Why it's time to get picky with Indian stocks

Individual country markets can wax and wane notably in the eyes of investors for multiple reasons, and those shifting fortunes have been especially evident in Asia.

China has fallen hugely out of favour since 2021 and we've seen India in the ascendancy over the same period. The MSCI India index made returns of almost 30 per cent (in sterling terms) in 2021, managed a modest gain even in the global equity bear market of 2022 and has made huge returns both last year and this year.

India is increasingly present in other ways. Funds focused on the country have proved popular, with the Investment Association's India/Indian Subcontinent sector having enjoyed consistent monthly net inflows over the course of the past year, in contrast to consistent outflows for China funds and mixed fortunes for the funds in the IA's Asia Pacific ex Japan sector.

India also represents an increased share of the MSCI AC Asia ex Japan index thanks to a combination of growth and index rebalancing. It makes up roughly 22 per cent of the index, with the country's Reliance Industries, HDFC Bank and ICICI Bank among its top 10 constituents.

The case for investing in India has all the marks of an emerging markets narrative. It has strong demographics thanks to its young population and a growing middle class. It also has a business-friendly government, with Narendra Modi having over the past decade helped to stabilise the country's finances and focused on various reforms. That in part explains its extremely strong returns as of late.

Strong returns, however, can prompt some caution. For one, investors might wonder if there is enough positive news to help maintain the momentum of recent years, while many worry that Indian shares now look pretty expensive by certain metrics.

Jay Jeon, senior vice-president for multi-asset strategies at Research Affiliates, was recently among those to single India out as an emerging market that has looked far from cheap. "Current cyclically adjusted price/earnings (CAPE) ratios suggest that most emerging markets are fair or undervalued," he said.

"However, with their outsized recent returns, both Taiwan and India now have valuations that appear to be stretched to extremes. With Cape values at the 91st and 98th percentiles for Taiwan and India, respectively, mean reversion could provide return headwinds for these markets."

It's also worth noting that Modi failed to secure as strong a majority as some expected in elections earlier this year, prompting concerns that he may struggle to carry out as many reforms as some might have hoped.

We should also not forget, amidst such big recent gains, that this is an emerging market with the volatility this can entail. As Rob Morgan, chief analyst at Charles Stanley, notes: "It has been a fantastic growth market over the years but its record is punctuated with some big drops, usually when valuations got ahead of themselves and sentiment suddenly turned sour." While India has not found itself in the midst of a trade war or had a regulatory crackdown in the way China has, things could certainly turn.

As Morgan adds: "It’s very sensitive to foreign investor flows, which bring a lot of extra volatility. Valuations are fairly rich at the moment, but I don’t think it can be overlooked by growth investors given the favourable demographics and corporate dynamism that persists." He adds that the quality of the companies on offer can vary dramatically, suggesting that active funds might have an edge over trackers here.

Which sectors of the Indian market should investors focus on?

Looking at the composition of the market, financials tend to play a big role in the MSCI India index, where they make up a chunky weighting of around 25 per cent, and names such as HDFC Bank and Axis Bank sit among the biggest constituents. Consumer discretionary stocks make up around 13 per cent of the index, with information technology on roughly 11 per cent.

Such sectors should prove promising in a region driven by strong consumption, although investors might be tempted to delve further down the market cap spectrum if they want to capture such growth. Passive funds here do often tend to be dominated by the likes of large-cap stocks whereas some dedicated active funds, including the Ashoka India Equity trust, have made big gains from backing small and mid-cap shares.

Finally, it is worth noting just how heavily any active fund is going into India. Some have invested enthusiastically in this market in recent years, especially after growing more cautious on China. Whether they wish to be so careful with Indian valuations, too, or believe these look justified, will have a major bearing on returns in the coming years. The Asia region does, however, offer investors plenty of opportunities to diversify into other geographies.

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