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01/04/2011

Returning as a Tiger: The Economic Reincarnation of India (Part II)


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INDEX: INDIAN PUBLIC EQUITIES | VALUATIONS IN INDIA ARE REASONABLE | CURRENCY: SHOULD ONE BE A RUPEE GROUPIE? | CONCLUSION: PORTFOLIO DHARMA

The first part of this article discussed recent economic developments in India and the prospects for high growth rates over the long term. Part II covers the performance of the equity and currency sectors and offers compelling reasons to include India in either a global or EM (emerging-markets) portfolio.

India has been on investors’ radar screens since at least 2000, but it has rocketed to even greater prominence in the post-crisis recovery. Its major stock index, the Sensex 30, has grown more than 125% since its low in March 2009, outpacing the S&P 500 Index (up 82% since March 2009), China’s Shanghai Composite (up 65% since October 2008), and even the highly popular Brazilian Bovespa (up 115% since December 2008). India-related ETFs have proliferated, allowing easier access to Indian market returns. The emphasis on the centrality of China in the global economy can make it easy to miss the opportunities offered by China’s neighbor.

Table 2: Selection of India-related ETFs
India-ETFs

Table 3: Market Recovery from Crisis Lows

Recovery Stats from Market Lows
Source: Bloomberg, December 18, 2010.

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INDIAN PUBLIC EQUITIES

Figure 5 shows the total return equity curves of MSCI indices for India and several reference countries. India’s curve is slightly thicker and in black. The curves are normalized to 100 at the start of 2004, the first full year for which the MSCI BRIC composite index is available.

Figure 5: Comparative Equity Total Returns, January 1, 1999–December 17, 2010

Comparative Equity Total Returns, January 1, 1999–December 17, 2010
Source: Bloomberg, December 18, 2010.

Although Brazil and Indonesia stand out on this chart for the steep sloping recovery, India still ranks respectably, approximately matching the performance of the diversified BRIC index, and clocking in with a higher final value than both China and the diversified EM index. Interestingly, at the time of writing, most indices on this chart have made comparable recoveries from their pre-crisis highs. India has reached 80% of its pre-crisis high (in USD total return terms), and most of the other indices lie within 80%-90% of their previous highs. Notable exceptions are China (at only 70%) and Indonesia (20% higher than its pre-crisis high).

Figure 6: Risk-Return Chart

Figure 6: Risk Return Chart
Source: Bloomberg, December 18, 2010.

Figure 6 plots India and other indices on a risk-return chart to show risk-adjusted performance, based on MSCI USD total return close values. The return on cash is set to 2.65%, the average 90-day T-Bill yield over the same period. Although India does not return as much as Brazil and Indonesia do in absolute terms, its risk-adjusted performance is comparable in that India’s lower total return is commensurate with its lower volatility. An investor who levered up an exposure to India over the same time period could expect to earn levels of return comparable to those of Brazil and Indonesia.

An interesting feature of Figure 6 is that China has substantially underperformed India and the other EM indices on both an absolute and a risk-adjusted basis, despite (or perhaps because of) the substantial press it receives. Nonetheless, all the indices still outperform the US total return index, and MSCI’s ACWI (All Country World Index) is hardly much better. Over the last decade, emerging markets have clearly outperformed developed markets by a wide margin. At the same time, most major emerging markets and EM indices do deliver returns approximately in line with their total risk, suggesting that the major emerging markets are starting to become more efficiently priced, even if there is still a return premium for emerging markets as a category.

Table 4: Quantitative Data on MSCI Weekly TR Indices in USD (January 1, 1999–December 17, 2010)
  Table 4: Quantitative Data on MSCI Weekly TR Indices in USD

Source: Bloomberg, December 18, 2010.

Table 4 presents quantitative figures drawn from MSCI total return indices in USD for India and other countries and benchmarks for the period from January 1, 1999, to December 17, 2010. MSCI’s BRIC index is not included because its data only goes back to late 2003. The risk-free rate used in the calculations is 2.65%, as before.

India’s total return over the period averages 22.2% annually, falling squarely in the upper range of the indices in the table. Brazil and Indonesia did generate higher average returns, but they are also more volatile. India’s volatility is lower than China’s for the period even though its returns are 1.5 times larger, indicating that India has actually offered a better risk-return trade-off than China. Importantly, India’s market has the highest Sharpe ratio of all indices in the table, with Indonesia and Brazil as runners-up and MSCI’s diversified EM index also not far behind.

India’s beta to the ACWI index is just under 0.9, indicating that it exposes investors to systemic risk similar in scale to the global economy. In addition, India’s low to moderate correlation to the index helps it provide diversification benefits to global portfolios. Moreover, the nonsystemic risk component has generated highly positive alpha (17.2% annually) over the last decade, so investors who have overweighted India have generally outperformed the index.

The alpha for India is high, as it is for most emerging markets, in part because the ACWI index—dominated by US, European, and Japanese markets—delivered low returns over the decade. Over the 1999–2010 period, the ACWI produced a market risk premium of 2.72% over cash, corresponding to a 5.37% total annual return. During this time, emerging markets as a whole greatly outperformed the global economy: Table 4 shows that MSCI’s diversified EM index generated 10.85% in alpha, or nearly 11% more return than can be explained by EM markets’ risk and correlation to the global economy.

Even within emerging markets, India has performed well. Its beta to the MSCI EM index is about 1.3, and it has still been able to deliver 7.77% more than what would be expected from a “generic” emerging market with a similar EM beta. On top of this, India’s 0.67 correlation with the EM index means that it adds diversification benefits even to a strictly EM portfolio.

