Indian equities have been a rollercoaster for investors over the last two years but now could be the time to buy back in (or get in if you thought you’d missed it), according to Ocean Dial Asset Management’s David Cornell.
The manager of the five FE Crown-rated India Capital Growth investment trust believes that the market was overbought last year but could be nearing attractive levels again.
India has been a popular choice for investors and emerging market managers as the country has been through a number of reforms from prime minister Narendra Modi.
In particular, demonetisation has meant that investors are no longer able to hide non-taxed capital in cash or in assets such as gold or real estate.
“Because real interest rates are positive and because it is now hard to hide cash on which tax has not been paid and because bond yields are down there is a bucket load of money pouring into the equity market and that was what really drove the market last year,” Cornell said.
Indeed, as the below chart shows, the MSCI India index returned 25.66 per cent in sterling terms last year.
Performance of index since start 2016
Source: FE Analytics
But earnings, as measured by the price-to-earnings (PE) multiples, have failed to catch up as other reforms such as the goods and services tax among others impacted the profitability of companies.
“Earnings did not catch up, so we had a big multiple expansion. The PE went through the roof but the E did not. So the PE multiples expanded without any earnings growth to support the rise in the market,” he said.
“India got very expensive last year – that is the bottom line – and it was driven by non-fundamental factors i.e. fund flow.
“This is because all of the structural changes that Modi has put in place over the last three years, whether that is demonetisation, the goods and services tax, real estate regulation act, insolvency and banking act – all these big structural changes have had a negative impact on corporate profitability.”
This year has been a different story, however, with the market falling 3.15 per cent on the year and 7.64 per cent off its mid-January highs.
There are three factors that have gone into this pull-back, with the lack of earnings mentioned above the first, Cornell said.
“That is why India is correcting and that is a good thing. We need that correction and the market to either stand still at best or come back a little bit to get foreign interest back into the market,” he noted.
Second is the oil price, which has recovered in recent years from its lows in January 2016, rising 145.72 per cent since then and hovering around $80 per barrel at time of writing.
Performance of oil price over 5yrs
Source: FE Analytics
“India is a big importer of oil so its bill tends to go up dramatically as oil goes up and that imports inflation because the current account weakens and the currency weakens as a consequence of that,” Cornell said.
“The market is worrying about interest rates in India having to go up to protect the currency and to keep inflation under control. Economically it is negative for the country if interest rates begin to go up.”
This will have a knock-on effect on bond yields, which having come down all of last year because of the excess cash in the system, look this year as though they could rise again.
Additionally, there is a general election coming up about this time next year, meaning India is 12 months away from Modi seeking an updated mandate for another five years, Cornell added.
“We are getting into a period now where politics is going to trump policy – it is all about winning the election now rather than putting in good policy,” he said.
“Investors are generally (and not surprisingly) nervous about making a commitment to the market ahead of political uncertainty.
“But I think if Modi gets re-elected, which is quite likely, then that renewed optimism will come back because they will see another five years of strong mandates where he can continue this momentum on the reform agenda.”
Investors should not wait for the outcome however, he warned, as there are positive drivers that could make stocks quite attractive before the election.
First is that the aforementioned lack of earnings growth in previous years seems to be reversing.
Indeed, while India’s aggregate earnings has been compounding at 6-7 per cent for the last four or five years, which the manager described as “pathetic really”, there are signs that earnings growth is coming through more strongly now.
The manager said that he expects earnings growth of between 15 and 18 per cent this year with the potential to reach 20 per cent next year.
“The reason it is recovering is because earnings have been poor meaning we are coming off quite a low base. You are getting some optically attractive earnings numbers but if you annualise them over a couple of years it would probably be more like 11 per cent per year,” he said.
“But on top of that we are also starting to see some signs of the economic recovery as well after the last three years have all been about reform which has had a dampening impact on economic growth and corporate profitability.”
Overall Cornell said this combination of a falling market with increasing earnings should create a number of valuation opportunities within the market.
“I think it is quite healthy in a way and I hope there will be a buying opportunity,” he said.
“You have got to buy India when it is on its knees and now is a good time to be looking at it on a three to five-year view
“Don’t wait for Modi to be re-elected to be confident that the story is going in the right direction, you have got to buy it at a time when it is under a bit of pressure because that is when you get the value.”
Cornell overseas the £107m India Capital Growth trust, which last year moved from the Alternative Investment Market (AIM) to the main market.
The investment company has a focus on mid- (25.8 per cent) and small-cap (57.7 per cent) stocks, with just 12.8 per cent in larger firms.
Performance of fund vs sector and benchmark since start 2017
Source: FE Analytics
Since the start of 2017, the portfolio is up 30.41 per cent although it strongly outperformed in 2017 before falling further than the wider market this year.
The investment trust’s shares are on a 16 per cent discount to its net asset value according to data from the Association of Investment Companies (AIC). It is not geared and has ongoing charges of 2.21 per cent.