At SKAGEN we are fundamental and value-based long-term investors. A key part of our bottom-up investment process is to gain intimate knowledge of the companies and markets in which we choose to invest our unit holders’ capital. As such, travelling to the places where our portfolio companies are based and meeting with management in a local setting form an important part of our ongoing work. While we always return from our trips with an improved understanding of the businesses in which we invest, they also provide us with new perspectives on market opportunities, on-the-ground risks and, more importantly, the prevailing investor sentiment.
Our most recent trip to Hong Kong and Delhi could not have provided a more divergent experience.
"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair."
Charles Dickens, A Tale of Two Cities
To start with the obvious, investor sentiment clearly suffers from recency bias of news flow and financial performance. While we have written extensively about the challenges (and opportunities) of the Chinese equity market over the last five years, its performance has left much to be desired. India, on the other hand, has been one of the better performing global stock markets over the last five, ten and twenty years.
So much so, that the weight of India in the MSCI EM index overtook that of China, an economy almost five times as large, in early September.
Unsurprisingly, therefore, the prevailing mood in Delhi was unrecognisable from that which I had encountered in Hong Kong the week before. While Chinese investors voiced concerns over weak demographics, slowing economic growth, balance sheet recession and a deflationary debt spiral, Indian investors rejoiced in the strength of the country’s unstoppable economic growth, infrastructure investment opportunities and rapidly developing capital markets.
It really was a tale of two very different cities.
So what, you may ask? One equity market has outperformed the other (by a wide margin) and, based on recent trends, should continue to do so. Any rational investor would surely allocate a growing share of his/her capital to the market that is doing better? After all, this is exactly what happens “automatically” in an index fund. You get more of what has done well.
However, as value-based and contrarian investors we are always cognizant of the price paid relative to the value we can expect to receive in the future. And here, the picture is less clear-cut. On simple measures such as price to earnings, MSCI India is currently trading at its highest level relative to 12-month forward earnings, while MSCI China is trading close to its lowest point over the last ten years. India is not only trading at a significant premium to its own history, it is also elevated relative to other markets around the world, and therefore a clear outlier in terms of the price investors are willing to pay for future earnings.
Put differently, India’s (admittedly very attractive) long-term prospects are not only appreciated more than those of almost any other market globally, but they are also appreciated much more than they have been historically.
The exact opposite appears to be the case for China and the difference between the two had reached unprecedented levels as of the end of August.
As such, we can probably conclude that India and China’s divergent prospects are, at least partially, factored into market pricing.
This observation alone does not provide much value or context, in our view. However, prior to joining SKAGEN, I was managing a China equity portfolio based in Shanghai from the end of 2014 onwards. While it may seem like a distant memory now, domestically listed shares on the Shanghai and Shenzhen stock exchanges (commonly referred to as A-shares) were then the hottest ticket in global markets.
A combination of monetary easing, an economy growing at over 7% p.a., local investors trading on margin and global investors clamouring for access resulted in a significant run-up in prices and euphoric sentiment about future gains. As seen in the chart below, the local CSI300[1] index rallied more than 150% in the space of 6 months, far exceeding the gains of the (largely China-focused) Hang Seng index of Hong Kong.
Unfortunately, or perhaps unsurprisingly, this euphoric state did not last. Regulatory clampdown on high-risk investor behaviour (including margin financing) and a sharp rise in equity supply through IPOs and insider selling eventually overcame investor demand, especially as China’s economic performance failed to live up to elevated expectations. As seen in the chart below, both the number of transactions and size of new equity issuance grew significantly as the market rose during 2014 and 2015.
High prices found both new buyers and willing sellers in unprecedented numbers!
The run-up in Shanghai and Shenzhen was largely driven by domestic retail investors who pushed valuations to previously unseen levels. To put this into context, dual-listed companies[2] saw their domestically traded shares go from trading at a 10% discount to the same shares in Hong Kong to a near 50% premium in the space of 12 months. Such was the power of the Chinese retail investor when she got the taste for equities.
Could something similar be afoot in India?
There are many arguments that suggest “probably not”.
Most importantly, in our view, India’s demographics and, therefore long-term prospects, are currently far superior to those of China ten years ago. The population is younger, it is growing faster, and the country’s remaining investment needs are far greater.