Of the 22.2% annualized average return over the decade, we can attribute about 2.65% of the return to the risk-free rate, 3.49% to global market returns, 9.30% to general EM returns, and 6.78% to returns unique to India.

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VALUATIONS IN INDIA ARE REASONABLE

Fundamental economic stories and past performance data can be compelling, but assets can still get overvalued. In India, the current valuation data show that the market is close to its historical average. Although valuation metrics can be difficult to compare across countries due to differences in country-specific risks and regulations, it is nonetheless useful to examine historical ranges for both trailing price-earnings metrics and dividend yields in India, the US, China, Brazil, and Indonesia (Figures 7 and 8). Limitations on available data mean that some countries necessarily have longer valuation histories than others.

Figure 7: Comparative Price-Earnings Ratios for India and Other Markets

Figure 7: Comparative Price Earnings Ratio for India
Source: Bloomberg, December 20, 2010. Markets Referenced: Sensex 30 (India), S &P 500 (USA), SHSZ 300 (China), Bovespa (Brazil), and Jakarta Composite Index (Indonesia).

Figure 8: Comparative Dividend Yields for India and Other Markets

Figure 8: Comparative Dividend Yields for India
Source: Bloomberg, December 20, 2010. Markets Referenced: Sensex 30 (India), S &P 500 (USA), SHSZ 300 (China), Bovespa (Brazil), and Jakarta Composite Index (Indonesia).

The valuation data indicate that—to the extent that historical yields and ratios still apply—India’s market is close to fairly valued. Its P/E ratio of 18.3 at the time of writing is about 7% above its long-term average of 17.1; although lower than that of most countries, its dividend yield of 1.32% is slightly higher than the 1.26% average. Low dividend yields are generally not an issue for companies and indices where high growth is expected, as it is in India, and the fact that the current yield is above the long-term average tends to balance out the concern that the P/E ratios are slightly higher than average.

India’s P/E ratio is lower than that of most countries on the chart, whether looking at the mean, historical range, or current value. Lower P/E ratios generally suggest better value, but the low comparative valuations may also reflect higher perceived risks or may represent an opportunity for additional alpha. In China, there is clearly fear of a property bubble and potential monetary tightening; in India, there is still concern over rising inflation and a push to tighten, but little fear of asset bubbles at present. A bigger concern may be the rebirth of interest in the capital controls that the country has historically liked to implement.

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CURRENCY: SHOULD ONE BE A RUPEE GROUPIE?

Foreigners investing in India do take on currency risk. Figure 9 shows the history of Indian rupee (INR) exchange rates in USD and EUR over the last decade. Higher values on the chart represent a stronger rupee. Exchange rates with the dollar have been relatively stable over the period, varying between 40 and 50 rupees per dollar and averaging 45 INR/USD. The rupee has weakened relative to the euro over the same time period, but this reflects the strengthening of the euro relative to the dollar more than specific weakness in the rupee.

Figure 9: Strength of the Indian Rupee, January 1999–December 2010

Figure 9: Strength of Indian-Rupee
Source: Bloomberg, December 18, 2010.

While not having an official policy of pegging the rupee to the US dollar, India’s central bank practices a managed float regime that uses open market operations to reduce exchange rate volatility, primarily versus the greenback. One can see this policy reflected in the fact that the USD/INR curve is substantially smoother than the EUR/INR curve. After 2008 the dollar curve becomes choppier, suggesting that the central bank is possibly reevaluating the dollar-centeredness of its approach.

Managing the dollar-rupee exchange rate makes some sense for India, given that the US is one of its largest trade partners and that the other two largest partners—China and the UAE—also peg their currencies to the dollar, officially or unofficially. In addition, one of India’s largest imports, petroleum, is priced in dollars.

India does not use a hard peg to manage its currency, allowing the country a wider range of options for managing economic stresses. Even so, the current policy presents the risk of importing inflation as the US proceeds with quantitative easing and its own deficit spending. As inflation heats up in India, the central bank may be content to let either interest rates or the exchange rate rise (or both). As a result, US-based investors do not presently face substantial currency risk directly from exchange rates. In fact, having currency exposure to the rupee (i.e., not hedging the currency risk of rupee investments) is more likely to result in a net positive for USD-based portfolios in the near term.

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CONCLUSION: PORTFOLIO DHARMA

The economic story of India as a world growth center with favorable demographics and an economic growth trajectory provides a strong base for including the country in equity portfolios. The stock market as measured by the MSCI India country index has generated excellent risk-adjusted returns even among the EM countries, and offers diversifying advantages in both global and EM portfolios. India’s valuation is not at bargain levels by historical standards, but it is reasonable. From the perspective of a US investor, currency risk seems relatively low and may even add an additional return if the central bank lets the rupee strengthen.

The risks in India are primarily those that affect the global economy: uncertain economic growth and service demand from the industrialized countries, the price of oil, and the potential for war and terrorism. Inflation appears to be the most immediate threat to India’s continued outperformance; even so it seems unlikely to derail India from its long-term growth trajectory.

If a portfolio is allowed to invest in emerging markets, there is little reason that India should not be in it, and very likely overweighed. In Hinduism, dharma roughly translates as “righteous duty,” and portfolio managers with policies that permit emerging markets will find that their dharma includes taking a close look at the growth and diversification potential of India.

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–Bruce P. Chadwick, PhD, CFA, is principal at Chadwick Global Research and Consulting, an independent consulting firm specializing in macro strategy, including quantitative, emerging market, and SRI research.

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