Caution Is Merited For India’s Stock Market

The stock market of India today is probably the most hyped and loved by emerging markets investors. Investor enthusiasm is rooted in the assumption that the country’s high growth rate can be sustained by structural reforms aimed at boosting productivity and modernizing the economy.

As a low-income economy, India has considerable potential for boosting economic growth simply by narrowing the productivity gap that it has with more developed economies. Though India has many world class companies in sectors such as information technology, pharma, manufacturing and banking, much of the economy, particularly small-scale informal manufacturing and farming, suffers from abysmal levels of productivity. Stifling bureaucracy and corruption make operating a business very difficult in India and promote informality. India ranks 130th in The World Bank’s 2017 Ease of Doing Business survey, the worst of any large economy.

Since market-oriented reforms were first introduced in 1991, India has entered into an accelerated catch-up phase, enjoying GDP growth of 6-7%.  For the 2014-2018 period, GDP growth will average about 7% annually, making India the fastest growing large economy in the world. Moreover, in recent years India’s trade accounts and inflation have benefitted from low commodity prices.

In principle, higher GDP growth should justify higher stock market valuations. In many countries, there is a well-established and logical correlation between GDP growth and corporate earnings growth. A generally optimistic view of the potential for long-term growth in earnings has resulted in high multiples for Indian stocks. Moreover, the relatively high valuations in India may be validated by the corporate structure of the Indian market which is dominated by well-managed and profitable private companies operating in industries with stable growth characteristics, in contrast to the much higher concentration of cyclical businesses and mismanaged state-owned firms in the stock markets of Russia, China and Brazil.  We can see this in the chart below, which shows cyclically adjusted, 10-year average price earnings ratios (CAPE) for major emerging markets. India has traded at the highest PE multiples for this group of countries for the past 15 years, as the market has priced in high expected earnings growth and low expectations for future volatility. The market sees India as a “high quality” stock market, with high earnings and low volatility, in contrast to markets like Turkey, Brazil or Russia which are seen as low-growth and high volatility. The only other market currently held in such high esteem by investors is the Philippines.

However, investor enthusiasm for India’s stock market may be misplaced.

India, with its bouts of uncontrolled inflation, high fiscal deficits and elevated public debt levels, recurring balance of payments crises, currency volatility, extreme inequality,  complex democratic politics, and highly inefficient and corrupt bureaucracy, resembles Latin America more than it does East Asia. East Asia has benefited from strong commitments to competitive currencies, a financial system geared to support manufacturing, trade and small-scale farming, and widespread education, none of which are the reality in India or Latin America. Consequently, though India’s GDP growth may be relatively high, it is likely to be volatile, leading to choppy earnings growth for its listed companies.

Furthermore, high GDP growth may be more a curse than a blessing for many of India’s blue chips as it promotes more competition. In recent years, India is seeing many new entrants in sectors like consumer goods and banking. IT powerhouses like TCS and Infosys are threatened by disruption from cloud-based providers. India’s high growth and looser regulations are bringing more foreign competition in many industries (e.g., motor vehicles), potentially disrupting powerful incumbents over time.

In general, stock markets that are very popular with investors because of attractive growth prospects do not tend to perform well in the future. Nevertheless, though expensive relative to other emerging markets, the Indian stock market may continue to do well. It trades today at a CAPE valuation which is below its long-term average and about in the middle of its long-term range, which does not seem prohibitive at a time of very high asset prices around the world.

Still, from a relative performance point of view, there is a high probability that over the next 3-5 years, India will not perform as well as cyclically depressed markets such as Turkey, Russia and Brazil.

One of the ironies of investing in emerging markets is that high GDP growth most often results in excess investment and low future returns. The best stock market returns are often found in depressed cyclical markets which have seen a period of low investment and where companies stand to benefit from operating leverage during powerful cyclical rebounds.

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