Can Indian equities keep outperforming?

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

All data referenced in this article are sourced from Refinitiv Datastream unless otherwise stated, and are accurate at the time of publishing.

Key points

• Indian equities have outperformed their global peers by 8% annually in common-currency terms over the past four years, a move which has been justified by a strong improvement in company fundamentals
• The Indian economy is projected to remain one of the largest contributors to global growth over the next couple of years, supported by a young population, a growing middle class and an increase in infrastructure investments. These favourable dynamics should help local companies sustain superior earnings growth
• While long-term investment prospects remain attractive, recent gains in the country’s stocks have pushed valuations into extended territory, potentially limiting short-term returns
• The recent outperformance of Indian equities may lead investors to be more selective, focusing more on company fundamentals like profitability and growth. We have already started to see some evidence of this in recent months, with stocks being less correlated with each other. This type of environment tends to favour active management strategies over passive ones

Indian equities have had a stellar performance in the past four years. While most of this performance has been driven by fundamentals, Indian equities have also benefited from investment flows out of China, which continues to struggle with economic woes and depressed investor sentiment. Without a more significant and targeted stimulus package, sentiment in China is unlikely to rebound meaningfully in the near term. 

The key questions for investors today are whether Indian equities can continue to outperform in the coming months, and how to position for structural growth in the region.

Indian equities have generated stellar returns over the past four years …

Indian equities have performed remarkably well over the past four years, outperforming global equities by 10% per annum in local currency terms, or 8% in common currency. The MSCI India equity index has returned 32% per annum over the period in local currency terms (29% in USD), compared with annualised gains of 20% for the MSCI All Country World Index. 

Indian equities’ weight in the MSCI Emerging Market index has steadily improved to 17%, compared to only 8% back in March 2020. Over the same period, China’s weighting in the index has declined to 23%, from 32%.

… justified by a significant improvement in company fundamentals 

The strong performance of Indian equities over the past four years has been attributable to a combination of robust earnings growth and a re-rating. Indian corporate earnings have risen by 15% annualised over the period, driven by solid revenue growth and margin improvement. In contrast, the bulk of equity performance globally is down to multiple expansion. Global earnings have increased by only 6% annualised over the past four years.

It is also worth noting that corporate earnings in India have generally been more stable and more predictable than in other emerging markets (as measured by the dispersion of analysts’ forecasts).

In addition, Indian companies have managed to increase returns on equity substantially, from 6% in late 2020 to 15% at present. This compares favourably with global equities’ 12% returns on equity currently.

Investment prospects over the medium to long term remain attractive …

The Indian economy is projected to remain one of the largest contributors to global growth in the next couple of years, supported by favourable demographics, rising income levels and infrastructure spending. In the longer term, structural reforms and pro-growth policies should lead to more productivity gains. 

In addition, India should be one of the main beneficiaries of companies diversifying their supply chains away from China, should this trend gain more traction. Economists at Barclays Investment Bank expect the country’s real gross domestic product to grow by 6.8% in 2024 and 7.0% in 2025, after expanding by 7.7% in 2023. This is substantially above their global growth forecasts of 2.9% for both 2024 and 2025. 

This should translate into superior corporate profit growth. Based on IBES consensus estimates and MSCI indices, Indian companies are expected to grow earnings by 14% in 2024 and 15% in 2025, significantly above global earnings growth forecasts of 9% and 13%, respectively.

Investment prospects also look attractive, based on long-term valuation measures. Historically, cyclically adjusted price-to-earnings ratios (CAPEs) have been reliable indicators of long-term returns. At current levels, this measure suggests that Indian equities could generate total returns of 7.3% in the next 10 years (including dividends), slightly above the 6.9% implied for global equities (see chart).

CAPEs suggest Indian equities could generate total returns of 7% annualised over the next ten years

Indian equities’ total returns in the ten-year period following a given cyclically adjusted price-to-earnings ratio, over the past 20 years

… but further upside in the near term appears more limited

However, in the near term, the potential for further upside looks constrained by demanding valuations. Indian equities have significantly re-rated in recent months, and now appear expensive in absolute terms and relative to global equities.

The MSCI India index trades at a forward price-to-earnings multiple (PE) of 22.2x, up sharply from 12.4x in March 2020 (see chart). This is over 30% (or 1.6 standard deviations) above the 20-year average. Relative to global peers, Indian equities are also trading at a significant PE premium to history (20% relative PE premium today, versus 13% on average in the past 20 years).

Potential risks in the near term include the execution of a busy structural reform agenda, as well as market volatility around the upcoming general elections in April and May.

Indian equities’ forward PE valuations look stretched relative to history

MSCI India’s forward price-to-earnings ratio over the past 20 years

Investment implications and ways to position for structural growth in the region

Indian equities remain attractive over the medium to long term, supported by strong economic growth and robust company fundamentals. However, after a strong performance, valuations look stretched and further upside appears limited in the near term, at the index level. Attractive opportunities can still be found at the stock level, but investors need to be selective and favour active management over passive investing.

The Indian equity market seems particularly favourable for stock picking at present. We have seen an increased dispersion of returns in recent months, with Indian equities becoming less correlated with each other, relative to their recent past, but also relative to their global peers (see chart). 

We expect this trend to persist, with stocks being increasingly driven by idiosyncratic risk as opposed to macro factors over the coming months. 

After a period of exceptional performance, investors are likely to become more discriminating in their investment approach, and focus more on company fundamentals such as earnings growth, profitability, financial leverage and capital distribution.

Indian equities have become significantly less correlated with each other in recent months and relative to global peers

Average correlation of stocks with their respective index for the Nifty 500, S&P 500 and Dow Jones Stoxx Europe 600 indices (based on 1-month percentage price changes over a year)

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