India Warms to Reform: Part 3 of 3

The MSCI India Index is up more than 50% in U.S. dollar terms from its trough last August, with some small-cap stocks rallying even more. And if the government delivers on the reform agenda, which we discussed in Part 1 and Part 2 of this series, earnings are likely to expand substantially over the next few years. We believe India is at a crucial turning point, and has potential to offer further upside over the coming years.

Fundamental Change

Economic activity in India has been stagnant over the past few years, but growth is showing signs of bottoming out and a strong reform effort by the new government could accelerate this process. Indian companies have been cutting costs and reducing debt to cope with the low growth environment. They are now enjoying higher degree of operating leverage that should work well as growth recovers. We believe margins and return on capital metrics should expand from here.

Earnings and Expectations

Earnings revisions have not caught up with recent share price moves yet, which isn’t surprising given the sharp and sudden rally. We currently find the better opportunities to be in the consumer discretionary and financial sectors; certain materials stocks also offer a good tradeoff between valuation and fundamental trends. In contrast, energy and capital goods stocks have run a lot, but their potential for near-term earnings improvement is likely more limited because of the structural issues for these sectors. We recognize, however, that in the medium-to-long term they will be very strong beneficiaries of the reforms and the pick-up in capital spending discussed previously. There are also many high-quality stocks in the export-oriented sectors like health care and information technology, but we believe they will likely lag in an environment of currency appreciation and higher domestic growth. We are cautious on consumer staples because of expensive valuations.

Valuations

Indian equity valuations are at a premium to the rest of the emerging market universe, but at 15 times forward P/E, the market is in-line with its own historical average. Admittedly, valuations have priced in quite a bit of the expected improvement near term, and some market consolidation is likely. But as earnings grow and return on equity improves over time, there is room for multiples to expand further as well.

Risks

We highlight two potential risks that could cause the market to underperform. One is a failure of Indian policymakers to bring inflation lower. Despite some monetary tightening, real interest rates are close to zero. If inflation doesn’t decline, the central bank will have limited flexibility to bring rates lower in the near term. The second risk is a potential spike in oil prices coming from the situation in Iraq. India is a large importer of crude oil and other energy products. Higher energy prices will be detrimental to their fiscal accounts and to economic growth.

All of this means that we’re rather optimistic about India’s prospects, but we realize that much of that optimism is dependent upon Prime Minister Modi’s ability to turn his political mandate into economic progress. As the factors that shape our views change, we’ll keep you updated.

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The information in this article has been derived from sources believed to be accurate as of June 2014. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

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