With concerns about the election results and policy continuity diminishing, the primary question for the Indian market now is: when will foreign investors return in a meaningful way?
Ridham Desai, Managing Director and Chief Equity Strategist for India at Morgan Stanley, explained why foreign funds are currently staying away and when they might return in an exclusive interaction with CNBC-TV18 from the sidelines of the Morgan Stanley India Investment Forum.
Desai identified four key reasons keeping Global Emerging Markets (GEM) funds away from the Indian market: valuation concerns, a significant increase in India's weight in the emerging market (EM) index, persistent inflows from domestic funds, and a general slowdown in EM fund flows due to uncertainty about China.
Monthly FPI/FII Net Investments
Source: CDSL
Despite India’s strong growth prospects and potential for 20% compounded corporate earnings growth over the next 4-5 years, some GEM funds remain ‘underweight’ on India due to high valuations.
More importantly, fund managers have been struggling to keep pace with the sharp increase in India’s weight in the EM index, which has risen to 17% now from 8% pre-Covid.
For GEM funds to turn ‘overweight’ on India, they would need to invest a staggering $50 billion. The largest inflow that foreign portfolio investors (FPIs) have put into India over a 12-month rolling period is about $35 billion.
Another key factor is the surge of domestic fund inflows. If domestic funds do not invest $100-150 million daily, they accumulate substantial cash reserves from these persistent inflows.
“In the market, there are only two cohorts: domestic investors and foreign investors. You only get a trade if one is selling and one is buying, so obviously foreigners end up selling,” Desai explained.
However, he expects this trend to reverse in the second half of the year as the third cohort—corporate issuers—becomes more active. “I expect a deluge of primary deals in the next several months and that will allow foreigners to start buying in the second half of the year,” he said.
Desai believes a 21 times headline price to earning (P/E) multiple is currently masking the attractiveness of the Indian markets which is only halfway through an upcycle. "There's a long way to go before the earnings peak out."
If you go to the previous bull market, the Nifty at the peak traded at 33 times earnings. And earnings was around 7% of the GDP (gross domestic product). This time, the profits to GDP will go to 10%.
"History suggests that there's more room for this P/E to go up," he noted.
Desai also highlighted sectors that still have value and can be looked at from a longer term investment perspective.
Q. When will foreigners return? We had the EPFR representative with us earlier. He was saying that dedicated India funds are still getting a lot of inflows. It is the GEM funds where there is reluctance. But what matters for us is at a net level, we get money in. When will that tide turn according to you?
A. So, it's a little complicated actually, there are multiple moving parts. So firstly, EM as an asset class, especially because of China is on the back foot, so it's actually the least preferred equity market in our global pecking order, and I think that's also reflected in the flows, so if EM as a whole is not receiving inflow, it is hard for India to receive inflow, so that's the first point. Now having said that, when we do the calculations, we find out that fund managers with GEMS mandate, Global Emerging Market, are slightly underweight India, so ideally they should have been overweight because India is persistently a big outperformer in an EM context, but obviously they have been worried about valuations and therefore they have been waiting for the market to correct, and the market is not obliging, so they remain underweight. India's weight in EM has gone up significantly in the last three years, so we were at around 8% pre-COVID, we're now 17%, and essentially fund managers have not been able to keep pace with the rise in India's weight in the index.
In fact, one of them asked me this question three days ago, that what would it take in terms of money flow for GEMS portfolios on average to be overweight India? The answer is a staggering $50 billion. Now the largest inflow that FBIs have put into India in a 12-month rolling period is about $35 billion, so this is a lot of money for them to put. The third is a local reason. We have domestic inflows which just keep rising. Every morning domestic mutual funds have to buy about $100-150 million in stock. If they don't buy for five or six days, suddenly they have close to a billion dollars in cash and more work to do because the inflows don't stop. Now in the market there are only two cohorts, there are the domestic investors and then there are the foreign investors. You can't get a trade if both are buying, you only get a trade if one is selling and one is buying, so obviously foreigners end up selling. This changes in my view as we go into the second half of this year, because the third cohort will get very active, which is the corporate issuer. So I expect a deluge of primary deals in the next several months and that will then allow foreigners to start buying. So if I make a prediction here, it is that FPIs will start buying India in the second half and it's largely because primary issuances will go up, so that creates the space for them to buy.
