FLIN - EPI: Still Room For Upside Heading Into India's Election Season

2023-12-03 21:03:37 ET

Summary

• It's been a great couple of years for Indian equities.
• Indian ETFs that apply a quality filter, like WisdomTree's India Earnings Fund, have further outpaced broader indices.
• EPI's portfolio offers investors exposure to a relatively cheaper, higher-quality basket of Indian stocks heading into election season.

2023 has been a challenging year for stocks, with 'higher-for-longer' global rates and geopolitical risks weighing on emerging Asian equities. As I highlighted in my prior coverage , India has been the notable exception, outperforming post-Q1 this year on remarkably strong corporate earnings growth. There have been some near-term road bumps, most notably the RBI's (Reserve Bank of India or the country's central bank) precautionary tightening in reaction to weather-driven shocks, which led to a temporary sell-off through October. Now that we've moved past the worst of the weather headwind, the RBI has also stepped up efforts to tighten unsecured lending standards , which could see bank earnings come under pressure from slower loan growth (note financials is the largest sector component of most Indian ETFs, including WisdomTree's India Earnings Fund ETF ( EPI )).

Given the well-capitalized balance sheets of EPI's large-cap bank holdings, though, any headwinds should be manageable. Instead, I would focus on the accelerating pace of portfolio inflows (reversing persistent outflows earlier this year) as US bond yields normalize lower. An intact low to mid-teens % earnings growth estimates for next year and a high-teens % long-term growth runway also bodes well for India's future return potential. In the meantime, the latest state election polls suggest policy continuity remains the most likely outcome for next year's general elections; in line with prior cycles , expect EPI, along with the broader Indian market, to catch a bid through India's late-2023/early-2024 elections.

WisdomTree India Earnings Fund Overview – A Differentiated Focus on Profitability

The WisdomTree India Earnings Fund tracks, before fees and expenses, the performance of the WisdomTree India Earnings Index, an Indian large-cap basket subject to two fundamental screens – 1) market cap/liquidity requirements and 2) profitability and foreign investor eligibility. The ETF now charges a slightly higher 0.85% expense ratio on a significantly larger $1.6bn asset base - a slight premium to its largest fundamentally weighted comparable, the Invesco India ETF ( PIN ) (see prior coverage here ). For investors indifferent to ETFs with factor-based overlays, on the other hand, the lowest-cost Indian ETF remains the Franklin FTSE India ETF (FLIN).

The fund's sector breakdown indicates it is relatively well spread out (by emerging Asia standards), with no single sector exposure exceeding 25%. Following the HDFC/HDFC Bank ( HDB ) merger completion , the largest EPI sector is Financials at 24.2%, followed by Energy (16.0%). Materials, previously the largest sector holding, is down to 13.7%, with Information Technology and Industrials recovering slightly to 12.4% and 7.6%, respectively. Key comparable PIN features a similar portfolio composition, though its exposure to Financials is much lower (17.4%), while more cyclical sectors like Energy and Materials also feature less prominently. EPI is also the more top-heavy of the two, with its top five sectors contributing an additional 6-7 percentage points to the overall portfolio.

Despite the sector reshuffling, EPI's single-stock portfolio allocation is still led by Indian conglomerate Reliance Industries ( RLNIY ) at a larger 7.7%. HDFC Bank and ICICI Bank ( IBN ) have, however, emerged as the second and third-largest holdings at 6.4% and 4.9%, respectively. The most notable change is steel-making company Tata Steel (TATLY), which drops out of the top ten list in favor of tech services companies Infosys ( INFY ) and Tata Consultancy Services (TTNQY). While the ten largest holdings now contribute a slightly larger 38.5% of the overall portfolio, EPI remains as well-diversified from a single-stock perspective as its closest fundamentally weighted comparable fund, PIN.

WisdomTree India Earnings Fund Performance – Among This Year's Best Performers

On a YTD basis, the ETF has returned +10.4% in market price terms (+10.2% in NAV terms), outpacing the +7.8% returned by its closest US-listed Indian ETF peer, PIN. Zooming out, the fund has now compounded at a +3.6% pace since its inception in 2008, though this headline figure penalizes the fund for a challenging base (i.e., during the 2008 financial crisis). The ETF's performance over the last decade, on the other hand, is best-in-class, with an annualized ten-year return of +9.5% in market price terms (+9.4% in NAV terms vs +8.1% for PIN and +8.5% for MSCI India trackers like the iShares MSCI India ETF (INDA)). The annualized returns over near-term timelines are even more impressive at +17.7% and +11.9% in NAV terms over the last three and five years, respectively. Note that this already accounts for EPI's wider-than-usual tracking error vs. its benchmark (even by Indian ETF standards), a result of the rebalancing required in tracking a fundamentally weighted index.

Like most other Indian ETFs, there isn't much of a distribution here at ~0.7% (30-day SEC yield). Historically, the yield has also consistently tracked at sub-1% and been volatile through the cycles, so income investors should probably look elsewhere. Where EPI shines, even more so than other Indian ETFs, is its mix of growth and quality at a reasonable price. Relative to the ~27x P/E for MSCI India and ~24x P/E for PIN, the EPI portfolio is priced at a far lower ~16x P/E (~12x cash flow), which will appeal to value-oriented investors.

Still Ample Room for Upside Ahead of India's Election Season

Indian ETFs, in general, have outperformed this year, with EPI's stock selection overlay adding a few additional percentage points to its total return. Going forward, the external outlook is set to improve significantly, with inflation and rates easing off alongside fears of a 'hard landing' outside of China. In combination with India's domestic strength, a low-teens % earnings trajectory seems well within reach for 2024, supporting the mid-teens earnings valuation of the EPI portfolio.

And even after this year's rally, Indian equities (using the Nifty 50 as a proxy) aren't particularly overextended relative to their emerging Asia counterparts, so I wouldn't rule out a re-rating boost either. The only blemish I can see from here is EPI's financials-heavy exposure (like most other Indian ETFs), which will be pressured by the RBI's lending restrictions and a likely rate cut cycle next year. By focusing on well-capitalized large caps, though, EPI's bank holdings should remain insulated from the worst of the fallout, allowing the ex-financials part of the portfolio to pick up the slack. Ahead of a state and general election double-header, I remain upbeat on EPI.

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