Passage to India

This emerging market has been running like a Brahman bull and will build on recent gains thanks to economic reforms, lower energy costs and burgeoning middle class.

People often refer to emerging markets as if they are one homogenous investment bucket. But this couldn’t be further from truth. Just as it would be mistaken to equate developed economies and invest equally in the U.S. and France, there are worlds of difference among the EM nations.

To that end we keep hearing the U.S. is the best, and possibly only, game in town for investors. I have two numbers telling a very different story: 3.2% and 8.6%. The first is the amount the S&P 500 Index (SPX) is up year to date. Respectable, yes. But it falls far short of the latter, which is the amount the Bombay Sensex Index is up this far in 2016.

More impressive is the run over the past two weeks, which has pushed shares up over 12% to a new 8 month high and clear of major resistance.

IFN Chart 6.7.16

The Indian stock market appears poised to run even higher in coming months.

India Emerging  

The demographics and urbanization of India’s population is what makes it one of the most promising of the BRIC nations. Nearly 65% of the population is under the age of 40, and while there is still rampant poverty, there has been a steady trend of upward mobility. This potential for growth has not gone unnoticed by the corporate world, with companies such as Netflix (NFLX) and Amazon (AMZN) expanding aggressively, with the latter’s CEO, Jeff Bezos, recently meeting with Prime Minister Modi committing to a $5 billion investment over the next 5 years.

India is the now world’s fourth largest economy and the second largest importer of oil. Lower energy costs will accelerate growth and fuel further gains for its stock market. India deserves a place in your portfolio.

An election in 2014 brought in a new government with a mandate to implement sweeping economic reforms, which was the catalyst behind India’s stock market gains early that year, but then the reality of implementation sunk in, taking stocks with them. After some growing pains the promise is now transforming into a reality.

The core to the initiatives has been to reduce regulation, privatize businesses and encourage foreign investment. The reforms are beginning to take hold as its budget deficit dropped to just 4.2% of GDP, a seven-year-low. This led Fitch to boost its rating on India’s Sovereign debt by two notches to BBB.

Last week government data showed growth in industrial output accelerated to a three-month high of 2.5% in April, from 0.50% in January and much better than the 0.60% prediction by economists. GDP is expected to increase to 6.9% for 2016 and 7.1% in 2017.  This is a return to the type of growth that made India and the other BRICs the darlings of investors during the early 2000s.

Positive Flow of Low Oil

The sharp drop in oil, which has declined some 30% over the past three months, couldn’t have come at a better time. It will allow Modi to implement the initiative of lowering social subsidies with reduced political backlash.

At over 3.5 billion barrels per year, or nearly 70% of its consumption, India is the world’s second largest importer of oil behind China. This dependence not only constrains economic activity but also leaves it vulnerable to inflation.

The big drop in oil since last year’s highs is boosting production and profit margins. Even at the recent rebound to $50 per barrel the lower price provides the flexibility to continue its extensive food subsidy program, which is crucial for its large population living in poverty.

Data showed the consumer inflation rate fell to 5.52% in April from 6.46% in January. That too was better than the 5.70% prediction by economists and the lowest since the government introduced the current series of consumer prices in January 2012.

The combination of lower oil with affordable food will allow the government to pass the economic baton onto the private sector and the growing middle class over the next few years.

Add in the recent decline in the U.S. Dollar and India will not only be paying relatively less for imports such as fuel and food, but will make its own exports such as textiles more competitive. Also, India has a highly respected technology sector in terms of both trained employees and entrepreneurial culture.

The Trade

The vehicle I choose is the India Fund (IFN), a closed end fund traded like a stock, with diversified holdings of India’s large cap companies. Here is the exchange traded funds market exposure by sector.

IFN sector breakdown 6.7.16

As you can see financials are strongly represented at 26% of the NAV. What’s more important is the strong predisposition towards Consumer, Non-Cyclical and Consumer, Cyclical. Consumer spending has grown vastly over the last years and is expected to thrive on India’s GDP growth.

Given my long term expectations for shares to continue trending higher I’m targeting the purchase of LEAP call options. Given the recent run in shares I’m going to use a limit order to enter on a pullback. Specifically;

-Buy January 25 calls are $1.20 per contract

IFN call risk 6.8.16

— Steve Smith

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About the Author: Steve Smith