Q. Let's focus a little bit on the domestic money. We're just scratching the surface in terms of the number of Demat accounts as well. But what if there is some kind of curb that's put on the retail participation in the F&O market? Do you think it will sour sentiment or do you think the investor that's putting this SIP (systematic investment plan) is very different and will not have much of an impact?
A. SIP numbers have withstood a fair number of events over the last few years and they only keep going up. See the story started in 2015 when the Prime Minister allowed provident funds to invest in Indian equities. This was very similar to what had happened in America in 1980 when 401k plans were allowed by President Reagan to invest in equities. What you got then in the US was a 20-year bull run which ended with the Nasdaq bubble. Domestic households in America were buyers all along the way, even during the 1987 crash when the Dow was down 22% in a single day. So they became very resilient. Similar thing is happening in India with two differences. One is the starting point of equity ownership on household balance sheet is very low. I estimate it's about 7-8%. It's gone up from say 5%. So it's still only in single digits. In the US, that number even today is about 40%. And then the second thing is the demographics. When we entered the millennium, America had already started aging. Baby boomers started retiring and withdrawing their equity savings. In India, that doesn't happen for the next 20-30 years. So we have a lot of legs to go on this. At some point in time, it's quite possible that the limit on provident funds and NPS (National Pension Scheme), which is currently pegged at 15% of incremental flows into equities could be raised to 25%. The last nine years have been very sweet for them. They've been able to deliver good returns to their subscribers and it's largely because of the equity returns that they are getting. So I don't see the domestic bid going away on a structural basis. There could be cyclical ups and downs, but the structural bid is here to stay.
Q. Let’s talk investable ideas. You expect 15-16% earnings growth to continue for the the market. You said a lot of the money is on the sidelines because of valuation. So where is it that you find pockets of value and where do you think things are overheated?
A. That number is actually 20%, not 15-16%. And there's a big difference between 15 and 20. We are in a market where earnings are likely compounding at 20% for the next four or five years and that makes the market cheap. A 21 times headline multiple is masking the attractiveness of the Indian markets because we are in an up cycle for growth. And I think we're just about halfway through this cycle. So there's a long way to go before the earnings peak out. And what happens is that in a bull market, the earnings and the multiples both peak almost simultaneously. If you go to the previous bull market, the Nifty at the peak traded at 33 times earnings. And earnings as a percentage of GDP was at 7%. This time I think profits to GDP will go to 10%. I'm not going to predict where the PE multiple goes, but history suggests that there's more room for this PE to go up. So in terms of returns, this bull market is a long way to go.
On the second part of your question on value, it is not about low PE (price to earning) and low price to book. That's a very lazy way of assessing value. Value is when you can buy future cash flows at a rate which is better than your expected rate of return. When you discount it by your expected rate of return, you get a number which is the share price which is above the current share price. So that's value. And I see a lot of value in the market. I see value in many places. Just to highlight a few, I see that in private banks. I think we are in a very sweet cycle. Margins have dropped. Growth at the credit level remains quite robust. And the credit costs are not coming back in a hurry. And the stocks represent very good value. I see value in consumer discretionary, like autos, auto parts, retail, a slew of businesses that benefit from discretionary spends by consumers. I see some value in industrials, not all across the board. Industrials is probably the more tricky sector because the growth there will be stupendous, but some stocks are trading at levels which may be discounting most of that growth. So we have to be careful about making a ubiquitous call on industrials. I see value in IT services. The US cycle is looking up, and IT services stocks look quite attractive. So there's a lot of value everywhere. Where there is limited value is in consumer staples. I don't think those stocks have the same earnings upside that the rest of the consumption space has. So I would be a little cautious there. We have to be very selective in health care. Value is not there across the board. And likewise in global commodities, where we have to be a bit more cautious.
