EEM - Use SMIN's Small Caps To Profit From India's Sweet Spot

2023-05-09 03:42:01 ET

Summary

• The iShares MSCI India Small-Cap ETF makes for a valid investment as it could appreciate by 19% despite recession risks in the developed world.
• My bullish stance is supported by strong GDP figures, infrastructure investments, reforms undertaken by the Indian government, and India's less correlation with global growth.
• Additionally, the country does not suffer the same geopolitical risks as Chinese equities, which puts it in a sweet spot, thereby justifying its premium valuations relative to emerging markets.
• Also, recent fund flows seem to be indicating that there is a preference for Indian equities over Chinese ones.
• Noteworthily, in India, contrary to the U.S. and defying what we already take for granted, it is small caps that have outperformed their larger peers.

Large caps have traditionally outperformed small caps as shown by the difference in performance between the S&P 500 and the Russell 2000 indexes. However, in India, it is the other way around with the iShares MSCI India Small-Cap ETF ( SMIN ) in the blue chart below largely outperforming the iShares MSCI India ETF ( INDA ) which holds large caps by a whopping 52.8% during the last three years.

This outperformance was delivered in the 2020-2022 period which has been marked by the Covid market crash as well as central banks throughout the world including India tightening monetary policy aggressively , events synonymous with acute market volatility, especially for small stocks. Moreover, since early March, a period that coincided with the start of the banking turmoil in the U.S., there seems to be a resurgence in investors' interest in SMIN as seen by the blue chart steepening upward.

Hence, the objective of this thesis is to assess whether Indian small caps can maintain their edge as the global economic environment gets more uncertain and there are increasing talks of recession as central banks have to think twice before hiking rates to tame inflation in order not to deteriorate liquidity conditions.

Also, for EM (emerging markets) which generally-speaking compete for capital inflows, it is also important to assess whether China's reopening of its economy from the Covid freeze can prove detrimental to India-exposed ETFs in case more money flows toward Chinese growth.

Looking at Fund Flows across EM

In order to verify whether this has actually been the case, I make a comparison of the price performances of SMIN and INDA with the iShares MSCI China ETF ( MCHI ). The result shows that MCHI has beaten its Indian peers by more than 17.7% in the last six months which includes the reopening period. However, the one-month and three-month data show fund flows toward Chinese stocks have not been sustained.

Thus, after getting some traction following the reopening, investors' appetite for Chinese stocks seems to have waned, with the three-year performance showing that Indian equities have historically gained.

Looking at other EM, one of the reasons for India seeing inflows is that the recovery is not going according to plan in South Korea while export orders are significantly down in Taiwan. These countries also export products like semiconductors to China, whose recovery has proved to be uneven up to now. Hence, the Chinese services sector including accommodation and catering recorded nearly 14% YoY growth in the first quarter of 2023 as domestic tourism boomed and there was also uptake in retail and restaurant businesses. On the other hand, the secondary sector constituted by construction and manufacturing grew by only 3.3% signifying that other EM countries like Brazil or South Africa may have to wait before China's commodity imports surge back to pre-pandemic levels.

Hence, Indian equities are in a strong position to benefit from EM woes and are likely to see sustained capital flows, also supported by certain India-specific factors.

The Solid Indian Economic Recovery

First, again in contrast with China, the recovery of the Indian economy coming out of the pandemic was strong with real GDP growth of 6.8% in 2022. During this period, the government also performed structural reforms , namely labor laws, and incentivization of the manufacturing sector through production-linked schemes. Along the same lines, some high-profile privatization moves like for Air India, the national carrier helped to show that India is investor friendly, but there is more, namely in terms of infrastructure.

Second, the government has increased the amount it intends to spend on building roads, airports, electrification, railways, and many other facilities to the tune of $122 billion for the April 2023-April 2024 period, which is something unprecedented and particularly relevant to SMIN, as it is composed of 21% of Industrials and 19.6% of Materials as shown below.

These are two sectors that should directly benefit from infrastructure spending since government-driven building activities involve companies across the board, with small and medium caps also likely to benefit, not only large multinationals.

Pursuing further, with the economy growing, the financial sector which constituted 15.7% of the underlying fund's overall weight as of May 4 remains well positioned, and on top, as per Fitch Ratings , it is healthy in terms of asset quality, capital adequacy ratios, and profitability.

Then there is also Consumer Discretionary which should benefit a country where growth is driven more by internal consumption than exports. This is another factor that differentiates India from the rest of EM and means that its economy's strength is less correlated with global growth and therefore less immune to recession risks in the international major economies. Furthermore, putting things into perspective, while the U.S . and the EU are faced with an economic slowdown and even contraction, India is expected to grow by 5.9% in 2023 and 6.3% in 2024.

Thus, there are plenty of reasons to invest in SMIN, but it is important to get the valuations right.

Valuing SMIN by Comparing it with INDA

Here, the problem is that after a three-year appreciation of 110% compared to less than 10% for the iShares MSCI Emerging Markets ETF ( EEM ), SMIN's valuations have become relatively expensive. Thus, as per Morningstar, it comes with a price-to-earnings ratio of 14.64x which is higher than EEM’s 12.25x , and MCHI’s 11.36x .

This begs the question of whether this year SMIN's holdings can exceed the earnings growth achieved in 2022 in order to deserve better multiples. Well, this is possible given that inflation has dropped to a 15-month low in March compared to last year auguring well for wage inflation and the cost of doing business in general. At the same time, the price of iron ore which is used in construction has fallen below 2022 levels while India is one of the few countries which benefits from cheap Russian oil.

Consequently, the ingredients are here for better corporate profitability in 2023, while government spending also translates into more revenues for industrial and material companies, especially for smaller caps which are faster to catch opportunities as their sizes confer to them the ability to be more nimble than INDA's large caps.

Thus, SMIN deserves better multiples and to come up with an appropriate figure, I make a comparison with INDA which has a higher P/E of 17.39x . Thus assuming a multiple of 17.39x for SMIN, I have a target of $63.17 (17.39/14.64 x 53.18) based on the current share price of $53.18.

This represents a 19% upside which is considerable in this period of high volatility, thereby making it important to stress the risks.

Concentration Risks and India's Sweet Spot

In this respect, as shown in the introductory chart, SMIN's stock, while delivering a better upside over the three years, has been subject to a higher degree of volatility over shorter periods of time. The same has been the case in the U.S. with the Russel 2000 index being more volatile, but unlike India, it has underperformed the S&P 500.

Coming to investing in an uncertain environment, normally investors who choose small caps want higher returns from their investments while accepting a higher tolerance to risks, especially during adverse market conditions. Here, the fact that Indian small caps held by SMIN have outperformed their larger peers held by INDA is noteworthy as it goes against common belief.

Part of the reason is that more than 95% of Indian companies are considered small-caps signifying that the index managers at MSCI have a wider equity base out of which they can choose the best stocks. Secondly, SMIN's lower volatility can also be attributed to its large number of holdings, or 412 compared to only 114 for INDA. Moreover, each individual's stock weight is limited to a maximum of 2% which means lower concentration risks.

For investors, SMIN tracks the MSCI India Small Cap Index and charges fees equivalent to 0.74%.

In conclusion, this thesis has shown that the Indian small-cap equity ETF makes for a valid investment, not only thanks to the economics but also in the context of heightened geopolitical tensions between America and China. Thus, with a history of past disputes along its border with China, India has emerged as a de facto U.S. ally alongside Japan while also having good relationships with Russia. As such, and with its economy growing sustainably, it is in a sweet spot and its equities deserve their valuation premium.

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