How to Manage One of India’s Most Important Risks

India’s equity market performance has been remarkable over the past year—20.7%1. Emerging markets were basically flat over this period, and U.S. equities were up about 12.7%2.

In short, India was one of the best performing equity markets in the world.

With Remarkable Performance May Come Valuation Risk

A greater than 20% return in an environment where broader emerging market equities were flat leads to a critical question: Are India’s equities becoming expensive? One way to look at this is through the change in price-to-earnings (P/E) ratio over this period3 :

Rising Multiple: The MSCI India Index saw its P/E ratio go from 17.5x to 20.1x over this period, an increase of approximately 15%.

Lower P/E Tilts: The WisdomTree India Earnings Fund (EPI) saw its P/E ratio go from 11.9x to 14.6x over this same period, an increase of approximately 22%.

A Rally Driven by Multiple Expansion

Over this period, the biggest factors contributing to the performance of India’s equities were related to expectations of a more positive future—with the transition to Prime Minister Narendra Modi’s Bharatiya Janata Party (BJP) government front and center. It is not surprising that multiple expansion rather than earnings growth drove the story—earnings growth has yet to respond to this initial excitement as strongly as the initial price appreciation.

But how is it that EPI’s P/E ratio started about 30% lower than that of the MSCI India Index and—even with greater multiple expansion on a percentage basis—remained about 30% lower at the end of the period?

This is really the crucial question because we know that the nature of the rally in India’s equities has led to the chance of an increased risk of India’s equities becoming expensive.

The Answer

There are two core components within the methodology of the WisdomTree India Earnings Index (which EPI tracks after costs, fees and expenses) that we believe drive the results that we have seen:

1) Annually Rebalancing Back to a Measure of Relative Value: Instead of continuing to own stocks in greater proportions due to increasing market capitalization—which can certainly relate to rising share prices—the road to greater weight within the WisdomTree India Earnings Index is paved through increasing profits. Firms that increase in share price but do not increase their earnings would typically see reductions in weight at the annual rebalance.

2) Weighting Profitable Companies by Their Profits: As of March 31, 2015, the WisdomTree India Earnings Index had 282 constituents. At the annual rebalance, each of these firms had to prove its capability to generate positive profits over the fiscal year leading up to August 31, 2014—the index screening date. Positive profits must be maintained in order to remain within the Index at the next rebalance, and the biggest profit generators receive the biggest weights.

Below, we examine how these two components of the methodology influence the distribution of constituents by P/E ratio for both the WisdomTree India Earnings Index, and EPI. The market capitalization-weighted benchmark for both EPI and the WisdomTree India Earnings Index is the MSCI India Index, which we also include for reference.