Jonathan Pines, Portfolio Manager of the Hermes Asia ex Japan Equity Fund, shared his view on Morningstar U.K. It has been reproduced below.
As contrarian investors, we typically buy stocks that have underperformed the market for a number of months – sometimes quite significantly. We are able to do this because we are truly long-term investors and focus on value, rather than news flow. Our positioning in India is a good example of this.
The Indian stock exchange sold off sharply in August last year, especially in U.S. dollar terms, with the market hit by concerns about the impact of Federal Reserve tapering. We used this sell off as an opportunity to increase our exposure to specific Indian stocks.
But the Indian market has soared in recent months as Modi fever gripped the country, with investors optimistic about the business-friendly new government. From the third quarter of 2013 to the end of June this year, the Sensex index climbed 38% in U.S. dollar terms.
Putting this into context, India now trades at a 39% premium to the region on a price-to-book versus return-on-equity valuation model. Indonesia is valued at the same premium. Only the Philippines is more overvalued, at a 48% premium to the region.
While the new government under Narendra Modi is clearly business friendly, the rise in stock valuations has been broad and indiscriminate. However, decisive reforms are unlikely to rapidly help earnings. And earnings are ultimately the driver of stock prices. Reforms also seldom help all companies equally. Indeed, reforms beneficial to India as a whole might actually be harmful to some companies. The companies that have been hampered the most by bureaucracy, indecision, delays and the status quo will clearly be the major beneficiaries of successfully implemented changes.
Indian listed companies today have among the highest returns on equity in the region. There are likely to be some companies benefitting from the status quo and may suffer in a more competitive environment. It is actually possible the largest beneficiaries of reform are not yet listed.
As there will likely be both winners and losers, a bottom-up approach is best suited to evaluate which companies are likely to benefit most from reforms and to what extent this is already reflected in stock prices.
