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.   The Result: Tilting Greater Exposure to Lower P/E Stocks • Approximately Two-Thirds of EPI’s Weight Is in Stocks Below the Median P/E Ratio of the MSCI India Index: The median P/E ratio of the MSCI India Index is 21.38x. As EPI tracks the return of its underlying Index, it is apparent that it is positioned more heavily in less expensive corners of India’s equity market. The P/E ratio distribution of the MSCI India Index is VERY different with more than 50% of its weight in stocks with P/E ratios above this same median value.⁴   • Approximately One Quarter the Exposure to Companies with Negative Earnings: We think this is remarkable, in that EPI had 233 holdings as of March 31, 2015, and the MSCI India Index had 65 constituents as of this same date. It may be surprising to learn that an investor can venture into exposure to small cap companies without necessarily needing to sacrifice exposure to those firms that are generating profits.⁵   The Importance of Managing Valuation Risk in India’s Equities There are a lot of reasons for excitement surrounding India, and there is little question that the market has great potential. However, we always find it important to remind people that managing valuation risk is one of the single most important things to do in any equity market. We believe that EPI is a tool designed with that potential in mind.         ¹Refers to the performance of the MSCI India Index from 3/31/2014 to 3/31/2015, sourced from Bloomberg. ²Refers to the performance of the MSCI Emerging Markets Index and S&P 500 Index from 3/31/2014 to 3/31/2015, sourced from Bloomberg. ³Source for bullets: Bloomberg. P/E ratios measured on percentage change basis from 3/31/2014 to 3/31/2015. ⁴Source for bullet: Bloomberg, with data as of 3/31/2015. ⁵Source for bullet: Bloomberg, with data as of 3/31/2015.