Fundamentals remain solid

We recommended the Morgan Stanley India Investment Fund (IIF) and The India Fund (IFN) in the last few months and both have performed strongly with the rise of the Indian stock market. However, significant regulation changes have recently fuelled major market volatility.

"This moderation of speculative offshore capital inflows may create more short term volatility but in the longer term but we believe a more stable Indian stock market will benefit investors."

We address this issue in the report as well as reiterate our investment rationale for the Indian funds.

On 17 October, the Indian stock market regulator, the Securities and Exchange board of India (SEBI) proposed restrictions on unregistered foreign investors. This was aimed at curbing the rush of speculative foreign cash into Indian equities in the preceding months. The proposals have subsequently been approved.

The restrictions involve a clamp down in Participatory Notes (PNs), which are essentially equity derivatives sold by approved institutions to offshore investors. These allow buyers to gain exposure to the Indian stock market without them acquiring the actual securities and without having to register with SEBI. Foreign investors were drawn to this route due to its relative low cost and anonymity compared with owning the underlying securities.

The proposals sparked a violent reaction in the benchmark Sensex Index following the announcement. This is hardly surprising seeing that offshore investors had pumped a massive $18 billion into Indian equities year to date, half of which have been in the form of PNs.

Shortly after, SEBI provided more clarity and outlined its reasons for the proposals, which helped stabilize the market.

A week later, and after consultation with business groups, SEBI adopted new rules to grant offshore investors easier registration in order to buy Indian stocks. This includes permanent institutional registration instead of regular three year renewals. The regulatory body is also opening the doors to all pension funds and also plans to make registration easier for high net worth individuals.

These subsequent proposals mean that as foreign capital inflows in the form of PNs are gated, higher institutional registrations will pick up the slack. Offshore cash looking for Indian stocks will still be invested, and the flows will become more transparent.

The moderation of speculative offshore capital inflows as a result of the abolishment of PNs may create more short term volatility but in the longer term, we believe a more stable Indian stock market will emerge and this will benefit investors. Our view of the Indian stock market remains bullish.

Looking at the charts, the Sensex has gained 47.8 percent in the last 12 months and recently reached an all time high of 19199 in October. However, a pause in the upward trend during the past two weeks saw the index dip to the 17170 region, before rebounding back towards the highs.

In the near term, we anticipate further consolidation within this range, but as prices remain above 17170, the dominant feature remains the longer-term upward trend. Given the resilience of this trend over the past 5 years, we believe there remains considerable upside potential in the months ahead.

Notwithstanding the recent volatility, investment rationale for the funds is based on solid economic fundamentals and these have not changed. Indian GDP is still expected to grow over 8 percent this fiscal year ending March 2008 and inflation is well within central bank targets.

In addition to this, corporate earnings are forecast to grow by a robust 22 percent this year and we believe there is potential for years of above average growth to come.

There are three factors that we believe help drive this further growth. The first is the booming service industry, particularly the burgeoning business process outsourcing sector. The massive surge in IT and IT related exports is a good example of this.

We also believe that the government's investment in public and private infrastructure will be a key focus in years to come. India's underinvestment in this area has created the potential for spending to increase dramatically as the nation builds the platform to support its burgeoning growth. This should benefit both infrastructure and infrastructure related sectors.

And finally, there is the emerging might of the Indian consumer. India's young demographic mix (compared with China) and an increasingly wealthy middle class are likely to drive spending which sets the scene for a more robust consumer sector in the next few decades.

Looking now at each fund in turn, we see as evident on the daily chart the Morgan Stanley India Fund (last reviewed in FAT84) rallying strongly in recent months. In October, prices reached a 17-month high of $57.36, coming within reach of the all time high of May 2006 at $58.10.

Although the notable increase in volatility over the past two weeks signals that a period of consolidation is possible, we believe that downside risks are limited with substantially higher levels achievable in time given the strength of the broader upward trend

The Morgan Stanley India Investment Fund trades at an 11 percent discount to Net Asset Value

Turning to The India Fund (last reviewed in FAT72) and we see from a charting perspective that it has continued to trend higher since our last review in July. Earlier this month, the fund achieved a 17-month high of $59.60. As evident on the daily chart, this represents a gain of more than 65 percent since the beginning of the year.

Despite the increase in volatility over the past week, underlying upward momentum remains strong and while we cannot rule out a temporary pause for consolidation in the near term, we believe downside risks are limited with a retest of the all time high of May 2006 at $65.25 achievable in the months ahead.

The India Fund trades at a 13 percent discount to Net Asset Value.

We believe the regulation changes imposed by SEBI do not affect the solid fundamental outlook of the Indian stock market. As such, we retain an optimistic outlook for the performance of our Indian funds. Accordingly, The Morgan Stanley India Investment Fund and The India Fund Inc will remain firmly held in the Fat Prophets Portfolio.