Beyond headline valuations of emerging benchmarks
While we are all guilty of widely referring to benchmarks for intra-market comparisons, such comparisons often understate or overstate differentials due to vast difference in industry constituents between benchmarks. Markets such as Russia (Energy makes up more than half of the RTS Index), China (Financials make up half of SSE Composite and nearly 70% of its float) and South Africa (Materials make up more than 40% of JSE Top-40) are prime examples of markets whose headline benchmark valuations are mostly not comparable to those of other markets.
Is it fair to view Russia as relatively cheap when fair multiples for Energy names are in single digits?. Similar case can be made for China where banks trade at about 5x C2012E earnings, heavily skewing the benchmark. So, while headline valuation for Korea might suggest that it trades at nearly 30% premium to China, it actually trades about in line with China on a truly comparable basis. It’s a scary situation if Russia or China ever trade at headline multiples that are either “in line” or at a premium vs. others. They shouldn’t. In sharp contrast, we note that nowhere in the major emerging world are sector weights more evenly spread out than in India (It is the only major emerging market where top 3 sectors still don’t account for >60% of the benchmark). Nonetheless, we can’t reconcile underlying fundamentals with Nifty’s current 100%+ premium over the Russian RTS index. By our estimate, strictly based on absolutes, India’s Nifty (ex-financials) shouldn’t trade at more than 50% premium over Russia’s RTS (ex-financials)[1]. When viewing broader market valuations, we prefer to adjust free-float weighted benchmarks to make them comparable (see Exhibit 1a, which shows C2012E valuations for major emerging market benchmarks – As reported AND By using Nifty weights).
To be clear, the purpose of Nifty’s comparison with Russia’s RTS, which sports the lowest multiple among all major emerging markets, wasn’t to make India’s Nifty look pricier than it is. While one can make a case for absolute upsides across most major emerging markets, India’s relative valuation for benchmark constituents is unquestionably steep across most sectors, with Consumer Staples in particular (ITC and Unilever) being extremely rich (see Exhibit 1b, which charts headline multiple differentials for Nifty sectors vs. peers in other major emerging markets). While emerging markets continue to look more attractive vs. NA and Western Europe (in absolute terms), India’s relative run-up vs. other emerging markets makes Nifty constituents not quite as “relatively” attractive vs. other emerging market peers and several selected domestic small and mid-cap names. The latter is also an area that we continue to monitor closely and where we have selectively built exposure.
While it is quite clear that most Nifty constituents trade at a significant premium to their emerging market peers, we would stress the following 2 points:
Indian Consumer Staples and Private-sector banks show little signs of cracking on thin ice. As of the end of September, more than 3/4th of all Indian sell-side analysts still had a “Buy” recommendation on ITC, when the most
bullish analyst on the name was suggesting barely low-teens incremental upside. The rationale behind such opinions is completely lost on us. In certain other groups such as Financials, we see a massive dichotomy (private sector banks account for more than 80% of Financials weight within Nifty) – While India’s private sector banks are by far the most expensive in the world (even more expensive on a comparable basis than Consumer Staples), state-owned banks within Nifty trade about in line with their state-owned peers elsewhere (mid-cap state-owned banks are among the cheapest in the world). It is quite apparent that capital requirements at most state-owned banks will need to be beefed up in order to comply with Basel III. Nonetheless, in many such cases, even stress-tested ROEs are not at levels that can support their valuations to be in line or below the murky balance sheets of Chinese state-owned banks.
Case of 2 Indias. Nifty has never been less representative of India’s broader market valuations than it is today. On a truly comparable basis[1], Nifty closed 3Q12 at a whopping 40%+ premium over domestic mid-cap peers (20%+ premium excluding financials), making it comfortably the highest premium afforded to benchmark constituents anywhere in the world. It is critical to note that even this comparison vs. midcaps understates the true rich valuation of Nifty constituents – We picked the biggest of the midcaps to create a comparable index, and multiples in India drift materially lower with capitalization. With the exception of Bharti Airtel, which is still the most expensive benchmark telecom name in the developing world, nearly all Nifty constituents trade at a premium over comparable mid-cap names, with Financials showing the sharpest differential (see Exhibit 2a)
By our estimate, just as in most other major markets, Indian mid-caps should trade at least in line with Nifty constituents. We estimate that the largest of Indian mid-caps need to “relatively” appreciate by about 25% vs. Nifty in order to simply bring valuations in line with underlying fundamentals (see Exhibit 2b).
Investors should note that while most Nifty constituents trade at a premium to their emerging market peers, nearly all of our long book constituents (small-mid caps) trade at a discount to their global peers, with majority of our names trading at 30%+ discounts to comparable names elsewhere. While we hate to get drawn into precisely forecasting Nifty’s Dec 31st close, we think that there are better than even odds that domestic midcaps and most major emerging market benchmarks would likely outpace Nifty over the new few quarters.
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Piyush Sharma, born and raised in India, is investment manager of the Globe Minerva Fund. Having spent time with Citigroup and Bombay Stock Exchange in India, he moved to United States in 2002, where he covered stocks within Business Services, Autos, Consumer Products and Financials with Sanford Bernstein, Longbow Research and Avondale Partners, working in teams that received accolades by leading institutional research arbiters , including Institutional Investor (II) and Greenwich Associates. Piyush received an MBA from University of North Carolina at Chapel Hill, MS from MNNIT, and BS in Accounting from University of Allahabad. Piyush will be sharing his fundamental views periodically.