Description

Anyone who has had the pleasure (or misfortune) of being driven through the streets of Mumbai in recent years will not question India’s economic boom, particularly when compared with the moribund economy of fifteen years ago.  Signs are visible everywhere – from the ubiquitous cellphones (every chauffeur seems to own one), to new residential construction, gleaming new retail malls in former textile mills, to almost daily headlines in the business media about U.S. and European companies planning to enter India.  (WalMart and Starbucks have both recently announced plans for India.)  Meanwhile, Lou Dobbs notwithstanding, Western companies continue to offshore IT, call center, and other service jobs to India to benefit from the abundant, educated, talented, and lower-cost English-speaking workforce, and this trend should continue for at least another decade or two.

From a macroeconomic perspective, India appears to be an attractive investment destination today.  Indian companies reportedly earn an average ROE of 19%, versus mid-single digits for their Chinese counterparts.  The government has built up foreign currency reserves of US$170 billion today compared with virtually zero in 1991.  Interest rates have declined in recent years, and inflation is now running at about 4%.  The rupee has appreciated modestly against the dollar in the last few years, after decades of steady decline.  GDP growth is likely to approach 10% annually for the next few years.

Unfortunately, but not surprisingly, I am not the first person to realize the potential for investing in India.  The stock market has risen significantly in recent years, following the dot-com crash of the early 2000s.  So what’s a thoughtful investor looking for exposure to India to do?  My answer follows:

Morgan Stanley Growth Fund (MSGF) is perhaps the most intelligent way to invest in the Indian stock market today.  MSGF, a closed-end fund which trades on the Bombay Stock Exchange (BSE), trades at a 13.6% discount to NAV, with a catalyst for this discount to be fully eliminated in two years.  Additionally the fund has a very strong long-term performance record relative to the Indian market, so that one can reasonably expect its NAV performance to at least match market returns.

Later in the report I also propose an alternative hedged approach to benefiting from this discount.

(All prices and NAV amounts in this report are in Indian Rupees (INR), unless stated otherwise.  The exchange rate today is US$1 = INR 44.11.  The exchange rate when the fund was created was approximately US$1 = INR 30.00.)

History

MSGF was created by Morgan Stanley in early 1994 as a vehicle for Indian investors to invest in the local stock market, with a goal of long-term capital appreciation.  The fund got off to a rocky start with investors.  The prospectus stated that the target was to raise INR 3 billion (US$100 million at then exchange rates), but reserved the right to accept more than this target.  Investors misperceived the vehicle as an opportunity to invest in a “multinational company IPO”, so that the stock initially traded at a 60% premium to its offering price, in the gray market.  Morgan Stanley received applications for INR 9.5 billion, and (unsurprisingly) chose to keep all of the money.  The premium to the offering price rapidly collapsed, until the stock was trading at a discount to its NAV.  This discount has persisted continually since then, which is of course not unusual for a closed-end fund.  But the experience soured many investors to Morgan Stanley, and many remain bitter about the experience today.

What makes this security interesting is that the fund has a finite life of fifteen years from the date of allotment of shares.  The fifteen years end in February 2009, or just over two years from now.  At that time investors will be able to redeem their shares at NAV.  The current price is INR 43.03, and the NAV is 49.82, giving us a discount of 13.6%.  Viewed the other way, the NAV is 15.8% higher than the market price.  There are 600 million shares outstanding today.

In annualized terms, assuming that we get redeemed at NAV in 2 years and 2 months, we will get a return of 7.0% per year from the closing of the discount, ceteris paribus (assuming no change in the NAV or exchange rates).

So if one is interested in investing in India, this vehicle has the potential to turbocharge your return, by giving you this 7% per year head-start.  My guess is that the discount will gradually narrow in a fairly linear fashion over the period.  The discount was 21%-22% one year ago, and has narrowed to less than 14% now.

What kind of overall return can one expect from this investment?  My best guess would be an annualized rate of return of 18% - 19%, broken down as follows:

10%          Annual NAV appreciation

1% - 2%   Annual currency appreciation

7%            Annualized gain from closing of NAV discount

18%-19%  Total annual return

Indian market valuation and prospects

The Indian market has had a strong run following the dot-com bust, and looks fairly priced today, but perhaps not overvalued given the strength and prospects of the economy and businesses.  The benchmark BSE Sensex index is at 13,787 today, or just under 20x expected earnings of INR 695-705 for the current fiscal year (which ends 3/07).  Earnings growth of 15-16% is expected for the fiscal year ending 3/08, implying a forward multiple of about 17x.

My best guess is that the Indian market will provide a total return of 10% annually over the next two years, including dividends, i.e. price appreciation of 8% annually (which excludes the dividends) will average about half of the expected earnings growth rate.  This will result in a modestly lower market multiple.  Please don’t ask me to defend this in any detail; it is just a best guess expectation.  Persuasive arguments can be made that the total expected return should be higher, or alternatively that the market should retreat after a strong run.  However, I can guarantee that the market will be volatile.

Historical performance of MSGF

The NAV of MSGF grew at a CAGR of 15.23% from inception through 9/30/06, compared with 10.09% for the benchmark BSE Sensex index.  Some of the outperformance is the result of the fund buying back stock at a discount to NAV in the open market, but most of it is apparently from good stock picking.  My assumption going forward is that the NAV growth matches the total market return, i.e. the fund will neither outperform nor underperform the market over the next two years.

The fund’s website is www.msgfindia.com; much information is available there, including reports to shareholders and the composition of the portfolio.

Regarding the exchange rate: The rupee depreciated for decades against the dollar and other currencies, with the trend only reversing since 2002.  From US$1 = INR 30 in 1994 (when the fund was created), the rupee steadily lost value, bottoming at INR 49 to the dollar in 2002.  The exchange rate today is US$1 = INR 44.11, or appreciation of about 10% over the last five years.  With inflation under control, and strong capital inflows, my guess is that the rupee will continue to gain modestly going forward.  The Indian government faces pressure from exporters to not let the currency get too strong.  I assume that the rupee will gain 1% to 2% annually against the dollar.

Although the Indian government has restrictions on investments by foreigners, non-Indian investors can buy this stock through brokers such as Merrill Lynch who have a presence in India.  These brokers use “promissory notes” to make the investment.  They buy the stock for their account, and then sell you these promissory notes, effectively transferring the economic interest in the stock to you.

One alternative way to play this security

(1)   The basic way to exploit this opportunity is to just buy MSGF.  If my expectations about the Indian market and currency are accurate, you make an annualized return of 18% to 19% over the next two years.

(2)   There is an intriguing alternative way to play it.  Morgan Stanley manages a closed-end India fund which trades on the NYSE, Morgan Stanley India Investment Fund (IIF).  Not surprisingly, IIF’s portfolio is virtually identical to that of MSGF.  What’s fascinating is that IIF today trades at a premium of 9.8% to NAV.  IIF was formed at almost exactly the same time as MSGF, and for most of its history it has traded at a discount to NAV.  During the last two years, this has reversed, so that it has traded at a premium much of the time in this period.  This is likely because of the increased interest in India.  So one can buy MSGF and short IIF, with the goal of earning both MSGF’s discount and IIF’s premium over time, without taking the risk of the Indian market or currency.  An increasing number of vehicles are available with new ones cropping up steadily for investing in India, including open-end funds, and at least one recently introduced ETF.  So the increased supply of product should serve to eliminate IIF’s premium over time.  A hiccup in the market there is also likely to accomplish the same thing.  The risk here is that the premium widens instead: irrational, but certainly possible.

Catalyst