India: A Focus on Earnings Leading to Large Gains

Less than a year ago, India was considered to be part of a group of “fragile” emerging market countries that had large vulnerabilities that sent its currency into a tailspin and caused a spike in the equity volatility. During times of volatility, the focus tends to be less on individual companies’ fundamentals and more on macroeconomic fears.

Opportunities typically present themselves during these times of heightened volatility and fear. When emotions can get in the way of making difficult portfolio allocations, WisdomTree’s rules-based process makes adjustments to portfolios based on strict readings of the underlying fundamentals.

By using this rules-based fundamental indexing process at the most recent annual rebalance last September, the WisdomTree India Earnings Index (WTIND) added significant weight to companies selling at depressed relative prices, and those companies have performed very well during the market rebound. This process has added significant value to the WisdomTree India Earnings Fund (EPI), which is designed to track WTIND, by focusing on these lower-valued securities, as illustrated below.

A Focus on Earnings

WisdomTree believes fundamentals such as dividends and earnings offer more objective measures of a company’s health, value and profitability than stock price alone. Because India is a low-dividend-paying country, WTIND screens and weights its constituents by earnings.

While the majority of Indian indexes are market market cap-weighted—meaning they tend to give more weight to companies that sell at higher prices than those that offer stronger fundamentals—the WTIND index methodology is designed to help magnify the effect of earnings on weights and total returns. Companies with low price-to-earnings (P/E) ratios typically receive higher weights. Additionally, as I discussed here, the WTIND also strives to represent the broadest cross-section of investable and profitable companies in the marketplace.

The focus on stocks with lower P/E ratios has worked particularly well since the last annual rebalance for the WTIND, as illustrated below.

P/E Quartile Performance

Low P/E Ratio Overweight Drove Outperformance – WTIND’s overweight exposure to low P/E stocks added more than 10% of outperformance compared to the MSCI India Index. This is impressive considering it accounted for almost two-thirds of the total 15.7% outperformance during the period.
More Weight in Lower P/E Ratios – WTIND had over 2.5x more weight in firms with the lowest P/E ratios. Evenly impressive is the fact that WTIND had almost two-thirds of its weights in firms with a P/E ratio less than 16.5x earnings, compared to the MSCI India Index, which had more than two-thirds of its weight in firms with a P/E ratio greater than 16.5x earnings.
Lower P/E Ratio Firms Outperformed – Firms within the lowest quartile outperformed firms in the highest quartile by more than 55% within both WTIND and MSCI India. Although the performance differentials among quartiles for the Indexes were similar, WTIND was able to outperform over the period as a result of its overweight to stocks within the lowest P/E quartiles. When sentiment gets very negative, the market often moves more than changes in fundamentals — in this case the earnings. Rebalancing back to those fundamentals may then be rewarded when positive sentiment returns, as we have seen in last nine months.
No Weight In Negative Earnings – Since WTIND screens companies for inclusion based on earnings, the Index will remove all unprofitable companies at its annual reconstitution. While company earnings may fluctuate between screening dates, we think this annual screening factor helps the Index manage valuation risks.