Indian markets have been underperforming world markets and other emerging markets for some time now. Year-to-date, the MSCI India Index has declined by 13.6% whereas the MSCI World Index has been flat, and the MSCI Emerging Markets Index has fallen by only 4.1%.
A plethora of scams; high inflation, and increasing commodity prices in the global markets have led to the underperformance.
Even so, Indian markets still trade at a premium to other emerging markets, thanks to sharp outperformance in the preceding years.
This valuation premium is increasingly at risk because Indian companies are facing a drop in return on equity (RoE) and a simultaneous rise in the cost of equity (CoE), says a report by IIFL Capital, India Infoline Ltd’s institutional equities business.
It points out that in the boom phase between fiscal 2004 and fiscal 2008, the difference between RoE and CoE of the companies under its coverage was as high as 8 percentage points.
This has narrowed to 2.5 percentage points.
Also, during that phase, Indian companies’ RoE was 4-5 percentage points higher than those of firms in other emerging markets.
This gap has narrowed to 1.5 percentage points.
Even so, Indian stocks trade at a considerable premium using the price-book valuation multiple. Unless several factors fall in place and RoE of Indian companies starts rising sharply again, the markets’ de-rating should continue.
So what are the factors that affect RoE of Indian companies?
IIFL Capital says rising competitive intensity in multiple industries is driving down operating margins.
Besides, there is a sharp deceleration in capital formation, which is affecting the profitability of sectors that are linked to the investment cycle.
What’s more, asset turnover ratios are dwindling because of large equity dilutions. Large overseas acquisitions, too, are contributing to the drop in RoE because the acquired companies invariably operate at much lower margins than their domestic parent companies.
Rising interest rates, too, are leading to increases in the cost of equity.
This has further compressed the excess return Indian companies are earning.
“Given our hypothesis that RoEs will stagnate at current levels while CoE is set to rise further, the excess return gap is set to shrink further,” IIFL Capital says in its report.
If the story continues to play out in this fashion, foreign investors will have more reason to exit their Indian investments.
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