Time to reduce India after ‘broad and indiscriminate’ rise

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“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 long-term investors and focus on value, rather than news flow. Our positioning in India is an example of this”, says Jonathan Pines, portfolio manager of the Hermes Asia ex Japan Equity Fund.

The Indian stock exchange sold off sharply in August last year, especially in US dollar terms, when the market was 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.

More recently, the Indian market has soared with investors optimistic about the business-friendly government. From the third quarter of 2013 to the end of June this year, the Sensex index climbed 58% in US dollar terms.

Taking profits

In response, we have taken steps to reduce our Indian exposure– selling down Bharat Electronics and Polaris Financial Technology.

While the new government under Narendra Modi is clearly business friendly, the rise in stock valuations has been broad and indiscriminate. However, although reforms help the economy and thus promote confidence which can provide an impetus to stock prices, even decisive and quickly implemented reforms are unlikely to rapidly help earnings. And earnings are the ultimate long term 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. In this context Indian listed companies today have among the highest returns on equity in the region. This may imply that there are some companies benefiting from the (less competitive) status quo. And these companies might suffer in a more competitive environment. The companies that will do best from reform will be those that are currently most hampered by bureaucracy, indecision, delays and the status quo. Some of these are listed. However it is possible the largest beneficiaries of reform are small and thus not yet listed. In such cases the benefits of the reform will accrue to original owners rather than stock market investors.

As always we believe that 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.

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