Q. So if the thesis is right, if you stretch the time horizons long enough, most things will do well, right? You've got to be prudent, and they'll do well in waves, and something will go up first, and then something else. So my question now is, what's right ahead of us in that sense? And where is the government focus and thrust likely to be? Some suggest there will be a concerted push now to help consumer demand pick up. There is a report talking about a Somanathan plan to increase money in the hands of retired government servants, may be go back to what the old pension scheme gave. And there is so much more which is being talked about. What is your sense on important thrust areas from a market-sensitive point of view?
A. I don't think it's the instinct of this government to redistribute taxes in the form of cash in the hands of people. That's fueling inflation. And over the last ten years we have worked very hard to earn macro stability. And that is the basis of this economic cycle. It's the basis of how India's external deficit has contracted. It's why inflation volatility is at all-time lows. A lot of the gains that we have accrued is largely because of this government's incessant focus on macro stability. As I have repeatedly said, the Prime Minister is an inflation hawk, and it doesn't serve the purpose of controlling inflation and its volatility by distributing cash into the hands of people. So, building social infrastructure is the way forward. We've already heard about housing, and there are a lot of projects.
Q. Is it possible to redirect some of this within the confines of being fiscally prudent to doing what I said, which is supporting consumption at the mass end?
A. The best way to do it is to fuel an investment cycle. Investments gets jobs back, jobs get cash flows back, cash flow gets consumption back. It's the right way to do it, and that's the way the government will do it. And what we will see in the budget is a reiteration of the transition from government spend to private sector spending. The government is going to take a step back. It did a lot of heavy lifting during COVID. I think we are heading into a primary balance. We'll be the only country in the top 15 nations in the world with a primary balance, which is hyper bullish for stocks. So it's going to come via the investment cycle, and that's how we'll filter down into better consumption. I think we will see a big change in the July budget as compared to the interim budget, because some of what you said, which is the government holding back, we saw that, right? In terms of the spends allocated in the BE numbers, the estimates on roads and so many other areas, defence and the percentage increase in FY25 BE was much smaller as compared to what we've seen over the last couple of years. And the argument back then was that the government can only do so much. The private sector needs to step in.
Q. So will we see something very different in this full budget?
A. Yeah, the difference between February and July is that the government has an additional 50 basis points in its pocket, because what was not in the interim budget was the 30 basis points of extra dividends that the RBI gave. And if you recall, the interim budget was on the basis that the fiscal deficit will be at 5.8% for FY24. That's actually come in at 5.6% now. So 20 plus 30, that's an extra 50 basis points to play around with. I think the overall fiscal consolidation will be ballpark around the same number, which is around, say, 5%. And then you have an extra 30, 40 basis points to decide where to allocate. That's a lot of money by the way. So the government does have some flexibility in the current fiscal year to spend a bit more than what was there in the interim. A lot of that spending will be targeted towards investments. I would highlight railways very especially. We wrote a very detailed report on this one month ago. That's going to occupy top attention of government spends. There could be, as we discussed, mass housing. And then renewable energy. That's another area which will attract a lot of attention. So maybe if I were to single out three sectors, these are the three sectors. Maybe there's a rejig on PLIs. So sectors such as defence, aerospace, food processing, lab group diamonds, these may actually get revised PLI plans.
Q. Final question. Things are looking up for India. We're in a bit of a Goldilocks scenario, which is great news. What are the risks then? Crude has been fairly well behaved, which is good for us, irrespective of how other commodities have played up. A couple of risks that you'll be tracking and a quick comment on crude being well behaved?
A. Yes, from a risk perspective, we have to be careful about global growth because India is trying to increase its engagement with the rest of the world. So if global growth doesn't fare well, it does put India back. I would worry about China's deflations because Chinese deflation creates greater competition for Indian companies trying to sell abroad. And that could be a very important threat. China's currency could be depreciating, which could make us less competitive versus China. We have to worry about the capacity constraints that we have. There's still a lot of supply side work that has to be done for us to sustain higher growth rates in the judiciary, in bureaucracy, in education, in skilling, in health. And on oil, the math has changed for India. The intensity of oil to GDP has halved in the last six, seven years. So we are less sensitive to oil. But if oil went up $30 or $40 all of a sudden, it would create near-term pain. But otherwise, oil is a lesser concern for us than in the past.
