Investing in India vs. China - the dilemma for UK investors

I know the world doesn't always fall neatly into 'either/or' dichotomies. But it's always tempting to frame such questions - famously, the Guardian used to ask sportsmen 'Britney or Madonna?' (Equally famously, Brazilian footballer Ronaldo replied, 'both'.) You might ask BP or Shell? Vodafone or BT? BAT or Imps? And, of course, when we're talking emerging markets, India or China?

Actually I got the chance to explore that question in some detail recently, talking with an Indian friend who has just finished his MBA here. He's wired into his local business community and quite a few of the companies he knows do business with China. Obviously, this perspective could be a little slanted, but I was interested by the comments that were made about the relative difficulties of doing business in each country.

First of all, China has major quality issues. Quite often, a Chinese company will make one 100% perfect prototype, but when it comes to manufacturing in bulk, there are major quality problems. This is even the case in highly quality-conscious areas such as medical supplies. So although China is a cheaper place than India to manufacture, Indian businesses haven't been impressed by what they're getting for their money. On the other hand, the Indian government is trying hard to raise the quality bar. Quality is considered to be a strategic issue, and that's why the government considers it important to police that quality.  India focuses on quality - China on price.

I also talked about investment, and this was very interesting. Indian companies are still constrained by capital, and investments generally follow the business - that is, once you've got a customer contract, you spend money fulfilling it.

In China, on the other hand, investment often works on the 'if you build it they will come' basis - hence the reports of almost empty new city centres. Building strategic infrastructure is one thing - putting up too many office blocks is another. (I can't help remembering the way Russian companies behaved in the mid 1990s - often buying huge amounts of new equipment which then lay fallow as they hadn't got the business they needed to reach break-even utilisation.) It appears that the absence of a credit crunch in China reflects the fact that capital is being inappropriately allocated (which does quite often happen in a non-capitalist system - and sometimes in a capitalist one).

Another thing India has going for it is a cadre of managers, engineers and other professionals who have learned their trade as ex-pats in the US or Europe. Some of the diaspora are going home to roost - and having a western MBA or professional qualification makes dealing with western customers easy if you're trying to export, or raise capital. I have not been very impressed by the standard of management of most of the Chinese companies I've seen in the UK - partly down to the education system, perhaps, but equally to the fact that few Chinese outside Hong Kong seem to have much international experience.

My final bias is mine alone. I like tech. I like the high margins that come with owning your own intellectual property. I like big dominant tech gorillas like Google and Oracle and Cisco. If I'm looking for these, frankly I am not going prospecting in China. I have a nasty feeling that for all its potential economic power, China is going down a cul-de-sac in its reliance on assembly operations and reverse-engineering of foreign products. That is not the way to create a sustainable long-term advantage.

On the other hand India's high tech sector looks pretty good right now - Wipro just announced a 19% rise in December quarter profits [ref] http://www.reuters.com/article/idUSSGE60J07320100120 [/ref] . Besides the IT sector, India has a strong healthcare and biotech sector, offering a good chance for the country to build its own intellectual capital in technologically advanced industries.

Intriguingly, I was told that some Indian IT companies had been outsourcing to China last year to take advantage of cheaper costs. They are 'insourcing' again now after experiencing quality issues. At the same time, the big call centres and IT firms are hiring again after a bit of a lull.

There's not a lot to choose between the two markets on valuations, apparently. Sensex is trading about 17.5x earnings, which is above its five year average, and also above the 14.5 average for the region, excluding Japan. But it's almost exactly the same rating as China.

Now, fired up by this discussion, I did wonder what Indian stocks might be on AIM. Quite a few, apparently - though I was disappointed by the sectors represented. A quarter of the total are property stocks, with about 10% power companies - and no tech at all, which is sad. The quality also hasn't been great - raising money on AIM back in 2006 was like shooting fish in a barrel, and an unchoosy market tends to encourage the bad stocks to drive out good.

Eredene Capital is involved in port and warehousing projects in India; it should start to generate income this year, after a few years of making losses while investing its portfolio. At 16p, it's trading below its NAV of 20p [ref] Eredene 2009-10 interim results: *** [/ref] - no longer the steal it was, but for the longer term investor, an interesting play on India's long term success as an exporter.

Ksk Power Ventur Plc is one of India's private power operators - again, an investment in infrastructure. 2009 saw a fall in profits as a result of regulatory disruption, but Ksk Power Ventur Plc is now investing in new power station openings, and is expected to see earnings at least double in each of the next two years. Just as well really, as it's on a prospective PER of 35 times according to forecasts from Arden Partners. 

I'd rather head to the US where I can buy shares in Indian IT - NFY is traded on NASDAQ, and WIT on NYSE; INFY's valuation, at 24x historic earnings, isn't out of line for IT companies. What I particularly love about these companies is that they have consistently been able to raise their game. You might think 'Indian call centre' or 'basic outsourcing', but Infosys has now added management consultancy and business process management - high margin professional services. Both companies are currently seeing the best pipelines they've had for a while, and getting close to 20% increases in revenues and profits.

Mind you, they still look expensive compared to IBM on 13x earnings - and paying out 1.5% in dividends - or even ACN  on 18x (with similar yield). What's different of course is the growth rate - IBM scored a miserable 1% revenue growth in Q4 2009 [ref] IBM earnings statement: http://www.ibm.com/investor/3q09/press.phtml [/ref] . Even in its growth markets, IBM just isn't growing that fast (about 6%). Accenture too appears lacklustre compared to the Indian companies - and they are not forecasting a great 2010, just a fairly good one. I'm not absolutely convinced this is the right time to buy, but I shall certainly be putting £WIT and £INFY on my watch list.

By the way, if you thought India was behind the times, here's a great statistic for you: more than 26% of Indian railway tickets are now bought online. That comes from Grant Thornton's great emerging markets blog [ref] http://www.grant-thornton.co.uk/thinking/emergingmarkets/index.php/article/the_flavor_of_e-commerce_and_digital_sector_in_india_in_2010/ [/ref] . I was amazed.
Unfortunately, foreigners can't buy Indian shares directly (unless you're an NRI - non-resident Indian - or person of Indian origin). That's one reason why Indian shares traded on exchanges outside India often trade at a premium - they have a certain scarcity value.

ETF coverage isn't great, either; most of the available ETFs are US listed. Deutsche Bank has an X-trackers S&P CNX Nifty; Lyxor also tracks this index. Closed end funds are probably the easiest way to track the Indian market as a whole (though I know, funds are boring).

Though I find the lack of quality investment ideas frustrating, there is some hope that things might improve. The government has continued to liberalise the economic system - something which inspired a major increase in foreign investment, both institutional and direct, after the last election, despite the ongoing credit crunch. (That may have helped India weather the economic storm better than it would otherwise have done.) Some of those restrictions might disappear - let's hope so.