The India Premium
22nd January 2022 - Bytes - White Oak
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India has historically traded at premium multiples compared to other emerging markets. On Price to Earnings (P/E) multiple, currently it is trading at ~80% premium based on consensus estimates. India certainly has been, and is projected to be, amongst the fastest growing EMs (20-year growth: 7.0% real GDP). But GDP growth or even earnings growth, in and of itself, does not warrant a premium multiple or deliver higher returns. For instance, China has grown at a faster rate (20-year growth: 9.0% real GDP) for a long period of time and yet has consistently traded at a discount and its equity market has underperformed that of India over long time periods measured in decades. 

This is not different from what is observed for relative multiples of individual company valuations. As we all know, in any sector or country, the company with fastest growing sales or profits does not necessarily merit the highest multiple. In fact, other factors such as corporate governance and quality of underlying assets usually are the dominating factors in affecting multiples. It should not be surprising then if the same is true for the overall market multiple across countries. In this year’s newsletter, we discuss why India has deservedly traded at a premium because of superior country level governance and underlying asset mix. 

Governance Factor

To state the obvious, the value of any country’s equity market is the sum of the value of its constituent companies, which in turn is the present value of future cash flows of these companies. By investing in a company’s equity shares an investor is effectively buying the proportionate rights to its equity cash flowsinto perpetuity.

Where corporate governance is poor, there is a significant risk that cash flows would be diverted by controlling shareholders to the detriment of minority shareholders. As a result, the assumption of minority shareholders having a proportionate right to such a company’s cashflows is weakened. Not surprising then that such companies trade at discounted multiples compared to its better governed peers. Weaker the governance, the greater the discount. 

By logical extension, shareholder rights to the perpetual cash flows of equities would be more valuable in jurisdictions where
such contractual property rights are less prone to be challenged by other parties, including the authorities, and if challenged, there exists an institutional framework that provides fair protection to the holder of such rights (equity shareholders).

Countries with strong democracies generally have wellestablished independent institutions such as the Judiciary, the Central Bank, and the Election Commission, among others. Constitutionally there exists a separation of powers between  these institutions and the executive branch of the government of democratic countries. In well functioning democracies, separation of powers amongst these independent institutions and the executive branch of the government is not only enshrined in the constitution but is also operational in practice. Such institutional framework can be thought of as the soft infrastructure of a country, which is essential to upholding property rights as well as maintaining economic and political stability

 

While such soft infrastructure is taken for granted in the developed democracies of the West, it is in varying degrees of  evolution in emerging markets. In our view, India is a more  mature democracy compared to most other EMs and it scores well ahead of its EM peers on this crucially important soft infrastructure.

India exhibits a more robust institutional infrastructure, in many respects befitting of a developed democracy, with independent
Judiciary, Central Bank and Election Commission. There exists strong protection for property rights under the Common Law
system, and institutional checks and balances ensure accountability of the government. This feature is best exemplified by BTI’s “Separation of Powers” score, where India ranks highly among EM peers, as illustrated in Exhibit 1.

Exhibit 1: A robust system of checks and balances in India

Source: Transformation Index of the Bertelsmann Stiftung 2020 Note: The question in the survey refers to basic configuration and operation of the separation of powers (institutional differentiation, division of labor according to functions and, most significantly, checks and balances). A higher score suggests there is a clear separation of power with mutual checks and balances.

 

In the absence of adequate separation of powers in authoritarian regimes, corporates and investors are exposed to a much higher risk of abrupt and arbitrary policy actions. Recently we saw regulatory crackdown on certain companies and industries, and a general heavy-handed approach to dealing with businesses in one such economy. In certain resource dependent EMs there have been instances of expropriation of assets in the past. In many countries, foreign institutions and investors, particularly minority shareholders, have little recourse to appeal for the protection of their property rights.

It is not to say that there have been no disagreements between authorities and investors in India. But what is different from many other jurisdictions is that corporates and investors, domestic or foreign, can expect fair hearing under the country’s laws. A case in point is the tax dispute between Vodafone and Indian tax authorities in which India’s Supreme Court had ruled in favour of Vodafone. There are very few other emerging markets where foreign companies or investors can file a lawsuit against the government, and not only expect a fair trial from the domestic court but also continue to operate in the country without any fear of vindictive repercussions.

Adequate institutional checks and balances have also given India the unique distinction of being among the few EMs with no instance of a currency crisis, sovereign default or political coup in many decades. Investments in emerging economies are often subject to such risks as shown in Exhibit 2. But the absence of such debacles in India is the result of its robust soft
infrastructure, which in turn reduces the country risk and contributes to its premium multiples.

Exhibit 2: No instance of currency or political crisis in India

Source: Instances of currency crisis and sovereign debt crisis from IMF’s Systemic Banking Crises database; Instances of coups, impeachments and political crisis from (1) Powell and Thyne (Global Instances of Coups from 1950 to 2010: A New Dataset) (2) Center for Systemic Peace 

Includes restructuring 2
Includes attempted coups and impeachments

 

In our view, one of the key reasons why India is consistently rated as one of the most democratic countries is due to the institutional separation of powers and the robustness of its soft infrastructure. As illustrated in Exhibit 3, India’s Net
Democracy score ranks towards the top end of the emerging market peer group. 

