India, like China, has a massive state sector that it is doing its best to reform. In the run-up to the May results of the general election, Indian state-owned enterprises saw their share prices surge.
The business-friendly incumbent Prime Minister Narendra Modi won a handy majority at the polls. But "Modi 2.0" has disappointed so far in terms of reform for the state sector. The new finance minister's first budget delivered on July 5 contained no details on how India will proceed with divestment.
Investors should therefore avoid the SOE sector, for now. The share surge has ended, and a period of tough corporate performance beckons for state-run companies. There are smarter ways to play Indian equities, as I'll explain.
State-owned enterprises make up 10% of the Indian equity market. They're known as Central Public Sector Enterprises, or CPSEs, in India. Of the 339 CPSEs, 63 are listed on the stock market -- and they're often massive.
State-owned companies saw their stocks rally leading up to India's most-recent budget. The CPSE exchange-traded fund (the Reliance MF CPSE ETF) listed on the National Stock Exchange as CPSEETF, hit an all-time high in January 2018, as Modi moved to reform the sector. Then in the runup to the May elections, the ETF climbed 28.6% between mid-February and early June.
But the budget ended up disappointing, providing no specifics or clear roadmap about how state-owned enterprises are going to be sold off by the state. The CPSE ETF dropped an immediate 8.2% in response, and continues to trade in a range reflecting that loss.
"We are not enthusiastic about the index, despite low valuations, which reflect low growth expectations, in our view," the Asia equity strategy team at Société Générale wrote in a report on the topic, "Takeaway from India Budget: Avoid SOEs."
There's likely to be significant issuance of new "paper" as the government hustles to meet a newly set requirement that a quarter of state-owned enterprises be owned by the public. This is a key "overhang," SocGen believes.
State-owned enterprises look tempting as low-hanging fruit. The CPSE ETF produces a 4.5% dividend yield. It also trades at a discount of more than 65% when compared with the Nifty 50.
But those hefty dividends are under threat. Many of the SOEs have declining levels of cash on the balance sheet, which would make it hard to sustain the same level of payments to shareholders.
Earnings growth also looks lower for SOEs than for the Nifty 50 universe. The operational efficiency of state-run companies is another aspect of their management that the government would like to see improve.
Energy companies are at the epicenter of the SOE sector. The electricity producer NTPC, listed with an American depositary receipt as (NTPZY) , is the largest, while Coal India (CLNDY) , Oil & Natural Gas (OLNTY) and Indian Oil (INOIY) all make up 17% or more of the CPSE ETF, thanks to market caps of US$20 billion or more.
The Modi administration has set an ambitious target of divesting about $15.3 billion worth of SOE stock. That's a sizeable increase of 16.8% vs. the approximately $13.1 billion target set in February. The push is part of a general effort by the government to reduce India's fiscal deficit.
It did not outline any plans for the divestment of sizable portions of any of the SOEs. Instead, it seems likely that the Indian government will gradually lower its stakes in the companies by selling portions into exchange-traded funds, instead of by selling blocks of stock in specific companies.
The CPSE ETF is the main tool to do that so far. The government has raised about $5.5 billion in five tranches of share sales. That product is only available for investors with direct access to Indian equity markets.
The iShares India 50 ETF (INDY) is the product for U.S. investors to use to track the Nifty 50. It's up 8.5% year-to-date, performance outdone only by the derivative-enhanced Direxion Daily India Bull 3x Shares ETF (INDL) , a leveraged exchange-traded fund that would magnify losses as well as gains and is best used only for very short-term, day-long trades.
But given the issues with state-owned enterprises in India, investors should also look at the WisdomTree India ex-State-Owned Enterprises Fund (IXSE) .
The fund was only launched in April, so it has a miniscule amount of money under management, $2.5 million in assets. But like most WisdomTree products, it comes at the exchange-traded fund universe in India in an imaginative way.
The underlying WisdomTree India ex-State-Owned Enterprises Index excludes any companies with more than 20% ownership by the government. The resulting breakdown highlights "new economy" stocks -- particularly information technology, consumer discretionary, consumer staples and health care -- to the tune of 63.7% of index over "old economy" stocks from the energy, financial and materials sectors, which make up 36.3% of the index.
The balance is closer to 50%-50% for a traditional India index. So for investors who want to avoid the legacy issues with state-owned companies, IXSE is the way to go.