Indian equity markets performed strongly in 2014, mostly due to anticipation of prime minister Narendra Modi’s ascension to power, and the market was able to hold onto its gains through the end of the year, thanks to anticipation of investor-friendly reforms and the decline of oil prices. Modi ran on a slogan of “less government and more governance,” and he is still expected to unlock India’s vast economic potential. As investors look to position themselves for these improvements, we highlight some key considerations for investment vehicles offering exposure to India:
• Breadth of Coverage: The WisdomTree India Earnings Fund (EPI) currently has 230 holdings,1 and we believe that it offers the broadest representation of the Indian markets available in the exchange-traded fund (ETF) structure. Many other India-focused strategies are large cap in nature and include only 50 to 70 stocks. These large-cap-focused strategies can miss out on the mid- and small-cap segments of the Indian market, which typically are more sensitive to changes in the prospects for the Indian economy. While the economy suffered from depressed valuation in the past, it is now benefiting from the improved sentiment brought on by Modi’s election. Consider:
– Only 29 of the companies in EPI would be considered large cap—stocks with a greater than $10 billion market cap—while 70 of the stocks are between $2 billion and $10 billion, and 131 are smaller capitalization, having less than $2 billion in market cap.2
– The smaller-capitalization stocks were also the least expensive: the above-$10 billion stocks had a 15.7x price-to-earnings (P/E) ratio, while the small-cap segment’s P/E ratio was only 11.3x.3
– Traditional indexes for India, such as the MSCI India Index or the Nifty Index, generally have no exposure to this small-cap segment and less exposure to the mid-cap segment than EPI.
• Local Economy Focus: Mid- and small-cap stocks have reacted the most in 2014 to hopes of Modi’s reform agenda, leading to stronger gains for EPI than for most traditional (large-cap) indexes.4
The graph illustrates the performance differential that different exposures can create by showing the cumulative performance for the WisdomTree India Earnings Fund (EPI) against its benchmark, the MSCI India Index, for the 2014 calendar year.
For standardized performance of EPI, click here.
• Small and Mid-Caps Outperform: Over the period shown, the small- and mid-cap stocks in the EPI returned 56% and 37% respectively, compared with only 22% for large caps.5 EPI’s broader exposure to small- and mid-cap stocks, compared with MSCI India, contributed positively to its relative performance over the period.
• Strong Performance among Financials: EPI’s stock selection among Financials and its relative over-weight to the sector added to performance over the period. Financials were in focus during the year on expectations that they would benefit from more financial liberation; Financials also benefited from the stabilization of the rupee.6
• Industrials Outperformed: In EPI, the Industrials sector saw the best performance over the period, and better stock selection in this sector in EPI than in MSCI India added to relative performance. Small- and mid-cap industrial firms benefited from anticipation of pro-growth reforms and the decline in oil prices.7
Earnings Weighting Lowers the P/E Ratio
One potential concern for investors when such large gains occur in a short period is that the market may become expensive. The majority of Indian indexes are market cap-weighted —meaning they tend to give more weight to companies that sell at higher prices than to those that offer stronger fundamentals. On the other hand, the methodology of EPI’s underlying Index, the WisdomTree India Earnings Index (WTIND), is designed to magnify the effect of earnings on weights and total returns. WisdomTree’s earnings-weighted approach for India helps keep focus on lower-priced segments of the Indian market, and the annual Index rebalance in September helps manage the valuation risk. Our research shows that, since its inception, the WTIND has traded at a 34% discount to the MSCI India Index; the discount is currently at 27%.8