My trip to India confirmed again that its current stage of economic development and infrastructure are well behind those that met me in China a decade ago. Moreover, the growing “equity culture” in India as a means to build long-term wealth is very different to the speculative approach to equities I encountered in Shanghai in 2014. Equity investing was akin to short-term gambling while the best way for the middle class to build wealth was thought to be through real estate.
Plus ça change, plus c'est la même chose!
India, on the other hand, already has a well-established equity ownership culture, which accounts for 6% of household assets compared with 5% in China and 12% in the Euro Area. Whilst the comparison to more developed countries suggests there is a long runway for rising equity ownership, the change in India has also been very rapid. Prior to the recent equity bull market, the average Indian household allocated just 1% of incremental savings into equities in FY14-17, according to Jefferies. By 2024, this figure has risen to 7%, suggesting a material change in appetite for equity investing.
However, there are also some striking similarities between the China A-share bubble of 2014-15 and what I encountered in Delhi in 2024.
Firstly, short-term retail investors have become an increasingly dominant force in the equity market. Strikingly, short-term options & futures trading has grown five-fold in the Indian market over the last three years and the number of participants has grown faster than that for mutual funds. This short-term behaviour has probably supported the underlying equity market, just as it did during the “meme-stock craze” in the US during COVID lockdowns.
Worryingly, a recent report from the Securities and Exchange Board of India shows that this has not been a welcome development for the average investor. In fact, 91% of retail participants lost money trading derivatives in the last financial year. Moreover, the share of loss-makers was highest amongst younger and lower income groups. As such, the behaviour appears more of a “get rich quick scheme”, with its invariable end result, than a sustainable investment strategy, in our view. On the other side of the trade are both foreign and largely algorithmic-based proprietary (e.g. professional) investors who appear to be making large profits at the expense of individual investors.
This dynamic matters as it is the Indian retail investor who is currently driving the Indian equity market ever higher. Annual inflows into domestic mutual funds and equities have increased rapidly over the last five years and look set to break last year’s figure at the half-year stage[3].
But not everyone is buying. As was the case in China in 2014-16, India’s new domestic retail investors have found willing suppliers of equity at these historically high prices.
According to Jefferies, India is currently Asia’s busiest market for equity capital markets (ECM) transactions with the pace of both new listings and sell-downs by existing owners having increased materially. Of equity raised in the first half of 2024, 12% was primary issuance through an IPO while almost 70% was from private equity or promoter (e.g. insider) exits.
It always takes a willing buyer and a willing seller to make a market price, but it is worth asking what is it that the young, often inexperienced retail investor sees that insiders and professional money managers do not?
We therefore believe that a degree of caution is warranted. Yes, the long-term prospects of the Indian economy look very attractive, and we harbour little doubt that India’s “equity culture” is supportive of this development as a provider of risk capital.
That being said, we are also cognizant of elevated expectations and high valuations at a time when the supply of equity is growing rapidly. As we have experienced time and time again, retail investor flow can change rapidly in the face of disappointing returns.
It should come as no surprise, therefore, that SKAGEN Kon-Tiki’s exposure to India has fallen as prices have increased beyond what we believe can be justified and relative to investment opportunities elsewhere.
While this increasing caution has been premature, our experience from other markets that have run up on the back of a rapidly expanding retail investor base is that they sometimes fall under the weight of unrealistic expectations. And when they do, the same reinforcing dynamics that create a self-sustaining upwards spiral can go into reverse, often with painful consequences.
Given the importance of domestic retail flows for equity valuations and Indian households’ growing reliance on capital gains as a source of income, we believe that such a risk is currently ignored by the market.
My trip served many purposes, not least to better understand the long-term potential of what will soon become the world’s third largest economy. However, the strongest impression I came away with was a very eerie sense of déjà vu.
[1] The 300 largest companies on the Shanghai and Shenzhen stock exchanges.
[2] Companies with shares trading on either Shanghai or Shenzhen stock exchange as well as Hong Kong.
[3] India’s fiscal year runs from March to March so the YTD figure is for 5 months only, the equivalent to more than USD 60bn on an annualized basis.