INCO - INCO: Keeping The Faith In India's Consumer Champions

2023-12-31 11:13:38 ET

Summary

• India’s consumer names continue to outperform the broader market.
• Sector valuations are also high, though investors willing to underwrite the quality and long-term growth on offer stand to be well-rewarded.
• As one of the few sector-focused India funds listed in the US, low-cost consumer ETF, INCO, screens attractively.

After years of outperformance against other emerging Asian markets, Indian equities are hardly undervalued. Its consumer sector, which features many of the country's 'feel-good' franchises, still screens richly – since I last covered the fund, Columbia Threadneedle’s sector-focused India Consumer ETF ( INCO ) portfolio has de-rated slightly but remains multiple turns above MSCI India at ~40x trailing earnings.

This valuation isn’t undeserved, given the particularly attractive secular consumer tailwinds in India. As one of the few regions in the world in the early stages of a ‘demographic dividend,’ India stands to reap the benefit of a declining dependency ratio through the coming decades. That means higher income and a rapid pace of urbanization – themes already in play and boosting the P&L of India’s consumer giants. It’s still early days in the growth story as well, so consumer stocks have a particularly attractive runway ahead of them to capitalize on a proliferating ‘consumer culture’ backed by one of the highest disposable income growth rates in the world.

While the long-term consumer theme is as attractive as ever, the near-term setup has been challenged by inflationary pressures that have weighed on the purchasing power of consumers, particularly in rural areas. Yet, the urban consumer has picked up the slack this year, and as a result, large-cap consumer names have defied the rural headwinds this year. Many of INCO’s consumer franchises have also added to this growth by gaining further share across new markets and categories. So with rural, helped by normalizing inflation and fiscal support, finally set to catch up next year, consumer names are well-positioned on the revenue side. Similarly, easing commodity inflation should also continue to flow through to margins, supporting overall earnings growth. On balance, I remain upbeat about INCO ahead of election season early next year.

Columbia India Consumer ETF Overview – A More Cyclical Blue-Chip Consumer Portfolio

The Columbia Threadneedle-managed India Consumer ETF tracks (pre-expenses) the total return performance of the Indian consumer sector (staples and discretionary) via the free-float adjusted, market cap-weighted Indxx India Consumer Index. The index stipulates a stock selection criteria based on the following - minimum market capitalization ($100m), liquidity (traded on >90% of trading days over the last six months) and concentration (<4.9% per single-stock holding) requirements. The portfolio follows an annual reconstitution and rebalancing schedule.

Despite a great run this year, INCO maintains a relatively competitive ~0.8% expense ratio (0.77% gross; 0.75% net of fee waivers) – only just above broad-based single-country India trackers like the iShares MSCI India ETF (INDA). That said, liquidity is more of an issue here, as reflected in INCO’s wider median bid-ask spread of 0.19% (vs. 0.02% for INDA) and the tendency of its market price to deviate slightly from underlying NAV. Hence, investors should mind the execution risks here, especially if moving large volumes.

Broadly speaking, the INCO sector allocation has shifted even further toward consumer discretionary in Q4 at 59.2% (up from ~55% previously). This leaves a smaller 40.8% for staples, in turn, increasing the fund’s overall cyclicality.

Zooming in, the industry composition has similarly become more concentrated at the top – Automobiles, generally the largest INCO exposure, now contribute 31.8%. In contrast, Food Products and Personal Products have ceded portfolio share at 16.0% and 10.2%, respectively. Automobile Components is unchanged at 7.5%, while Hotels, Restaurants & Leisure is the most notable gainer at 7.4%. Overall, there’s certainly concentration risk from the top five industries (combined ~73% of the INCO portfolio); I would keep a closer eye, though, on the cumulative auto and auto components concentration (up to ~39%).

In line with the industry breakdown, INCO’s 30-stock portfolio also skews toward leading Indian automotives – three manufacturers, Tata Motors (TTM), Bajaj Auto, and Mahindra & Mahindra (MAHMF), occupy the top-five list. Leading jeweler Titan Co Ltd ( TQTQY ) is the other big discretionary holding, while Nestle India ( NSZTY ) leads the staples allocation at 5.1%. While the top-five holdings have overshot the fund’s weightage cap and, as a result, contribute an outsized ~28% of the portfolio, a periodic rebalancing process (due in Q1 next year) should keep the single-stock allocation fairly spread out over time.

Columbia India Consumer ETF Performance – Rally Continues; Multiples Still High

As strongly as Indian funds have performed this year, INCO has nearly all of them beaten, delivering a +26.1% NAV gain year-to-date (+27.3% in market price terms). This outperformance extends over longer timelines as well - since inception in 2011, the fund has now returned an annualized +10.5% (in market price and NAV terms), outstripping broad-based Indian and emerging Asia ETF comparables.

The catch, however, is that INCO has lagged its benchmark Indxx India Consumer Index by a wide margin - reflecting the fund’s persistently wide tracking error. This year, for instance, the delta between the fund's NAV and underlying index performance has reached around five percentage points – far wider than similar large-cap Indian funds and only just narrower than small/mid-cap funds like the iShares MSCI India Small-Cap ETF (SMIN).

To a large extent, this tracking error is a function of the fund’s outperformance. In a bull market, the combination of transaction costs, currency fluctuations, and capital gains taxes have an outsized impact on relative performance. In down years, like in 2022, INCO has kept its tracking error fairly narrow on a fee-adjusted basis. Either way, investors should keep a close eye on the size of this ‘invisible cost’ - a common denominator across all US-listed India ETFs.

INCO now offers a slightly higher trailing distribution yield of ~1%; given most of the yield comes from capital gains rather than income, though, further income upside is likely limited from here. Instead, the reason to own INCO remains growth, as reflected in the portfolio’s seemingly rich valuations (~40x trailing earnings). Relative to the quality of its holdings, many of which offer sustained double-digit % earnings growth runways and high-double-digit % return on equity profiles, there’s still ample room for INCO to grow into its valuations over time.

Keeping the Faith in India’s Consumer Champions

Consumer-focused INCO has always commanded high multiples and at ~40x trailing earnings, this fund certainly isn't for everyone. Relative to underlying fundamentals, however, the valuation is very justifiable – take a category leader like Nestle India, a major INCO component, for which high-double-digit % ROEs are the norm (>100% last year ). Coupled with one of the most compelling consumer earnings growth runway globally, INCO has all the necessary ingredients to grow into its valuation over time.

The near-term setup isn't bad either – growth is up, inflation is down, and job creation is strong, all of which bodes well for disposable incomes. For INCO's blue-chips, there’s ample room for growth within and beyond their categories, while tailwinds from easing commodity prices add further earnings support. Net-net, I still see plenty of upside in consumer-focused INCO ahead of election season early next year.

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