Opinion: This fast-growing country is taming inflation and in strong financial shape — and its stock market is calling

Lack of infrastructure has been a major impediment to unlocking India’s true growth potential. On a recent trip to meet with companies, it was clear to us that the construction of infrastructure as well as more affordable housing are well underway.  We traveled by car from Surat to Mumbai, a distance of 170 miles. Ten years ago, that trip would have taken 12 hours. We did it in six, driving on six-lane highways and stopping at several quality food establishments along the way. That was unheard of a decade ago.

In Mumbai, the skyline has transformed from 15 years ago. Dozens of buildings reach 50 or more floors, and a subway system is under construction. Residential housing is fast expanding. An example is the town of Palava, 20 miles from Mumbai’s central business district. It’s a master-planned community that reminds one of similar communities in China.

As important as these developments are, as bottom-up investors who’ve been actively traveling to India since the late 1990s, we believe a diligent focus on corporate governance will be an important factor moving forward. This might not be fully captured if one seeks to gain exposure to India through a passive investment vehicle that tracks the broader index. (Passive funds do not strive to outpace their benchmarks; rather, they seek to track the benchmark’s return.)

Let us explain. India has historically traded at a higher valuation on a relative price-to-earnings basis to other emerging markets. Based on our firm’s 30 years of investing in the country’s equity markets, we have found that corporate governance can be a powerful factor in driving valuation differentials within individual sectors. Most companies with strong governance have tended to be rewarded with much higher valuations, based on our experiences. For this reason, almost all conversations we have with management teams start and end with corporate governance.

Face-to-face relationships matter. India has some of the smartest corporate managements in the world, but transparency is key to ensure majority shareholder interests align with ours. Company founders and their extended families are often majority shareholders in their companies — in some cases even after the companies have gone public.

While our investment team has seen tremendous progress regarding governance standards in recent years, it isn’t always easy or a clear-cut decision. We have to triangulate information from our source networks to understand management team priorities. For instance, during our regular research trips we visit company plants multiple times. We talk to suppliers and customers. As an active manager, we invest in companies if they can help pursue a portfolio’s investment objective, not because it is held in an index.

Index construction often does not factor in management structure and pedigree or a company’s growth strategy.  This is especially important in a developing market like India, where traditional Wall Street research that typically focuses on large cap companies (typically market capitalization of $10 billion or more) often leaves major gaps with reference to investment opportunities given that small- (typically market capitalization between $2 billion and $10 billion) and midcap (typically market capitalization between $2 billion and $10 billion) companies currently dominate the market landscape.

Consider that within the MSCI India Index
XX:935600
there are very few Indian companies with a market cap exceeding $50 billion and just a handful that exceed $100 billion. Smaller companies, or those with a market value between $1 billion and $10 billion, make up almost half the index. And given the country’s economic growth — fueled by the steady buildout of both physical and digital infrastructure and an expanding middle class — we expect potential opportunities to increase, especially in the small-cap space.

Investors looking to take advantage of Indian small-caps can consider a actively managed mutual fund. For example, the fund we help manage, American Funds’ SMALLCAP World Fund SMCWX, leverages deep research into global companies under $6 billion in market capitalization at the time of purchase, including in India. HDFC Bank
HDB,
-0.16%,
Kotak Mahindra Bank
500247,
-0.61%,
Tube Investments of India
540762,
+0.02%
] and Max Healthcare Institute
543220,
+0.34%
are a few examples of current and former fund holdings as of last Sept. 30. 

What’s also attractive about India’s equity market today is the breadth of potential investments in finance, consumer businesses, manufacturing, real estate development and online technology platforms. This enables an active manager to build a diversified set of holdings across industries without necessarily concentrating risk in one area.

The fundamental outlook for India is arguably better than ever. The country has a lot going for it: It’s one of the world’s fastest-growing economies, inflation is under control, the government has been fiscally responsible and corruption is lower than it was a decade ago. The equity market is still relatively small compared to the size of the economy and its potential growth, making it a fertile hunting ground for an active portfolio manager.

Brad Freer is an equity portfolio manager at Capital Group in Los Angeles. Freer has 30 years of investment industry experience and has been with Capital Group for 29 years. Earlier in his career at Capital, he was an equity investment analyst covering multiple sectors as a generalist in both India and Australia.

Anirudha Dutta is a Mumbai-based India macro analyst at Capital Group. Dutta has 34 years of investment industry experience and has been with Capital Group for 11 years.

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