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Portfolio managers see opportunities in financial stocks in India. Private-sector banks such as ICICI Bank Ltd., Axis Bank Ltd. and HDFC Bank Ltd., picture above, are among the favourites.VasukiRao/istock

India is back in the spotlight as an attractive, longer-term emerging-markets play now that Prime Minister Narendra Modi has won re-election with a landslide victory in late May.

Both the S&P BSE Sensex index and National Stock Exchange Ltd.’s Nifty 50 index rose to record highs in early June shortly after Mr. Modi’s Bharatiya Janata Party regained power for a second five-year term. Although stock markets have since pulled back on profit-taking, they’re still up by about 7 per cent year to date.

“It’s important to have stability on the political front and continuity of reforms [in India],” says Atul Penkar, portfolio manager at Mumbai-based Aditya Birla Sun Life Asset Management Co. Ltd.

Even though political uncertainty is gone, stock markets still face headwinds. Trade tensions between the United States and China could weigh on investor sentiment and there also are concerns about India’s “twin” fiscal and current account deficits, high unemployment and a cash crunch among non-bank lenders.

All eyes now are on whether Mr. Modi’s policies can spur economic growth, which shrank to 5.8 per cent in the fourth quarter of fiscal 2019, ended March 31, from 6.6 per cent in the previous three months.

India’s main indexes, which rose by about 28 per cent in 2017, also lost momentum last year. Still, their mid-single-digit returns outpaced the losses in North America’s stock markets.

Key reforms such as the drive to demonetize high-currency notes in an effort to curb “black money” and the implementation of a goods and services tax (GST) to replace state and federal levies have been disruptive to the economy, says Mr. Penkar, portfolio manager of Sun Life Excel India Fund and Sun Life Excel New India Leaders Fund.

But these measures are all short-term pain for long-term gain, he stresses. “They will definitely have a very positive impact on business and the economy from a medium- to long-term perspective.”

In addition, Mr. Modi’s budget, delivered last week, sets a target of turning India into a US$5-trillion economy over the next five years from US$2.7-trillion today. Financial services-sector reforms including a capital infusion into public-sector banks, increased infrastructure spending and measures to boost foreign investment were among the budget’s highlights. The government initiatives will likely take six to 12 months to reflect in growth, Mr. Penkar says.

The Reserve Bank of India’s third interest rate cut this year to 5.75 per cent, the lowest level in nine years, will also help stimulate growth; another 25-basis-point drop is possible in 2019, he adds.

In the near term, a normal or bountiful rainfall during this summer’s monsoon season is critical to boosting agricultural production and reviving rural consumption, Mr. Penkar says, referring to the fact that half of India’s farms are rain-fed.

India’s stock markets are expected to move sideways until year-end, but climb higher with a recovery in economic and, thereby, corporate profit growth, Mr. Penkar says. He expects earnings growth to increase by about 14 per cent to 15 per cent annually over the next two years, up from 9 per cent for the fiscal year ended March 31.

But India is not immune to global growth concerns fuelled by the U.S.-China trade dispute – and that could dampen sentiment among foreign institutional investors, who are key drivers of the market, he says.

India’s long-term prospects are compelling because half of the 1.3 billion population is under the age of 25, which will drive consumer spending, Mr. Penkar says. “Growth [in the economy] is expected to return to between 7 and 8 per cent over the medium to long term.”

He sees opportunities particularly in financials because there is underpenetration of banking services. Private-sector banks such as ICICI Bank Ltd., Axis Bank Ltd. and HDFC Bank Ltd. are among the top 10 holdings in Sun Life Excel India Fund. Among non-bank lenders, he likes Bajaj Finance Ltd., which focuses on consumer financing and has been unscathed by the liquidity crunch affecting peers.

Mr. Penkar is not fussed that India’s major indexes have recently traded at around 18 to 19 times forward earnings compared with a long-term average of 14.5 times forward earnings. Valuations will decline with an acceleration in earnings growth; meanwhile, there are attractive companies outside the major indexes that have faster growth and trade more reasonably, he says.

Ingrid Baker, senior portfolio manager at Atlanta-based Invesco Advisers Inc. and co-manager of Invesco Emerging Markets Class fund, also sees Mr. Modi’s victory as a positive for the longer term.

As high stock valuations are a concern, the Invesco mutual fund only holds one Indian stock: HDFC Bank, which is India’s largest private bank.

“There are great businesses in India, particularly in consumer staples and private banks, but right now they are just overpriced in terms of how we value companies,” Ms. Baker says.

She praised some of the government’s past policies, such as GST reform, which removed bottlenecks on businesses; infrastructure spending, which is supporting growth; and a recapitalization program, which helps state-owned banks struggling with bad loans.

Still, the government faces challenges from pressures on its fiscal and current account deficits, the latter of which is affected by oil prices; however, “it is important to note that both deficits have shrunk,” she adds.

David Kletz, vice-president and portfolio manager at Toronto-based Forstrong Global Asset Management Inc., also has a bullish longer-term outlook on India, but is bearish in the shorter term.

Mr. Modi’s strong win is encouraging because he’s a “business-friendly leader who has the popularity, influence and political savvy … required to push through tough structural reform,” Mr. Kletz says.

He agrees with Mr. Penkar that the investment case for India also is bolstered by the country’s massive, working-age population, which can boost productivity and economic growth. The problem, though, is that there are not enough jobs.

“The unemployment rate has been rising pretty drastically” and appears to be at a 45-year high, he says. India’s jobless rate was 6.1 per cent in 2017-18, according to a survey the government released recently.

For the shorter term, Mr. Kletz also is concerned about woes among India’s non-bank lenders after Mumbai-based Infrastructure Leasing & Financial Services Ltd. defaulted on its payment obligations last year.

“If one [larger] institution goes down, it’s not going to be generally an isolated incident,” he says. “It squeezes capital” – and that’s in addition to state-owned banks being undercapitalized.

Although valuation for India’s main indexes is a concern, smaller companies remain attractive because they’ve been beaten up amid worries about getting financing, as they tend to deal more with non-bank finance companies, he says.

That’s why Forstrong, which manages portfolios of exchanged-traded funds, only has a direct investment in India through VanEck Vectors India Small-Cap Index ETF (SCIF-A). However, Forstrong has exposure to larger-cap names in India through Vanguard FTSE Emerging Markets ETF (VWO-A) and SPDR S&P Emerging Asia Pacific ETF (GMF-A).

However, Mr. Kletz says that large-cap Indian stocks are certainly expensive these days. “The big reason that they have traded at a premium is that [India] has had such a compelling long-term story … and now we have a leader in power who is really trying to unlock that potential.”

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