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30-05-2024 · Insight

Domestic flows underpin India’s equity valuations

India’s valuation premium to the MSCI Emerging Markets (EM) index is being sustained by inflows from domestic investors, and the trend can continue as long as economic fundamentals are positive.

    Authors

  • Helen Keung - Client Portfolio Manager

    Helen Keung

    Client Portfolio Manager

  • Joshua Crabb - Head of Asia-Pacific Equities

    Joshua Crabb

    Head of Asia-Pacific Equities

  • Abhay Laijawala - Head of Offshore Investments, Canara Robeco

    Abhay Laijawala

    Head of Offshore Investments, Canara Robeco

Summary

  1. India’s savings pool is increasingly being invested in domestic equities

  2. India is outperforming global and EM benchmarks post-Covid

  3. Domestic investors are favoring small and mid-cap stocks

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.

Figure 1: India is outperforming most global markets

Figure 1: India is outperforming most global markets

Source: Bloomberg, data from January 2021 to April 2024.

The rise of the domestic investor

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.

Figure 2: Post-Covid domestic flows (USD billion) have been unprecedented

Figure 2: Post-Covid domestic flows (USD billion) have been unprecedented

Source: Jefferies.

How durable is India’s ‘equitization’ of savings?

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.

Figure 3: The proportion of savings going into the equity market has significant room to grow

Figure 3: The proportion of savings going into the equity market has significant room to grow

Source: RBI, AMFI, Jefferies.

Implications of the surging domestic investor inflows

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:

1. India’s weight in benchmark indices has moved up sharply

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.

Figure 4: India’s index weight is growing fast

Figure 4: India’s index weight is growing fast

Source: MSCI, 31 March 2024.

2. India’s valuation premium has expanded

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.

Figure 5: MSCI India trading at a sustained post-Covid premium

Figure 5: MSCI India trading at a sustained post-Covid premium

Source: FactSet, IBES, Goldman Sachs Global Investment Research.

3. Outperformance of small and mid-cap stocks

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%.

4. India’s correlation with global markets has reduced sharply

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.

Figure 6: MSCI India correlations with other EM indices are declining

Figure 6: MSCI India correlations with other EM indices are declining

Source: Goldman Sachs.

Conclusion

We are growth-at-reasonable-price investors and hence we are cognizant of concern over India’s sustained valuation premium over other EM markets. India’s household wealth is growing, more of which is now being invested into equities. We believe that combined with India’s strong economic growth outlook, this has the potential to deliver significant upside, and provides comfort in protecting returns.

To complement our positive macro view, our flexi-cap strategy allows us to invest across the entire market cap spectrum and enables an optimal risk-reward balance. This way, large-cap stocks (typically comprising 65-75% of the portfolio) help to limit large and unexpected drawdowns during periods of excessive market volatility, but as with many domestic investors, we see the most significant source of alpha being generated from lesser-researched small and mid-cap stocks.

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Important information

This information is for informational purposes only and should not be construed as an offer to sell or an invitation to buy any securities or products, nor as investment advice or recommendation. The contents of this document have not been reviewed by the Monetary Authority of Singapore (“MAS”). Robeco Singapore Private Limited holds a capital markets services license for fund management issued by the MAS and is subject to certain clientele restrictions under such license. An investment will involve a high degree of risk, and you should consider carefully whether an investment is suitable for you.