After years of outperformance compared to other Asian emerging markets, Indian stocks are hardly undervalued. Its consumer sector, which includes many of the country’s “wellness” franchises, is still richly filtered – ever since I last cover the fund, Colombia Threadneedle’s sector-focused Indian consumer ETF (NYSEARCA:INCO) the portfolio has devalued slightly but remains several rounds above MSCI India at around 40 times current earnings.
This valuation is not undeserved, given the particularly attractive secular consumption tailwinds in India. As one of the few regions in the world entering the early stages of a “demographic dividend,” India is expected to reap the benefits of a falling dependency ratio in the decades to come. That means higher incomes and a rapid pace of urbanization – themes already in play and boosting the P&L of India’s consumer giants. The growth story is only just beginning, so consumer stocks have a particularly attractive runway ahead. of them to capitalize on a proliferating “consumer culture” supported by one of the highest growth rates in disposable income in the world.
Although the long-term consumption theme is more attractive than ever, the short-term setup has been challenged by inflationary pressures that have weighed on consumers’ purchasing power, particularly in rural areas. Yet, the urban consumer has taken over this year and as a result, major consumer companies have braved rural headwinds this year. Many of INCO’s consumer franchises also contributed to this growth by gaining more market share in new markets and categories. So while rural areas, helped by inflation normalization and fiscal support, are finally set to catch up next year, consumer names are well positioned on the income side. Likewise, slowing commodity inflation is also expected to continue to feed through to margins, supporting overall earnings growth. Overall, I remain bullish on INCO ahead of the election season early next year.
Columbia India Consumer ETF Overview – A More Cyclical Prime Consumer Portfolio
The India Consumer ETF managed by Columbia Threadneedle tracks (before expenses) the total return performance of the Indian consumer sector (core and discretionary) via the market cap-adjusted and weighted Indxx India Consumer Index based on market capitalization. The index stipulates security selection criteria based on the following criteria: minimum market capitalization ($100 million), liquidity (traded on >90% of trading days in the last six months), and concentration requirements (< 4.9% per single share). The portfolio follows an annual reconstitution and rebalancing schedule.
Despite strong performance this year, INCO maintains a relatively competitive expense ratio of around 0.8% (0.77% gross; 0.75% net of fee waivers) – just above large-scale Indian trackers like the iShares MSCI India ETF (EVERYWHERE THAT). That said, liquidity is more of an issue here, as evidenced by INCO’s wider median bid-ask spread of 0.19% (compared to INDA’s 0.02%) and the trend of its market price at s deviate slightly from the underlying net asset value. Therefore, investors should be careful about execution risks, especially if they are transferring large volumes.
Generally speaking, INCO’s sector allocation shifted further towards consumer discretionary in the fourth quarter, to 59.2% (from around 55%). This leaves a smaller 40.8% share for commodities, increasing the overall cyclicality of the fund.
Zooming in, the sector composition has also become more concentrated at the top – automotive, typically the largest INCO exposure, now contributes 31.8%. On the other hand, food products and personal products lost portfolio shares of 16.0% and 10.2% respectively. Automotive components remain unchanged at 7.5%, while hotels, restaurants and leisure are the most notable gainer at 7.4%. Overall, there is certainly concentration risk in the top five sectors (in total, approximately 73% of INCO’s portfolio); I would, however, keep a closer eye on the cumulative concentration of vehicles and automotive components (up to ~39%).
In line with the sector breakdown, INCO’s 30-stock portfolio is also skewed towards India’s leading automakers – three automakers, Tata Motors (TTM), Bajaj Auto and Mahindra & Mahindra (OTC:MAHMF), occupy the top five. Leading jeweler Titan Co Ltd (OTC: TQTQY) is the other major discretionary holding, while Nestlé India (OTC: NSZTY) leads the allocation to commodities at 5.1%. Although the top five holdings have exceeded the fund’s weighting cap and, therefore, contribute approximately 28% to the portfolio, a periodic rebalancing process (expected in the first quarter of next year) is expected to maintain the single-title allocation equitably distributed over time.
Columbia India Consumer ETF Performance – Rally Continues; Multiples remain high
As strong as the performance of Indian funds has been this year, INCO has almost beaten them all, recording a +26.1% year-to-date NAV gain (+27.3% in market price terms) . This outperformance also extends over longer periods: since its inception in 2011, the fund has now generated an annualized return of +10.5% (in terms of market price and net asset value), outperforming comparable ETFs Indian and emerging Asia.
The problem, however, is that INCO is significantly lagging its benchmark Indxx India Consumer Index, reflecting the fund’s still-significant tracking error. This year, for example, the gap between the fund’s net asset value and the performance of the underlying index reached around five percentage points – far wider than similar large-cap Indian funds and only slightly narrower than small/mid cap funds like iShares MSCI India Small- Capped ETF (SMIN).
To a large extent, this tracking error is a function of the fund’s outperformance. In a bull market, the combination of transaction costs, currency fluctuations and capital gains taxes has a significant impact on relative performance. In difficult years, such as 2022, INCO has kept its tracking error fairly narrow on a fee-adjusted basis. Regardless, investors should closely monitor the magnitude of this “invisible cost” – a common denominator across all US-listed Indian ETFs.
INCO now offers a slightly higher trailing distribution yield of around 1%; Since most of the return comes from capital gains rather than income, future income growth is likely limited from here on out. Instead, the reason to hold INCO remains growth, as evidenced by the portfolio’s seemingly rich valuations (~40x current earnings). Relative to the quality of its holdings, many of which offer avenues for sustained double-digit earnings growth and high double-digit return on equity profiles, INCO still has ample room to grow its valuations over time.
Maintain confidence in the champions of Indian consumption
Consumer-focused INCO has historically posted high multiples, and at around 40 times current earnings, this fund is certainly not for everyone. However, relative to the underlying fundamentals, the valuation is entirely justifiable – take a category leader like Nestlé India, a major component of INCO, for which high double-digit ROE percentages are the norm. (>100% last year). Combined with one of the most compelling consumer earnings growth tracks in the world, INCO has all the ingredients necessary to increase its valuation over time.
The short-term situation is not bad either: growth is increasing, inflation is falling and job creation is strong, which bodes well for disposable incomes. For INCO’s flagship stocks, there is ample room for growth within and beyond their categories, while tailwinds from lower commodity prices add further support to earnings. Net-net, I still see plenty of upside potential for consumer-focused INCO ahead of the election season early next year.