Exhibit 3: India’s high Net Democracy Score

To summarise this aspect, governance must and does receive paramount consideration in any robust investing framework. The idea of governance at a country level encompasses numerous strands, each intricately linked to the other; Is it a stable democracy or an authoritarian regime? What is the degree of institutional independence and separation of powers? Is the rule of law and property rights upheld by the judiciary?

The answers to these questions play a dominant role in determining the premium or discount that investors ascribe to different emerging markets. As evidenced by the data of more than twenty years presented in Exhibit 4, the markets in most democratic regimes have consistently traded at a premium to markets in least democratic regimes.

Exhibit 4: Higher PE multiples accorded to democratic countries

Superior Asset Mix: Ownership Profile and Earnings Stability

Even in an individual company, the quality of underlying assets has a large bearing on the relative premium that investors are willing to pay. Similarly, markets where a larger proportion of underlying constituents are deserving of higher multiples, would also at the aggregate market level be expected to have higher multiples.

In the EM context, government vs. private ownership of a company has a huge impact on a company’s multiple. Universally it is observed that government-owned companies (SOEs or PSUs) trade at a fraction of the multiple of their private sector peers.
We believe this is for good reason since, for the SOEs, shareholder value creation is not the primary goal, as is generally
the case for private sector companies. For SOEs, social and political objectives often assume greater priority over investor
interests. Often the cash flows generated may suddenly be appropriated for ad-hoc capital outlays or other initiatives that
might serve the government’s objectives but might not be in the best interests of minority shareholders. 

Over the years as emerging markets have evolved and investors have placed greater emphasis on governance, the valuation differential between private sector peers and SOEs has only widened. Consequently, at a country level, a higher degree of state ownership in equity markets would result in a lower market multiple and vice versa. As shown in Exhibit 5 countries
like Russia and China, which generally trade at lower multiples, also have higher SOE ownership than the EM average of 19%. On
the other hand, SOE ownership in India is one of the lowest at 6%, less than one-third of the EM average.

Exhibit 5: SOE ownership is relatively low in India

Exhibit 6: PE differential in EM universe: SOE vs Private Sector

Besides state ownership, sectoral representation across various EMs is also widely different. As illustrated in Exhibit 7, compared to major EMs, the Indian market has the most heterogeneous composition at a sectoral level, and within that it is the most diverse at company level. For instance, Taiwan’s stock market is  dominated by highly cyclical tech-hardware stocks which make up 69% of the weight with TSMC alone accounting for 37% of the total country index. South Korea is not much different, with technology comprising 41% of the index, and Samsung group  entities across sectors forming 39% of the market. Similarly, in Russia, commodity stocks constitute 60% of the index. In contrast, as evident from the table below, India has the most diversified sector mix with fair representation of most sectors. Unlike most other EMs, no single sector dominates the Indian.

Moreover, India has a well-distributed investible universe of companies by index weights. HHI (Herfindahl–Hirschman Index) is popularly used for measuring the degree of market concentration. It is calculated by summing the squared weights of the constituents. The higher the number, the greater the level of concentration. India has the lowest HHI score amongst all major emerging markets, evidencing the diversity or granularity of the investible universe.

Exhibit 7: Diverse asset mix in India compared to other EMs

Source: Factset, White Oak
Note: Data for Country MSCI IMI Index
Herfindahl–Hirschman Index (HHI) as calculated by Factset provides numerical measure of 
the portfolio concentration in aggregate. This is measured by summing the squared 
weights of the constituent companies of the index. Weights of securities that have the 
same parent entity are consolidated for this metric.

 

Besides high concentration, sectors like tech-hardware, energy, and metals & mining (which dominate many EM indices) are also deeply cyclical in nature. Consequently, the earnings decline for commodity-intensive markets such as Russia and Brazil, and homogenous markets like Taiwan, have been quite acute during past recessions.

On the other hand, India’s diversified corporate mix entails lower exposure to cyclical sectors compared to the EM average. Consequently, as seen from Exhibit 8, India’s corporate earnings have been more resilient during each of the cyclical downturns over the last two decades. In our view, India’s relatively stable earnings profile also contributes towardsits higher multiple. 

Exhibit 8: India’s earnings resilience during downcycles

We wish you and your loved ones a happy and a healthy 2022

 

APPENDIX

About Polity Project Database

The Polity Project database was compiled by Ted Robert Gurr, a Political Science expert. The Polity project database is the most
widely used resource for monitoring regime change and studying the effects of regime authority.
The Democracy or Autocracy Score is based on coding the authority characteristics such as competitiveness of political participation,
the openness and competitiveness of executive recruitment and constraints on the chief executive. Amongst all the large EMs,
India’s tenure as a full democracy is the longest at 68 years

References

1. The Quality of Government Institute Standard Dataset 2021 (University of Gothenburg)
2. Judicial Checks and Balances (Rafael La Porta, Florencio Lo´pez-de-Silanes, Journal of Political Economy) 2004
3. The Evolution of Institutions in India and its Relationship with Economic Growth (Arvind Subramanian, Johns Hopkins
University, 2007) 4. Polity Project (Dataset Users’ Manual, University of Maryland)
5. Transformation Index of the Bertelsmann Stiftung 2020 (Codebook for Country Assessments)
6. Systemic Banking Crises Revisited (Luc Laeven and Fabian Valencia, IMF Working Paper), 2018
7. ‘The Hidden Risks in Emerging Markets’ (Harvard Business Review, 2010) 8. Currency Crises in Emerging Markets (Council on Foreign Relations, 2015)

 


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