Market Economics | Smart money in India rides on small firms

Market Economics | Smart money in India rides on small firms

Predicting the Sensex, India’s key equity index, is an activity best left to day traders, chartists and talking heads on 24-hour news channels. For those who want to benefit from a decade or two of India’s economic transformation, it might be far more rewarding to invest in 10 unknown companies and see one of them make it to the benchmark in 10 years.

Why should smart money bother with the 30 mature companies represented in the Sensex when there are cheaper options to take bets on everything from the shortage of teachers and power to the country’s newly acquired taste for wine?

This isn’t to say that the large companies in India are a write-off. They are all growing fast in the home market and many—if not most—have managements capable of executing ambitious cross-border takeovers, though to what extent those acquisitions will enrich investors is a different matter.

As for unlocking of shareholder value through restructuring, the billions of dollars of wealth created by the 2006 division of Dhirubhai Ambani’s empire between sons Mukesh and Anil will remain the touchstone for a long time to come.

Meanwhile, the Sensex, which rose to a record 18,658 on Wednesday, is now quoting at a 19% premium to its 18-year average price-to-earnings multiple.

It may be time for investors in India to discover the next set of winners. And that means combing the universe of 22,000 for-profit organizations—companies, partnerships and family-owned businesses—out of which at least 5,500 are “diamonds in the rough", says Alok Aggarwal, chairman of Evalueserve, a business-research company that has analysts in India, China and Chile.

In the ’90s, software was such a rough diamond. Arisaig Partners, which buys chunks of small companies in Asian emerging markets, was an early investor in Bangalore-based Infosys Technologies Ltd in 1993, when it had a market value of $5 million (Rs19.6 crore). Today, the company’s shares are worth $31 billion.

Arisaig’s current picks include Educomp Solutions Ltd, which is creating digital lessons for India’s understaffed state-funded schools. The money manager also owns a stake in Champagne Indage Ltd, which controls 70% of India’s growing wine market. “One of the most exciting aspects of the Indian stock market is the way in which new businesses appear from nowhere and in a flicker become multibillion dollar activities," Arisaig, which has $2 billion in Asian assets, said in a June 2007 note to investors.

Of course, discovering these gems, and polishing them is not for everyone. Most of these aren’t publicly traded. Research costs could be high at as much as $50,000 a company, justifiable only if one has at least $10 million to invest. In most cases, that means assembling a buyout fund, with rich individuals and institutional investors as limited partners.

The private equity format is already a hit in India. According to Evalueserve’s research, India received $7.5 billion last year from more than 300 such funds that have been put together by venture capitalists and buyout specialists.

An additional 69 funds have either already raised or are currently raising money to invest in India. Citigroup Inc. is joining Blackstone Group Lp. and Infrastructure Development Finance Co. (IDFC) in a $5 billion fund to invest in India’s roads, ports and power utilities. ICICI Bank Ltd is seeking $2 billion for a similar fund. Jon Moulton, managing partner of London-based Alchemy Partners Llp., is raising $100 million for investing in India.

Buyout deals this year, may add up to $13.5 billion, surpassing the 2006 total in China, an economy two-and-a-half times India’s size, Evalueserve says. The researcher estimates annual private equity investment in India to reach $20 billion by 2010, a 1,000-fold jump over the 1996 level. The current buyout frenzy in India stems, partly, from some notable successes in the past few years.

New York-based Warburg Pincus Llc. took home $1.6 billion on its $290 million investment in a start-up mobile phone network from 1999 to 2001. Bharti Airtel Ltd is now valued at more than $50 billion.

Another 1999 deal that struck gold was the $1 million investment by ICICI Venture, a unit of India’s second biggest commercial lender, in Pantaloon Retail India Ltd, a Mumbai- based company that ran five clothing stores.

ICICI Venture sold its stake in 2003, recouping five times its investment. Today, Pantaloon is India’s biggest publicly traded retailer, valued at more than $2 billion.

The probability of discovering the next Bharti or Pantaloon is much smaller for any investor than the odds of guessing the movement—up or down—of any one of the 30 Sensex stocks in the next week and getting it right. Yet, spotting a dark horse and seeing it win the Derby has a thrill to it. And it’s that lure of a large payoff that makes private equity such an exciting game in India right now. BLOOMBERG

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