Domestic flows underpin India’s equity valuations

One of the most common pushbacks to the India investment story – from foreign investors – comes from high valuations. While the MSCI India has been trading at a valuation premium to the MSCI Asia-Pacific ex-Japan and MSCI EM for many years, this premium has widened considerably in recent years. India’s superior secular growth outlook and corporate earnings trajectory – relative to peers – only partly explain the expensive valuations. There is an additional and more potent determinant which may not only keep valuations elevated but also insulate Indian equity markets from global market volatility.

A structural and secular surge in domestic equity inflows, led by Indian households and retail investors, is dramatically transforming India’s equity markets, with material implications for investors. In this insight we look at the consequences of this transformation. The single biggest and most visible impact of this unique phenomenon is seen in the performance of the Indian equity market since Covid. Indeed, the MSCI India has been the best performing equity market globally since the end of 2020, with returns surpassing the Nasdaq, S&P 500, MSCI All-World, MSCI EM and MSCI Asia-Pacific ex-Japan indices.

A young, digitally savvy middle class with high aspirations for wealth creation, together with rising internet penetration, and a focused and successful investor education initiative by the Indian Mutual Fund Industry on the virtues of mutual fund investments, have led to a dramatic surge in Indian households’ preference for equities as a legitimate long-term investment option. The average annual domestic flows of USD 12 billion between 2016 and 2020 have jumped to average USD 29 billion from 2021 to 2023. While the ‘equitization’ of Indian savings has been underway since 2015, it accelerated dramatically post-Covid.

The natural question on seeing the large acceleration of domestic inflows and its manifold implications is its durability. Is this trend secular? We believe that unless there is any conscious action by the regulator or the government to dissuade equity flows or if the corporate earnings trajectory shows a marked decline, this trend is still at a nascent stage and will continue. The following reasons underscore why:

1. Despite the surge in mutual fund inflows, the share of mutual funds in total household savings in FY24 stood at only 3.3%.

2. Over the past two years, almost 45% of mutual fund inflows has come from monthly Systematic Investment Plans (SIPs). These are monthly commitments where investors sign up to invest a specified lump sum at monthly intervals in selected domestic mutual funds.

3. The current jump in flows into equities has also come alongside a real-estate price/housing sales boom, underscoring the resilience of equity market inflows.

4. The Indian equity market (Nifty 50 Index) generated a compound annual return of 17% from the beginning of 2021 to the end of April 2024.

These returns exceed those from bank deposits. As long as the differential between equity market returns and bank deposits remains wide, and there is no market correction that makes retail investors nervous, we see a low risk of the great Indian ‘equitization’ of savings reversing.

The secular rise of domestic equity inflows has created many virtuous factors, which foreign investors investing in the Indian market need to be aware of. These are:

As a result of the surge in domestic inflows, total liquidity in Indian markets has risen dramatically. Rising investor interest in India is forming a virtuous cycle of liquidity, sell-side coverage, investor participation, capital issuance and most importantly, promoters diluting their stakes to capitalize on the high valuations. These developments have resulted in India’s weight in both the MSCI EM and MSCI Asia-Pacific ex-Japan rising sharply over the past few years.

The surging liquidity from domestic inflows has resulted in a widening of India’s valuation premium, which has caused considerable angst to foreign investors. It is important to note that domestic investors have not reined in their investments, despite the higher valuations. In fact, as we show above, domestic investor inflows have been resilient over the past few years, which have seen India’s valuations expand.

One of the most unique aspects of the surging retail and domestic inflows has been their direction towards small and mid-cap companies. The domestic investor has shown an avowed preference for small and mid-cap companies or funds. This is reflected in the MSCI Small-Cap index outperforming MSCI India by 69%, while the MSCI Mid-Cap has outperformed MSCI India by 23%.

The sharp skew in the composition of total market inflows from domestic investors has resulted in a steep decline in India’s correlation with global indices. The domestic investor is insulating Indian equity markets from global macro developments. Indeed, this development coupled with the increasing size of the Indian equity market and rising volumes is leading to many investors arguing for a standalone allocation for India, rather than investing via exposure to broad emerging markets strategies or the Asia-Pacific benchmark.