India Election Spurs Gains: How to Best Participate

The landslide victory in the Indian elections by Narendra Modi and his party has garnered much attention. Newly elected Prime Minister Modi is described as a self-made man who broke through the dynastic rule of the Gandhi party to raise India’s hopes. Modi ran on a slogan of “less government and more governance”—and he brings expectations of unlocking India’s vast economic potential. The Indian stock market began to anticipate a Modi victory and climbed to new highs in May as a result.¹ Yet the Indian rupee is still well off its highs, so Indian exchange-traded funds (ETFs)—which inherently contain exposure to both the local stock market and the currency—still have to gain over 25% or more before they reach the previous highs set in November 2010. As investors look to position themselves for the improved sentiment Modi has brought to India, the following are key considerations for investment vehicles offering exposure to India: • Breadth of coverage: The WisdomTree India Earnings Fund (EPI) has 170 holdings², and WisdomTree believes it is the broadest and most representative representation of the Indian markets available in the ETF structure. Many of the other India-focused strategies are large cap in nature and only include 50 to 70 stocks in them. These large-cap-focused strategies can miss out on the mid- and small-cap segment of the Indian markets, which typically are more sensitive to changes in the prospects for the Indian economy, which has suffered from depressed valuation and is now benefiting from the improved sentiment brought on my Modi’s election.   o Only 31 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 another 69 are smaller capitalization and have less than $2 billion in market cap. o The smaller-capitalization stocks were also the cheapest: the above-$10 billion stocks had a 14.2x price-to-earnings (P/E) ratio, while the small-cap segment’s P/E ratio was only 11.0x.³ o Traditional indexes for India, such as the MSCI India Index or the Nifty Index, have roughly no exposure to this small-cap segment and less exposure to the mid-cap segment.⁴ • Local Economy Focused: Mid-and small-cap stocks have reacted the most in 2014 on the hopes for Modi’s election. Last year large-cap technology stocks did really well on the back of the weak rupee, which helped exports.⁵ But in 2014 the more local economy, rupee-sensitive sectors and small caps are doing well, leading to stronger gains for EPI than for most traditional (large-cap) indexes.⁶ Attribution⁷ Click here for EPI’s standardized performance. • Industrials have led the market up this year, returning over 60% during the period. Financials and Energy, the two largest sector weights in EPI, were both up over 35% through the end of the period. This is a direct reversal of last year’s disappointing performance. • The Information Technology sector, which led the market in 2013 based on the weak rupee, was negative during the period on a stronger rupee. EPI’s under-weight position in that sector had been one of the contributing factors to its performance during the period. • Consumer Staples, viewed as a more defensive sector and also which performed quite well in 2013, lagged the broader gains present in cyclical sectors over the most recent period. EPI’s under-weight to this sector also contributed positively to performance through the period. Earnings Weighting Lowers the P/E Ratio One potential concern for investors when there are such large gains in a short period is that the market may become expensive—and India historically tends to trade at premium prices versus emerging markets more generally.⁸ WisdomTree’s earnings-weighted approach for India helps focus on lower-priced segments of the Indian market, and the Index and Fund will rebalance in September to help manage the valuation risk from the big winners. Our research shows the WisdomTree India Earnings Index (WTIND) has historically traded at a 35% discount to the MSCI India Index since WTIND’s inception, and the discount typically widens after the rebalance. Conclusion Less than 12 months ago, India was considered part of a group of “fragile” emerging market countries with large vulnerabilities that sent its currency into a tailspin. The first start to improved sentiment came with the appointment of a new head of the Indian central bank, Dr. Raghuram Rajan. Rajan’s appointment coincided with the lows for the rupee and the bottom of the equity markets after he aggressively hiked interest rates to combat high levels of inflation. A worry concerning this policy was that it would hamper economic growth by raising the cost to borrow money. But now, with the new government, growth sentiment is improving. With the tag team of Modi-Rajan, investors are seeking more gains for India. WisdomTree is a long-term bull for India based on its very favorable demographic trends. A key risk for India has typically been very high market expectations, high inflation rates and government corruption, which has been a bottleneck on the economy. The trends appear to be going in the right direction. For those looking for continued improvement, having EPI—which is broadly representative of the Indian market and economy but also employs a process to manage equity valuation risk—as part of their equity strategy might be an attractive way to gain exposure to India.   ¹As measured by MSCI India Index measured in local prices ²Source: WisdomTree, as of 5/20/14. Holdings subject to change ³Sources: WisdomTree, Bloomberg, as of 5/20/14 ⁴Source: Bloomberg, as of 5/20/14 ⁵Source: Bloomberg, 12/31/12–12/31/13 ⁶Sources: WisdomTree, Bloomberg, 12/31/13–5/20/14 ⁷Please keep in mind that high double-digit returns were achieved primarily during favorable market conditions. Investors should not expect that such favorable returns can be consistently achieved. A fund’s performance, especially for very short periods, should not be the sole factor in making your investment decision ⁸Source: Bloomberg; refers to the price-to-earnings ratio of the MSCI India Index compared to the MSCI Emerging Markets Index for the period 4/30/04–4/30/14 ⁹Sources: WisdomTree, Bloomberg, 12/03/07–4/30/14