This has been a very good year for the Indian equity market. The SENSEX Index reached 4800 points on the 13th Oct 2003, a 49% rise in the index since the beginning of the year. The BSE Sensitive Index (SENSEX) is a market capitalization-weighted index of 30 stocks representing a sample of large, well-established and financially sound companies in India. It can be used to gauge the performance of blue chips in India over a period of time.

Chart 1

Source: Bloomberg

THE INDIAN ECONOMY

India's GDP grew at a record low of 4.3% last year (according to India's Central Bank). The low GDP growth rate was caused by a drought that affected the crucial farming sector. The farming sector, which makes up 25% of India's GDP, had a negative growth of 3.2% in 2003.

Chart 2

Source: Ministry of Planning and Reporting, India

However, with the arrival of the monsoon season, India is expected to achieve full year GDP growth of 6.5% to 7% for 2004, with the farming sector growing at 5.5% for the same period. More recently, India reported that GDP grew 5.7% in the second quarter, compared with a year earlier. Agricultural production gained 1.7% and exports (which make up 10% of GDP) grew 9.3% in the first four months to July 2003.

INDUSTRIAL PRODUCTION

Industrial production in India grew 5.6% year-on-year in July 2003. The growth was led by production of capital goods and manufacturing. India is increasingly seen as a manufacturing base for exports of automobiles, auto components, engineering and capital goods. The auto component industry in particular, has generated quite a lot of interest, as global auto makers like General Motors, Ford Motors and Delphi, turn to India for their auto parts. Rising costs in established component markets like Mexico and Brazil, means that auto component makers such as Bharat Forge, should benefit from growing overseas demand, reports Dow Jones Newswires. While the contribution of auto production to exports is still small (US$3 billion), the increase in such exports is encouraging as these are considered high-tech fields.

Chart 3

Source: Bloomberg

THE SENSEX INDEX

From Table 1, we note that IT Software and Pharmaceuticals are the 2nd and 5th largest components within the SENSEX index. Analysts and economists view the technology and pharmaceutical industries as major growth drivers for the economy. These areas have been the focus of investment for a large number of investors.

Table 1: Industry Component within SENSEX

A considerable portion of the 3 single country Indian funds available at Fundsupermart are invested into these two sectors. They are HSBC Indian Growth, OCBC Savers India and First State Regional India Fund.

Technology stocks typically make up 16% to 18% (as at July 2003) of these India funds. Both the First State Regional India and OCBC Savers India Fund invest in Infosys Technology Ltd, a leading provider of IT consulting and software services. Pharmaceuticals also form a significant sector allocation for the India funds. All 3 funds invest in RanBaxy Laboratories, a manufacturer and distributor of a wide range of pharmaceutical products.

The funds also invest significantly in consumer staples - companies that manufacture a range of consumer products such as soap, shampoo, toothpaste etc. These products cater to the domestic market, where consumer demand has been growing robustly over the years. Hindustan Lever Ltd, is an example of a large conglomerate in India that manufactures a large variety of consumer products, and is a primary holding for the First State Regional India Fund.

THE TECHNOLOGY SECTOR

Robust outsourcing demand from overseas clients has been a key driver in the technology sector in India, especially in the IT software and services. Outsourcing of IT software and services are included as exports in the IT industry in India.

The US is the largest country outsourcing its IT and software services. According to India's National Association of Software and Service Companies (NASSCOM), the US accounted for 90% of the outsourcing industry's $2 billion in revenue for the year ended March 2003. Companies such as General Electric, American Express and Citigroup have extensively outsourced back office operations, such as software for payroll processing to India. These firms are attracted by India's relatively low wages and a vast pool of professionals that are English-speaking and technology-savvy.

Infosys Technology is one such company that exports IT software and services to the US. The Group targets businesses specializing in the insurance, banking, and telecommunications and manufacturing industries. Listed on the Bombay Stock Exchange, Infosys is the second largest software exporter in India, next to Tata Consultancy Services. The latter is expected to launch a 32 billion rupee initial (1 USD = 45.36 rupees) public offering (IPO) before the end of March next year.

The PE ratio for Infosys is very volatile (a common characteristic of a technology stock). It ranged from a high of 422 times during the technology boom in early year 2000 to a low of 18 times. Just recently, Infosys reported a better-than-expected 33% increase in quarterly earnings. Analyst reports cite a recovering US market and stablizing billing rates (which shows greater pricing power for India's technology companies) as the primarily reasons for the good earnings. Outsourcing of IT services from the US account for about 70% of Infosys' revenues. It is currently trading at a PE of around 30 times.

Chart 4

Source: Bloomberg

THE PHARMACEUTICAL SECTOR

India's annual drug exports, led by generic drug sales to the US and Europe are estimated to be US$2.5 billion which is more than half the size of its US$5 billion domestic market. RanBaxy and Dr. Reddy's Labs, two of the largest pharmaceutical companies in India, export the generic versions of drugs that have gone off-patent to developed markets at a higher price. Both Dr. Reddy's Labs and RanBaxy rely heavily on the US and other developed markets to drive revenues. For these firms, it is important that they receive the approval from the US Food and Drug Administration (FDA) to produce and market these generic drugs. RanBaxy is seeking the green light to sell 28 drugs there while Dr Reddy's has 24 applications in the pipeline. Having a greater number of approvals indicate larger market share and better sales for these companies.

Currently, India's patent law allows companies to copy patented drugs, as long as the manufacturing process is different. This legal loophole enables contract manufacturers to produce cheaper versions of patented drugs (for example Viagra, Pfizer's drug treatment for impotence). This has discouraged some pharmaceutical giants from setting up production in India, and taking advantage of the country's low costs. They fear that some Indian companies may discover how to copy some of their blockbuster drugs (which are still under patent) and then flood the market with cheaper versions. The situation may improve in 2005 when India recognizes product patents rather than just process patents.

EARNINGS AND VALUATIONS

According to Bloomberg estimates (8th Oct 2003), the SENSEX is trading at a PE ratio of around 16 times and with an estimated PE ratio of 14 times for 2004. As the SENSEX has historically traded at a PE ratio of about 10 to 26 times earnings, this indicates that valuations for Indian equities ae still attractive. Going forward, we feel there's an upside potential of 40% to 60% in the next 3 to 5 years, for the Indian equity market.

Table 2: Forecast PE ratio and EPS for the India Market

INDIA FUND PERFORMANCE

The performance of the Indian funds has been relatively strong year-to-date. All three India funds have increased by more than 30% (as at end September 2003), outstripping the MSCI India Index, which rose 27% for the same period. The HSBC Indian Growth Fund was the best performing fund with a year-to-date return of 53.5%. The benchmark index for HSBC Indian Growth had been recently changed to S&P/IFC Investible India Index as at 31 July 2003.

Table 3: India Fund Offer to Bid Returns

The performances in Table 3 are calculated on an offer to bid basis with the inclusion of any income or capital gains dividends being 'reinvested' at the dividend date and annualised for periods longer than 1 year.

CONCLUSION

Going forward, we think that Information Technology and Pharmaceuticals will continue to be the driving factors behind India's economy. We believe that India's equity market is still attractively valued and has an upside potential of 40% to 60% in the next few years. However, single country funds are volatile and India funds are no exception. Also, a significant portion of the equity market is made up of cyclical technology stocks, further adding to volatility. For those investors who'd like exposure to Indian equities, we recommend they consider India funds as part of a supplementary portfolio.