PIN - PIN: Ride The Indian Surge Via This Quality-Focused Fund

2023-07-31 03:13:34 ET

Summary

• Buoyed by solid earnings growth and a healthy dose of multiple expansion, Indian equities have outperformed in Q2.
• While there are hurdles near-term, the structural drivers underpinning the long-term Indian thesis remain intact.
• Expectations are high, but the quality-focused Invesco India ETF can still grow into its valuation.

Indian stocks have been on a tear this year, and following the Q2 rally, valuations are now nearing new highs relative to the emerging market universe. While equity inflows have contributed to a large portion of the re-rate, along with the recent fall in yields, strong YoY earnings growth in Q4 FY23/Q1 FY24 has also played a key role in driving consensus estimates higher. The elevated valuation is a concern ahead of potential cyclical headwinds – not only from tighter liquidity conditions and the lagged impact of higher interest rates globally but also from monsoon-related uncertainty through the rest of the year.

Beyond the cyclical slowdown, however, it's hard to bet against the long-term Indian growth story, supported by a 'demographic dividend' and a rapidly growing middle class. In addition to the earnings growth runway, there's also the technical tailwind from a recovery in foreign flows (currently well below pre-COVID levels). On balance, domestic-oriented Indian stock portfolios remain a great way to ride the long-term story, with the Invesco India ETF ( PIN ) standing out for its quality filter.

Fund Overview – A Quality-Focused Portfolio of Indian Large-Caps

The NYSE-listed Invesco India ETF tracks (pre-expenses) the performance of the market cap-weighted FTSE India Quality and Yield Select Index, a group of Indian large-caps (including foreign-listed depositary receipts) in the FTSE India Index. Unlike other passive Indian funds, PIN's constituents are filtered based on quality (profitability and leverage) and yield criteria, with the bottom 10% of stocks excluded from the ETF. The market value of the fund's net assets has risen to ~131m (up from ~$92m in my prior coverage ) at the time of writing, helped by a combination of investor inflows and equity outperformance in recent months. While the fund's expense ratio runs above purely passive alternatives like the iShares MSCI India ETF ( INDA ) and the Franklin FTSE India ETF ( FLIN ), it is in line with comparable quality factor ETFs such as the WisdomTree India Earnings Fund ( EPI ) at ~0.8%.

The fund's sector allocation remains skewed to financials, with information technology still the second-largest exposure despite the recent equity price declines for PIN's main IT services holdings. Energy, materials, and consumer discretionary round up the top-five sectors – unchanged from last quarter. By style, the skew is toward large-cap growth (36.0%) over value (8.1%), though >50% of the portfolio is a blend of both.

Similarly, the single-stock composition is largely in line with last quarter, with conglomerate Reliance Industries still the largest holding at 10.0%. IT services corporation Infosys ( INFY ) has regained the second spot, as HDFC Bank ( HDB ) drops out of the list post-merger. The fund's stakes in Tata Consultancy Services and Hindustan Unilever remain broadly consistent with last quarter. The 169-stock portfolio is also more spread out this quarter, with the top five holdings now down to ~25% of the overall portfolio.

Fund Performance – Near-Term Outperformance Boosts the Overall Track Record

The ETF has further recovered from a sluggish Q1, with a strong Q2 performance driving the YTD return to +7.6% in NAV terms (+8.3% in market price terms). By comparison, the fund's benchmark FTSE India Quality and Yield Select Index has risen +8.7% over the same period. After adjusting for the expense ratio, this implies a low YTD tracking error for PIN as well – a welcome downshift from historically wide levels. Zooming out, this year's outperformance has propped up PIN's overall track record, with the three and five-year NAV returns now higher at +17.6% and +8.3%, respectively. Relative to passive India funds like INDA, PIN's prioritization of quality and yield continues to pay off, as shown by its relative outperformance. Compared to key quality factor India ETF comparable EPI, however, the lower-cost PIN has lagged slightly through the cycles.

Headed for Some Near-Term Turbulence

India has benefited from an ideal micro-macro setup in the last few months, with growth surprising to the upside and inflation to the downside. More recently, economic data releases have continued to show a resilient backdrop - core inflation again moderated in June, while industrial production and leading PMI indicators pointed to more underlying strength. Things could change in the back half, though, as India grapples with an uneven monsoon that could temporarily lead to supply-driven food price shocks. With El Nino adding to supply headwinds throughout the Asian region, expect headline consumer inflation to run slightly higher than the central bank's ~5% forecast. I don't expect any change to the policy rate path this year, though, given the ample stockpile and pre-emptive government measures (e.g., the recent rice export ban). But given consensus rate cut estimates have moved forward to Q1 2024, a food price shock does risk a delayed monetary policy pivot and, by extension, valuation pressure.

Thus far, India's earnings season has been shaping up well - quarterly results for the major consumer goods players have stood out, and more importantly, management commentary indicates a rural recovery is finally gaining momentum. As rural inflation continues to decline into next year, while agriculture GDP growth drives improved rural wages (in real terms), the path is clear for a return to pre-COVID levels. Another key catalyst will be government rural spending ahead of the election cycle (state elections in H2, general election next year). So assuming no lasting monsoon shock, expect consumer earnings to gain traction over the coming years, supported by structural demand tailwinds (India's rising middle class) and margin expansion from declining commodity prices. Alongside healthy loan growth for banks (vs. benign asset quality) and similar P&L tailwinds for materials (strong pricing vs. declining commodity and fuel costs), there's plenty here to offset any external headwinds.

Ride the Indian Surge via This Quality-Focused Fund

Following a massive re-rating for Indian large caps in Q2, the risk/reward isn't skewed as favorably as it was at the start of the year. On the one hand, India offers some of the highest corporate earnings growth in the emerging market universe; yet, valuations have also reset higher, supported by foreign inflows and a fall in sovereign yields. While the PIN fund's ~21x fwd P/E might seem demanding at first glance, compared to a high teens % ROE and consensus estimates of >20% earnings growth this calendar year (mid-teens % next year), there remains ample room to grow into its valuation. A continued recovery in foreign inflows (still down on pre-COVID) presents an additional technical tailwind.

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