Ridham Desai, Managing Director and Chief Equity Strategist for India at Morgan Stanley, explained why foreign funds are currently staying away and when they might return in an exclusive interaction with CNBC-TV18 from the sidelines of the Morgan Stanley India Investment Forum.
Desai identified four key reasons keeping Global Emerging Markets (GEM) funds away from the Indian market: valuation concerns, a significant increase in India's weight in the emerging market (EM) index, persistent inflows from domestic funds, and a general slowdown in EM fund flows due to uncertainty about China.
Monthly FPI/FII Net Investments
| Calendar year 2024 | Equity (Rs Cr) |
| January | -25743.55 |
| February | 1538.88 |
| March | 35098.32 |
| April | -8671.27 |
| May | -25586.33 |
| June | -6570.53 |
| Total | -29934.48 |
Source: CDSL
Despite India’s strong growth prospects and potential for 20% compounded corporate earnings growth over the next 4-5 years, some GEM funds remain ‘underweight’ on India due to high valuations.
More importantly, fund managers have been struggling to keep pace with the sharp increase in India’s weight in the EM index, which has risen to 17% now from 8% pre-Covid.
For GEM funds to turn ‘overweight’ on India, they would need to invest a staggering $50 billion. The largest inflow that foreign portfolio investors (FPIs) have put into India over a 12-month rolling period is about $35 billion.
Another key factor is the surge of domestic fund inflows. If domestic funds do not invest $100-150 million daily, they accumulate substantial cash reserves from these persistent inflows.
“In the market, there are only two cohorts: domestic investors and foreign investors. You only get a trade if one is selling and one is buying, so obviously foreigners end up selling,” Desai explained.
However, he expects this trend to reverse in the second half of the year as the third cohort—corporate issuers—becomes more active. “I expect a deluge of primary deals in the next several months and that will allow foreigners to start buying in the second half of the year,” he said.
Desai believes a 21 times headline price to earning (P/E) multiple is currently masking the attractiveness of the Indian markets which is only halfway through an upcycle. "There's a long way to go before the earnings peak out."
If you go to the previous bull market, the Nifty at the peak traded at 33 times earnings. And earnings was around 7% of the GDP (gross domestic product). This time, the profits to GDP will go to 10%.
"History suggests that there's more room for this P/E to go up," he noted.
Desai also highlighted sectors that still have value and can be looked at from a longer term investment perspective.
These are the edited excerpts of the interview.
Q. When will foreigners return? We had the EPFR representative with us earlier. He was saying that dedicated India funds are still getting a lot of inflows. It is the GEM funds where there is reluctance. But what matters for us is at a net level, we get money in. When will that tide turn according to you?
A. So, it's a little complicated actually, there are multiple moving parts. So firstly, EM as an asset class, especially because of China is on the back foot, so it's actually the least preferred equity market in our global pecking order, and I think that's also reflected in the flows, so if EM as a whole is not receiving inflow, it is hard for India to receive inflow, so that's the first point. Now having said that, when we do the calculations, we find out that fund managers with GEMS mandate, Global Emerging Market, are slightly underweight India, so ideally they should have been overweight because India is persistently a big outperformer in an EM context, but obviously they have been worried about valuations and therefore they have been waiting for the market to correct, and the market is not obliging, so they remain underweight. India's weight in EM has gone up significantly in the last three years, so we were at around 8% pre-COVID, we're now 17%, and essentially fund managers have not been able to keep pace with the rise in India's weight in the index.
In fact, one of them asked me this question three days ago, that what would it take in terms of money flow for GEMS portfolios on average to be overweight India? The answer is a staggering $50 billion. Now the largest inflow that FBIs have put into India in a 12-month rolling period is about $35 billion, so this is a lot of money for them to put. The third is a local reason. We have domestic inflows which just keep rising. Every morning domestic mutual funds have to buy about $100-150 million in stock. If they don't buy for five or six days, suddenly they have close to a billion dollars in cash and more work to do because the inflows don't stop. Now in the market there are only two cohorts, there are the domestic investors and then there are the foreign investors. You can't get a trade if both are buying, you only get a trade if one is selling and one is buying, so obviously foreigners end up selling. This changes in my view as we go into the second half of this year, because the third cohort will get very active, which is the corporate issuer. So I expect a deluge of primary deals in the next several months and that will then allow foreigners to start buying. So if I make a prediction here, it is that FPIs will start buying India in the second half and it's largely because primary issuances will go up, so that creates the space for them to buy.
