A continued derating

Global investors derate India as we avoid second generation reforms

India has underperformed its emerging market (EM) peers quite dramatically over the past three months. Indian markets are down about 30 per cent (in dollar terms) compared to 15 per cent for the broader MSCI EM Index. The underperformance, in my view, is linked to the severe and extended lockdown—the most comprehensive globally—and the inability of the government to support the economy with significantly enhanced spending. Given our slowing economy, we were quite constrained fiscally even before the crisis, and the lack of financial flexibility is now hurting.

Global Investors feel India’s weak social safety net and the large unorganised sector make it vulnerable to the Covid-19 disruption. Lingering fears remain about a further spread of the virus in the country, as despite the severe lockdown, cases continue to rise.

For the first time in my investing career, I will unfortunately experience a negative gross domestic product (GDP) growth in India. Its consequences for employment, livelihoods and corporate earnings will be catastrophic. Given the mass migration of labour back to their hometowns, many investors also worry about the pace of the eventual recovery. Newspapers estimate the number of migrants who have returned home to be 3-4 million. No one has any idea when— and if — they will come back to the cities. In their absence, how will business scale up?

Global investors are voting with their feet, selling non-stop across both debt and equity. Since the crisis hit, foreign portfolio investors have sold more than Rs 60,000 crore worth of equities and Rs 1 trillion worth of debt in India. 

The worst-performing sector has been the financials (down 45 per cent), with many of our top private banks down over 50 per cent. The weakness in financials reflects the discomfort investors have with asset quality and bank earnings in an environment of negative GDP growth, moratoriums and no clarity on the pace and timing of recovery. There is a growing feeling that with the government fiscally constrained, the banks will have to bear some of the costs needed to nurse the economy back to health.

While the pandemic is the current reason for our underperformance, the sad reality is that derating of India has been going on for some time. India has underperformed the MSCI EM benchmark for the last three-months, six-months, one-year, three-year and five-year holding horizons (in USD). 

Illustration: Ajay Mohanty

 

Over the last five years, MSCI EM is down 10 per cent (not annualised), while India is down 11 per cent. Over the past three years, India is down 19 per cent, while the EM index is down 7 per cent. India is still ahead of the broad EM index on a 10-year horizon, we are up 13 per cent, while MSCI EM is up only 5 per cent ( in USD, not annualised). However, this comparison can also turn negative if we continue to underperform.
 

A topic for another article is the huge outperformance of the US versus EM. Over the last 10 years, the S&P 500 is up about 175 per cent, compared to 5 per cent for the EM benchmark. This has to reverse at some point. 

As India has underperformed, it has slowly also been derated. Today, valuations for the broad market are reasonable, though the index hides massive divergence. A vast majority of the market is quite cheap, and only a small subset of quality is expensive. 

At 55 per cent, market capitalisation/GDP is at the same level as it was in March 2009. The long-term average is 75 per cent, and the peak on this ratio has been over 100 per cent. The mid-cap Nifty is 40 per cent below its peak as well as its market capitalisation as of December 2014. There are only 230 companies with $1-billion in market capitalisation in India, the same number as in 2007, this number had peaked at 330 in 2017. Today, we only have 10 companies in India with a market capitalisation greater than $25 billion, an astonishingly small number for a country with GDP of $2.5 trillion. The Indian PE multiple/EM PE multiple at 1.15, is below the long-term average of 1.52 and in the bottom 10 per cent of all observations of this ratio. The sad fact is that today the index weight of India at about 8.4 per cent is less than the combined weight of just two Chinese internet companies— Alibaba and Tencent, which together have a weight of 12.7 per cent!

Why has this derating happened? It comes down to global investors losing faith in the structural growth story of India. Once global funds were convinced that India would be the fastest growing large economy in the world and its structural growth rate was near 8 per cent. Today, most feel we will be lucky to come back to a trend growth near 6 per cent. This downshift is partly due to global factors, the world itself will grow more slowly. However, the bulk of the downward adjustment in trend growth rates is due to our internal issues. Most global investors are convinced we lack the administrative capability and structures to handle the complexity of running such a large economy. We have not seen any of the second-generation administrative, judicial and other reforms. In their absence, investors won’t be convinced that India will ever realise its potential.

A downshift in growth expectations of this magnitude, has huge implications for fiscal sustainability, terminal value assumptions in valuation models as well as earnings growth expectations for the broad market. Frankly, given the perceived difficulty in dealing with the Indian regulatory framework, why bother if you can’t get high growth and returns? 

The second pet peeve of global investors is the total lack of corporate earnings growth in India over the last seven years—this market has delivered an earnings per share growth of only 3-4 per cent per annum. The bulk of the share performance, even for the best companies has come from multiple expansion, not earnings growth. This cannot continue. Every year for the last seven years, earnings have been downgraded as we progress through the year. Global fund managers are tired of the multitude of excuses rolled out to explain the poor earnings. 

Undoubtedly, over the last seven years, we have seen a clean-up in corporate India. Inefficient groups have been driven out of business. Leverage has been reduced across both companies and promoters. Formalisation has been seen across the economy, and industry structure has improved, as the stronger players have gained share. 

However, the benefits are not visible. All these reforms have to deliver accelerated and better quality growth, otherwise what is the point of the pain? Hopefully, the growth acceleration will come, however global investors will now wait forever. Global Investors will wait for delivery, they will not be pre-emptive and pay up today. So, our derating will continue till we take the steps needed to realise our potential. The reforms needed are well known and we need to take the plunge now.

The writer is with Amansa Capital