Confidence in the future brings about a reduction in equity risk premium
Finally, in our view, a significant reason why India has and will continue to sustain its premium over other markets is the reduction in equity risk premium that has happened under the current government. Such a reduction in risk premium allows our team to have more confidence in future cash flows and discount them at lower rates. The contributing factors fall into three main categories:
- “Loss of capital risk,” or lack thereof – India has avoided inducing any permanent capital loss on foreign equity holders at the hands of the government. In contrast, various other EMs, such as Russia, Turkey, and several sectors in China, have seen a dramatic de-rating because of such permanent capital losses. India has emerged as a relatively “safer haven” and equity investors have opted to allocate more capital to India, essentially saying they expect their capital to be better respected in India. This confidence in the macro framework has contributed to a reduction of India's equity risk premia. Therefore, India’s valuation premium over peers has strengthened.
- Reduction in political/policy risk – We believe India could offer global investors the most stable government in the world over the next five to 10 years. Based on our experience, this often gets overlooked. With its rock-solid majority, the Modi government, already over the last nine years, has shown a resolve to make many policy decisions that may only pay off in the long term. For example, in 2017, India moved to a common single market with a single sales tax across the country and later cut income tax rates to regional averages. The measures took five years to show any impact, but today, the benefits are clear. Now, there is significantly higher tax compliance and record-high tax collections. The bulging tax kitty has enabled India to incentivize manufacturing, invest heavily in infrastructure, and build physical and digital connectivity across the nation.
- Deft management of geopolitical risk – Many global supply chains are considering manufacturing in India to offset geopolitical risk as tensions between the US and China remain elevated. Apple is the highest-profile company so far that has shifted a meaningful chunk of its capacity to India. One can imagine the discussions in boardrooms across the Western world — If Apple is moving to India, why aren’t we?
The three factors above have led to falling risk premia in India, which, in turn, could keep its valuation premium high. But the same factors also allow us to have much more conviction on the future cash flows of Indian companies and keep looking for long-term value-creating managements. We believe we’re at a very exciting phase in India today and prudent global equity investors may wish to consider Indian equities for potentially compelling, long-term performance.