Q. Let's focus a little bit on the domestic money. We're just scratching the surface in terms of the number of Demat accounts as well. But what if there is some kind of curb that's put on the retail participation in the F&O market? Do you think it will sour sentiment or do you think the investor that's putting this SIP (systematic investment plan) is very different and will not have much of an impact?
A. SIP numbers have withstood a fair number of events over the last few years and they only keep going up. See the story started in 2015 when the Prime Minister allowed provident funds to invest in Indian equities. This was very similar to what had happened in America in 1980 when 401k plans were allowed by President Reagan to invest in equities. What you got then in the US was a 20-year bull run which ended with the Nasdaq bubble. Domestic households in America were buyers all along the way, even during the 1987 crash when the Dow was down 22% in a single day. So they became very resilient. Similar thing is happening in India with two differences. One is the starting point of equity ownership on household balance sheet is very low. I estimate it's about 7-8%. It's gone up from say 5%. So it's still only in single digits. In the US, that number even today is about 40%. And then the second thing is the demographics. When we entered the millennium, America had already started aging. Baby boomers started retiring and withdrawing their equity savings. In India, that doesn't happen for the next 20-30 years. So we have a lot of legs to go on this. At some point in time, it's quite possible that the limit on provident funds and NPS (National Pension Scheme), which is currently pegged at 15% of incremental flows into equities could be raised to 25%. The last nine years have been very sweet for them. They've been able to deliver good returns to their subscribers and it's largely because of the equity returns that they are getting. So I don't see the domestic bid going away on a structural basis. There could be cyclical ups and downs, but the structural bid is here to stay.
Q. Let’s talk investable ideas. You expect 15-16% earnings growth to continue for the the market. You said a lot of the money is on the sidelines because of valuation. So where is it that you find pockets of value and where do you think things are overheated?
A. That number is actually 20%, not 15-16%. And there's a big difference between 15 and 20. We are in a market where earnings are likely compounding at 20% for the next four or five years and that makes the market cheap. A 21 times headline multiple is masking the attractiveness of the Indian markets because we are in an up cycle for growth. And I think we're just about halfway through this cycle. So there's a long way to go before the earnings peak out. And what happens is that in a bull market, the earnings and the multiples both peak almost simultaneously. If you go to the previous bull market, the Nifty at the peak traded at 33 times earnings. And earnings as a percentage of GDP was at 7%. This time I think profits to GDP will go to 10%. I'm not going to predict where the PE multiple goes, but history suggests that there's more room for this PE to go up. So in terms of returns, this bull market is a long way to go.
On the second part of your question on value, it is not about low PE (price to earning) and low price to book. That's a very lazy way of assessing value. Value is when you can buy future cash flows at a rate which is better than your expected rate of return. When you discount it by your expected rate of return, you get a number which is the share price which is above the current share price. So that's value. And I see a lot of value in the market. I see value in many places. Just to highlight a few, I see that in private banks. I think we are in a very sweet cycle. Margins have dropped. Growth at the credit level remains quite robust. And the credit costs are not coming back in a hurry. And the stocks represent very good value. I see value in consumer discretionary, like autos, auto parts, retail, a slew of businesses that benefit from discretionary spends by consumers. I see some value in industrials, not all across the board. Industrials is probably the more tricky sector because the growth there will be stupendous, but some stocks are trading at levels which may be discounting most of that growth. So we have to be careful about making a ubiquitous call on industrials. I see value in IT services. The US cycle is looking up, and IT services stocks look quite attractive. So there's a lot of value everywhere. Where there is limited value is in consumer staples. I don't think those stocks have the same earnings upside that the rest of the consumption space has. So I would be a little cautious there. We have to be very selective in health care. Value is not there across the board. And likewise in global commodities, where we have to be a bit more cautious.
