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India – and the choice between valuations and long-term growth

14 June 2022

If you were to do a pros and cons for investing in the region it would be heavily lopsided in favour of the former.

By Darius McDermott,

Chelsea Financial Services

How do you decide on the big decisions in life? I always have a distinct memory of my teacher at school telling me to write down the pros and cons of each option on a piece of paper to help me make an informed, rather than emotional, choice.

It’s a notion that can easily be applied to finance, where emotion can often be an investors’ downfall. Take India, for example. The truth is that if you were to do a pros and cons for investing in that region it would be heavily lopsided in favour of the former.

Strong demographics, growth, few geopolitical concerns, strong corporate governance, and the growing online economy all come to mind.

The trouble is, the investment world has spotted the trend, which brings us to the one negative – valuations.

Indian equity valuations have always been expensive relative to other emerging markets because of the positive characteristics mentioned, but at present they look particularly stretched versus other emerging markets and their own history.

They historically trade at a 40% premium to other emerging markets but by the end of April 2022 it was closer to 70%.


Short term pain or long-term gain?

The India versus China debate is a big part of the decision-making process on our fund-of-funds range. Last year, there was only one winner, with the S&P BSE 500 Index, which represents the major industry groups of the Indian economy, climbing 31% and trading at around 27x earnings. Contrast that with the challenges facing the Chinese economy in 2021.

But is India still attractive given those lofty valuations? To me, you have to strike a balance between short and long-term returns. The long-term tells you that you turn your back on Indian equities at your peril.

It’s a bit like buying a home in the UK – anyone who purchased one a decade ago probably paid a premium, but they are laughing now as house prices have risen more than £100,000 on average since.

As Alquity Indian Subcontinent fund manager Mike Sell points out – the growth has been justified given the likes of urbanisation, attractive demographics, and the rise of digitalisation.

He also points to the rapid reform under Prime Minister Nahindra Modi – with India gradually becoming a mainstream emerging market in the past five years.

Importantly, the likes of China and Korea do face demographic and corporate governance challenges.

FSSA Global Emerging Markets Focus co-manager Naren Gorthy says there are a few “pockets of froth” within Indian markets which account for the extended valuations.

One of those has been the explosion in the IPO market – with 600 or so in the past five years, many of which he says have had substantially high valuations. He says while many have corrected, there is scope for this to continue.

He also cites the rise of many consumer staples companies in India, which have been major beneficiaries of the re-rating process and now have incredibly high valuations.

By contrast, there are also opportunities in certain parts of the market, particularly among financials and general insurance firms.

Sell points to HDFC, a bank which is trading at a 30% discount to its 40-year valuation – adding the current price does not reflect the improvements in the business model or the strong growth outlook from rising interest rates.

Gorthy highlights ICICI Bank – citing that it is on 18x earnings and 2.5x book for a business growing at 15-20% a year and producing returns of 16-18% on equity.


How is India handling the challenging economic environment?

Clearly inflation is a challenge which has started to increase cost on the consumption side, resulting in some rating agencies downgrading their forecasts for GDP growth.

But there are positives, not least that India is expecting a good harvest this year so it can feed itself, removing some of the pressures you’ll see elsewhere.

Perhaps the bigger worry is the oil price. India is a major oil importer so should the price of a barrel go to $150-175 it would pose challenges. However, the central bank is now sitting on close to $600bn of cash reserves, which helps to mitigate the threat to a certain degree.

Gorthy says every time the oil price has been above $150 we’ve seen a massive correction, both in terms of a market sell-off and the foreign exchange rate. Although not at $150 yet, there have been no signs any correction would happen – mainly because there is a significant amount of domestic money coming into the market.

He says a huge amount of money is parked in fixed deposits in India – much larger than the equity market. He says that as rates correct, the marginal investor is thinking ‘I’m getting 4.5 to 5% after tax in a fixed deposit, let me just move some of that into equity markets’.

“As a result, we’ve seen around a 10% allocation away from fixed markets to equity markets – which is a massive inflow and has soaked the $25bn taken out by foreign investors.”

When people think about emerging markets, they often view it as a beta trade on global growth. But that is no longer the case, especially in India because of the strong domestic structural growth. Forget the developed world, India will go on its own path driven by urbanisation and population.

Although valuations looked stretched in the short term, you are paying a premium for the security India offers compared to its emerging market peers.

In summary, I’d say the only real fear is the oil price but, even if that did hit $150 a barrel, it could well offer investors an attractive entry point in the not-too-distant future.

In addition to the Alquity Indian Subcontinent fund, investors may also want to consider the Goldman Sachs India Equity Portfolio, managed by Hiren Dasani. While those looking for an emerging markets/Asia portfolio with exposure to India might consider the FSSA Global Emerging Markets Focus or the Schroder Asian Alpha Plus fund.

Darius McDermott is managing director of Chelsea Financial Services and FundCalibre. The views expressed above should not be taken as investment advice.

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