Do Indian Equities Warrant An Overweight Stance? Not Yet, Says CLSA

India underperformed the Asia-Pacific regional equities, excluding Japan, from the end of last October till March by 25%, mainly due to China’s outperformance after the scrapping of its zero-Covid policy, CLSA has said.

But in the second quarter of calendar year 2023, the Indian equities have regained some ground and outperformed the region by 12%, the brokerage firm said in a note on Tuesday. That, however, is not enough to warrant an 'overweight' status, it said.

CLSA remains cautious on India for now, given the exceedingly rich valuations and margin erosion depleting India's relative profitability. The other reasons are consensus earnings-per-share growth expectations remaining too optimistic versus the delivered track record and the RBI likely lagging emerging markets central banks in the timing and scale of policy-easing. "Our econometric model signalling the market is 14% overbought," it said.

CLSA said valuation was the most commonly cited reason for hesitating from greater portfolio allocation towards India.

From 2004 till 2019, Indian equities traded on an average 35% premium multiple versus overall emerging markets on 12-month forward consensus sector-adjusted earnings. Since 2020, that premium has averaged 80%, which is where the market is currently trading, according to the brokerage.

India's relative valuation has been more expensive since 2020, given the structural challenges faced by China and, hence, that market's depleted valuation multiples, CLSA said. "Indian sell-side consensus 12-month forward EPS forecasts remain subject to negative revisions, thus underpinning further PE multiple expansion."

CLSA pointed out that India's non-financial sector's net-profit margin compressed significantly more since the peak in November 2021 than the emerging markets overall—by 300 basis points (9.5% to 6.5%) versus 140 bps (7.5% to 6.1%) for emerging markets.

This relative margin depletion has driven down the country's relative return on equity to just 1.1 times to that of emerging markets—ROE of 13.4% versus 12.1%. Investors have to pay a 2.2 times book premium for Indian assets generating not much more profitability, according to the note. "We struggle to justify the downtrend in India's relative return on equity in conjunction with the re-rating of the market's price book in the absence of structurally superior growth and/or lower cost of equity."

The brokerage said the consensus pencilled in a particularly aggressive successive expansion of the market-level (local currency) EPS, which they are understandably sceptical about, given the track record since at least 2010. "Since 1996, aggregate consensus sell-side earnings growth projections for India have disappointed 82% of the time and on average overpromised by a factor of two versus what was actually delivered."

At present, EPS growth consensus forecasts for financial year 2025 are higher than the original estimate, which, if maintained, would be the first year since at least 2010 that the actual posted higher than the first forecast, it said.

Central banks in other emerging economies are likely to ease policy earlier than the Reserve Bank of India.

Brazil, Mexico and Indonesia are among the economies that appear better-placed to deliver policy-easing ahead of the RBI, the note said.

The MSCI India is currently 14% higher than the level which prevails macroeconomic conditions, according to CLSA.

It underscored that Indian equities were insufficient in comparison to other regional market model upsides to justify an overweight stance.

The brokerage has revised its stance on a few reasons previously contributed to their underweight position on Indian equities. The reasons include:

• Energy prices have dropped below India's typical pain threshold.

• The rupee appears better positioned albeit with medium-term risks.

• The credit impulse warrants double-digit equity momentum.

• Domestic retail equity appetite has slowed but may now recover.

• Foreign investor ownership is yet to recover to the levels seen in the first quarter of fiscal 2021.