Q. So if the thesis is right, if you stretch the time horizons long enough, most things will do well, right? You've got to be prudent, and they'll do well in waves, and something will go up first, and then something else. So my question now is, what's right ahead of us in that sense? And where is the government focus and thrust likely to be? Some suggest there will be a concerted push now to help consumer demand pick up. There is a report talking about a Somanathan plan to increase money in the hands of retired government servants, may be go back to what the old pension scheme gave. And there is so much more which is being talked about. What is your sense on important thrust areas from a market-sensitive point of view?
A. I don't think it's the instinct of this government to redistribute taxes in the form of cash in the hands of people. That's fueling inflation. And over the last ten years we have worked very hard to earn macro stability. And that is the basis of this economic cycle. It's the basis of how India's external deficit has contracted. It's why inflation volatility is at all-time lows. A lot of the gains that we have accrued is largely because of this government's incessant focus on macro stability. As I have repeatedly said, the Prime Minister is an inflation hawk, and it doesn't serve the purpose of controlling inflation and its volatility by distributing cash into the hands of people. So, building social infrastructure is the way forward. We've already heard about housing, and there are a lot of projects.
Q. Is it possible to redirect some of this within the confines of being fiscally prudent to doing what I said, which is supporting consumption at the mass end?
A. The best way to do it is to fuel an investment cycle. Investments gets jobs back, jobs get cash flows back, cash flow gets consumption back. It's the right way to do it, and that's the way the government will do it. And what we will see in the budget is a reiteration of the transition from government spend to private sector spending. The government is going to take a step back. It did a lot of heavy lifting during COVID. I think we are heading into a primary balance. We'll be the only country in the top 15 nations in the world with a primary balance, which is hyper bullish for stocks. So it's going to come via the investment cycle, and that's how we'll filter down into better consumption. I think we will see a big change in the July budget as compared to the interim budget, because some of what you said, which is the government holding back, we saw that, right? In terms of the spends allocated in the BE numbers, the estimates on roads and so many other areas, defence and the percentage increase in FY25 BE was much smaller as compared to what we've seen over the last couple of years. And the argument back then was that the government can only do so much. The private sector needs to step in.
Q. So will we see something very different in this full budget?
A. Yeah, the difference between February and July is that the government has an additional 50 basis points in its pocket, because what was not in the interim budget was the 30 basis points of extra dividends that the RBI gave. And if you recall, the interim budget was on the basis that the fiscal deficit will be at 5.8% for FY24. That's actually come in at 5.6% now. So 20 plus 30, that's an extra 50 basis points to play around with. I think the overall fiscal consolidation will be ballpark around the same number, which is around, say, 5%. And then you have an extra 30, 40 basis points to decide where to allocate. That's a lot of money by the way. So the government does have some flexibility in the current fiscal year to spend a bit more than what was there in the interim. A lot of that spending will be targeted towards investments. I would highlight railways very especially. We wrote a very detailed report on this one month ago. That's going to occupy top attention of government spends. There could be, as we discussed, mass housing. And then renewable energy. That's another area which will attract a lot of attention. So maybe if I were to single out three sectors, these are the three sectors. Maybe there's a rejig on PLIs. So sectors such as defence, aerospace, food processing, lab group diamonds, these may actually get revised PLI plans.
Q. Final question. Things are looking up for India. We're in a bit of a Goldilocks scenario, which is great news. What are the risks then? Crude has been fairly well behaved, which is good for us, irrespective of how other commodities have played up. A couple of risks that you'll be tracking and a quick comment on crude being well behaved?
A. Yes, from a risk perspective, we have to be careful about global growth because India is trying to increase its engagement with the rest of the world. So if global growth doesn't fare well, it does put India back. I would worry about China's deflations because Chinese deflation creates greater competition for Indian companies trying to sell abroad. And that could be a very important threat. China's currency could be depreciating, which could make us less competitive versus China. We have to worry about the capacity constraints that we have. There's still a lot of supply side work that has to be done for us to sustain higher growth rates in the judiciary, in bureaucracy, in education, in skilling, in health. And on oil, the math has changed for India. The intensity of oil to GDP has halved in the last six, seven years. So we are less sensitive to oil. But if oil went up $30 or $40 all of a sudden, it would create near-term pain. But otherwise, oil is a lesser concern for us than in the past.
First Published: Jun 12, 2024 10:30 AM IST
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