Still time to buy, or too late to profit from the best market since Covid?

The attractions of India are well known. It is fundamentally a growth story, forecast to power ahead by 6.3% this year, blessed with favourable demographics and a government committed to pro-business policies.

Moreover, it now has a larger population than China, and a much better ratio of youths per 100 working-age adults at 39, compared with China’s 26. The under-penetration of goods and services in such a large population, coupled with shifting supply chains, should drive performance, particularly as India’s GDP is around 60% domestic consumption, unlike most large emerging economies, which are predominately export-led.

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Critically, too, India’s economy is still just one fifth the size of China’s and expected to expand just as the Chinese economy slows.

Its stock market has also been in fine form. The S&P BSE 100 Index has been the best-performing market since Covid, up 149% from 3 April 2020 to 27 November 2023. In second place is the Nasdaq 100 Index, which has gained 112%.

Are investors paying too high a price?

Funds have poured into Indian equities and bonds at a very rapid rate this year, often at the expense of China. Customers of interactive investor have been taking note, with India Capital Growth (LSE:IGC) and Jupiter India entering the lists of the top 10 most-bought investment trusts and funds in September.

However, stock valuations are rich, begging the question of whether investors have already missed the boat. India now trades on a forward price/earnings (p/e) ratio of 22x, compared with 9x in China. Historically, when it has touched these valuation levels – which has occurred four times in the past 30 years – a period of disappointment has followed.

Will Scholes, fund manager of Premier Miton Emerging Markets Sustainable fund points out that investing in India is, in some senses, the opposite of investing in China. He says: “In China, there are huge question marks around growth but few around valuations, while India offers a seemingly predictable growth story, priced at levels that can leave you scratching your head.”

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One way to look at India’s high valuations is to examine the price investors are paying for potential equity returns compared with alternative investments, such as US bonds. For example, if you take the market’s price-to-book ratio (P/B ratio), which is calculated by dividing stock prices by their book value (ie the value of total assets minus liabilities), India currently trades on a P/B ratio of 3.5x, much higher than the traditional P/B benchmark which states that anything under 1.0 is relatively attractive.

Scholes notes: “If you compare the valuation of the MSCI India index to that of the broader MSCI Emerging Markets index, Indian stocks today trade at a significant premium; the price to book multiple for MSCI India index is 3.5x, while the MSCI Emerging Market index trades at 1.1x.”

“This cannot be explained by profitability alone: while analysts’ aggregate forecast for the India index’s return on equity (ROE) beats the broader index, at 22.2% compared with 16.5%, clearly it is not three times the level of profitability.”

Therefore, investors seem to be paying for the promise of growth, although history shows they routinely overpay for it, and in fact there is often a negative correlation between economic growth and equity returns.

The analyst that’s underweight India

Those outsized investor expectations are not backed up by corporate growth, according to UBS analyst Sunil Tirumalai. UBS is underweight India in the emerging market universe.

He says: “This premium cannot be explained only by the fundamentals of Indian companies. There is a lot of high sentiment premium in Indian valuations, partly driven by perception of better macroeconomic and geopolitical positioning, especially versus China. What has also helped is the sharp uptick in household flows towards the markets post-pandemic.”

“While India’s economic growth prospects stand at 6% plus compared to emerging market average of 4.3%, Indian corporate’s growth performance has been ordinary compared to other emerging markets. Indian corporates’ capex investment - which generally indicates the confidence in growth and demand - has been quite low, with a soft outlook into the next couple of years.

“Overall, it is the government that is investing big in India, not the corporates. Themes such as manufacturing relocation are still narratives and yet to move the needle in India’s trade numbers.”

This suggests the risk of the 2024 elections is acute, as a poor result at the polls might weaken the Bharatiya Janata Party’s ability to pursue its pro-market, reformist agenda. As a hydrocarbons importer, India is also vulnerable to imported inflation if energy prices rise, which could impair the Reserve Bank of India’s ability to lower interest rates and ultimately reduce the government’s ability to fund capital expenditure. Morgan Stanley recently issued a warning that sustained oil prices at $110 per barrel could force the Reserve Bank of India (RBI) to restart its rate hike cycle.

Caption: Narendra Modi, prime minister of India, and a member of the ruling Bharatiya Janata Party (BJP). 

Reasons to be bullish

However, Roderick Snell, who is co-manager of a number of funds and investment trusts at Ballie Gifford, believes the private sector is also thriving.

Snell, who is lead manager of Pacific Horizon (LSE:PHI) investment trust, says his broad enthusiasm boils down to the fact that both the government and the private sector are driving effective changes.

He points out: “The government at the reform level, for example with the Goods and Services Tax and Adhaar (a 12-digit identity number that can be obtained by Indian citizens), and in the private sector we see companies such as Reliance Industries innovating successfully. For example, it has built a mobile network from scratch in recent years, now with around 450 million users. Digital infrastructure improvement has given a breeze of new start-ups in India and the number of unicorns topped 100 in 2022.”

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Snell adds that companies are increasingly moving supply chains to India. For example, Taiwanese hardware companies are infiltrating Indian universities.

He continues: “India has an absolute advantage in terms of demographics, but at present India accounts for only 2% of global goods exports.”

“India seems to get tarnished with the too expensive brush by many investors. In truth, it is quite a bifurcated market with an expensive consumer staples sector, but reasonable valuations elsewhere.”

Where fund managers are looking for value

Many fund managers are avoiding the most highly rated sectors and instead buying cheaper sectors such as financials, and attractively valued consumer-facing tech.

Investment trust Fidelity Emerging Markets remains overweight India relative to other emerging markets. Its exposure is predominantly via financials to take advantage of the under penetration of consumer finance in the country, where the level of credit to GDP is far lower than in many emerging market economies. It owns India’s two largest private banks HDFC Bank Ltd ADR (NYSE:HDB) and ICICI Bank Ltd ADR (NYSE:IBN), and also Axis Bank Ltd DR (LSE:AXB). The trust also own Eicher Motors, which is exposed to the trend of premiumisation in India through its Royal Enfield brand.

Chris Tennant, co-portfolio manager of Fidelity Emerging Markets (LSE:FEML), points out: “Although multiples for the Indian market in aggregate are high, we continue to believe the market remains supported by good medium-term growth prospects and capital flows.

“Given low levels of per capita GDP, there are penetration gains stories in almost every part of India’s market. Although some pockets of the market have relatively extended valuations, we aim to avoid these by looking for more attractively valued businesses.”

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Nilang Mehta, portfolio manager of Indian Equities at HSBC AM, makes an argument for large caps. “The mid and small-cap parts of the market may have run ahead of themselves with their sharp outperformance in recent months,” he says. “However, the same is not true of large-cap stocks, which have registered much more modest short-term gains but have a history of stable returns and a comparatively favourable risk-return profile.”

Dzmitry Lipski, head of funds research at interactive investor, urges long-term investors to look beyond short-term volatility, and instead towards the market’s diverse range of companies with good fundamentals that can take advantage of the untapped growth potential.

For adventurous investors, Lipski suggests Stewart Investors Indian Subcontinent Sustainability fund as a quality option with a sustainability focus.

For the more risk averse, Lipski recommends broader Asian or emerging markets funds that can adjust exposure to the country. He picks out Pacific Assets (LSE:PAC) Trust, which has over 45% allocation to India, JPMorgan Emerging Markets (LSE:JMG) Trust (25%) and Utilico Emerging Markets (LSE:UEM) (11%).