ratios of the firm. The acquisition did not turn out well. Sales growth has remained tepid and margins have been muted. As a consequence the stock trades at a discount to its peers in the FMCG space.

The track record of acquisitions is hardly the only criteria to keep in mind when assessing managements. Another crucial aspect is the share pledging, if any, done by the promoters. When promoters pledge their stake to raise debt, it should be a clear red flag. This is because of the opaque nature of these transactions. Most of the time (but not always) promoters, who raise money by pledging their stakes, are the ones who have difficulty raising money from banks. It is quite possible that the entities that provide the loans could be privy to insider information. They will know at what stock price, the promoter will have to 'top-up' the loan. If he does not, they will dump the shares to recover the loan. This means that you, the Aam investor, is at a disadvantage.

Whatever might be the promoter's plans, the lender usually gets to know about it well before retail investors. This is why proper disclosure about the pledging data as well as the terms and conditions is vital. Unfortunately, such disclosures are limited. To end this moral hazard, the regulator must insist on complete disclosure by both parties involved. To be fair, both SEBI and the RBI have taken steps in this direction but a lot more needs to be done we believe.

To conclude we would like to say that no matter how diligently one picks stocks in India, global risk will always play a big role in moving stock prices. After all, FIIs are the dominant force in Indian equity markets. We came across one big risk factor for India that will certainly be on their mind. The fall in global crude prices has brought a lot of cheer to the government as well as the markets. It is certainly a positive event by our reckoning for sure. Crude prices have fallen to almost US$ 80 already.

However, there are forces at play in the world that could result in a turn for the worse. You see, one of the main reasons behind the price fall has been the US shale boom. The US is flush with shale oil and gas which have been extracted using modern techniques like fracking. However, there is a minimum level (estimated to be about US$ 75 per barrel) below which the shale business becomes unviable. There is a belief now that the oil producing OPEC cartel is deliberately suppressing prices to crush the US shale industry.

This capital intensive industry has been helped by the ultra low interest rates in the US thanks to the Fed's policies. The sector has raised funds via dubious 'junk bonds' in large quantities. As and when interest rates rise in the US, we could see several bankruptcies among shale players. This would put a strain on supply, resulting in an upward movement in crude prices again. Not good news for the Indian markets and consumers.

In the meanwhile, the Indian stock markets remained buoyant in the post noon trading session. At the time of writing, BSE-Sensex was trading higher by 25 points. Sectoral indices were trading mixed with pharma and banking being the biggest gainers. Stocks from metal and power were among the leading losers. Asian stock markets were trading mixed with Japanese market leading the gains and Hong Kong market leading the losses.

04:55  Today's investing mantra
"The less prudence with which others conduct their affairs, the greater the prudence with which, we should conduct our own affairs." - Warren Buffett
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2 Responses to "Watch out for this India vs. China Megatrend"

sandeep k raote

Nov 5, 2014

To make MODI'S campaign successful people should stop buying chinese products, as it is they are less durable and there performance is very poor but there look is much attractive. It's sort of silent protest.



Nov 5, 2014

I differ with your view expressed under " OPEC plans to bust the US shale boom!" It is the "shale oil/gas cartel" which rigged the oil prices from USD 20-30/ Brl in 2003 to above USD 150 in 2008 blessed by Dick Cheney & greedy elements of OPEC. It is true the break even for shale gas WAS about USD 63/Brl until last year. I read thru' some other source shale gas BREAK EVEN HAS GONE DOWN TO USD 40/ Brl thia year.So the global oil market is likely to see a major power struggle and all talks of OPEC bursting shalegas boom is absolutely baseless.

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