In the exotic world of emerging markets, India is has the potential to be a diamond in the rough.

Unlike many emerging countries, which rely on exports or government-funded infrastructure projects to spur economic activity, India is a hive of domestic consumption. Although natural resources such as oil are scarce, rising urbanization and a massive population of 1.2 billion have created an economy that is almost 70% weighted to domestic consumption.

India also benefits from widespread knowledge of English, a history of democracy and a cultural appreciation for education and entrepreneurialism.

“Consumption is our biggest investment theme in India, including automobiles, clothing, food and tobacco,” says Christine Tan, chief investment officer with Excel Investment Counsel Inc. of Mississauga, Ont.

During the 12-month period ended March 31, India’s annual $2.2-trillion economy grew by 7.9% year-over-year, surpassing China’s growth rate of 6.7% for the same period and making India the fastest-growing major economy in the world.

The pro-business government of Prime Minister Narendra Modi, elected with a strong majority two years ago, is pushing ahead with financial forms including a more efficient tax regime. Rising demand for India’s goods and services and the energy of a young population — two-thirds of the population is under the age of 35 — are expected to be strong drivers of corporate profits and the creation of new investment opportunities.

Furthermore, after two years of dry weather, the forecast for above normal rainfall this monsoon season could be a major boost for the agricultural sector — a significant part of the country’s gross domestic product (GDP) and strong influence on overall growth as inflation moderates in food prices.

The biggest exposures in Excel India Fund, sponsored by Excel Funds Management Inc. of Mississauga and managed by Birla Sun Life Asset Management Co. Ltd. of Mumbai, are to financial, consumer cyclicals, technology, industrials and health-care stocks.

The fund uses top-down stock picking to identify businesses with sustainable competitive advantages, and a growth rate in excess of India’s GDP. Major holdings include banks that will benefit from domestic consumption, including Yes Bank Ltd. Excel also has a significant position in Maruti Suzuki India Ltd., the country’s largest car manufacturer.

A new national goods and services tax that was approved by the government in August and is to be fully implemented by 2019, is expected to stimulate India’s economy. The levy will be applied across India’s many states, resulting in more efficient tax collection, and will help move the country toward a single market. The expected higher government revenue should flow back into the economy via spending on infrastructure and social programs.

The new tax system will also allow companies to operate more efficiently across multiple jurisdictions. Specifically, companies will be able to centralize operations with key manufacturing plants supporting multiple distribution branches, rather than the current system of companies having many separate production facilities in every state in which their products are sold.

Ultimately, consumers are expected to pay fewer taxes under the new regime, leading to more money in the pockets of Indians to purchase goods and services and, ultimately, job creation.

The new tax regime is complementary to India’s “Make in India” program that encourages the patronage of local industries and will also be an incentive to foreign investors to ramp up operations in the country.

Infrastructure has been a major focus of the Modi regime. The government plans to spend US$30 billion this year on projects that include 10,000 new roads. Modi’s five-year plan projects US$1 trillion of infrastructure spending.

Unlike China, in which infrastructure spending has been delivered as part of a top-down centralized plan, India’s government spending will be driven more by bottom-up needs of corporations and individual states, which will need to make a case for investment, Tan says.

“The infrastructure in India is not up to [that in] China, and has been held back by the fact that different states have different tax regimes,” says Mark Mobius, executive chairman of Templeton Emerging Markets Group, a division of U.S.-based Franklin Templeton Investments, in Singapore. “One of the most important reforms has been the move to a single national sales tax — the question now is who gets the money collected.”

The concerns that fund portfolio managers have about India relate to the strength of stock prices, which have risen strongly in the wake of Modi’s election. India’s stock market trades at a premium to other emerging markets, says Tan, but there’s room for further appreciation due to superior earnings growth and continued expansion of price/earnings multiples.

Gerardo Zamorano, director of investments at San Diego-based Brandes Investment Partners LP, and portfolio manager of Brandes Emerging Markets Value Fund, says he has taken profits in India as prices have risen, moving from being overweight, relative to the MSCI emerging markets index, to being underweight. About 2% of the Brandes fund’s assets under management are in India vs 8% for the benchmark

“As value investors, we search for companies that are not currently prominent or popular,” he says. “We’re finding opportunities in some of the less glamorous areas in India, like infrastructure and utilities, and we have some exposure to the jewelry business. We’re also looking at undiscovered opportunities in small cap stocks.”

This is the second article in a three-part series on emerging markets.

Up next: The quiet potential of Latin America.