Can India ETFs Keep The Good Times Going in 2013?

Despite concerns about inflation, decrepit infrastructure and the potential loss of the country's already tenuous investment-grade credit ratings, Indian equities were stellar performers in 2012.

For the year, the BSE Sensex 30 Index surged 25 percent, outpacing the MSCI Emerging Markets Index by about six percent in the process.

Indian equities and the corresponding ETFs were boosted last year by an array of factors ranging from waning inflation to government reforms aimed at increasing liquidity and foreign investment to bullish outlooks from various banks and ratings agencies.

For example, Goldman Sachs forecast 6.5 percent GDP growth for Asia's third-largest economy this year.

Prior to that, Moody's Investors Service reiterated a stable outlook on India's sovereign debt rating. Moody's also affirmed a Baa3 credit rating for India, which is one notch above junk status.

Still, there is more to the Indian investment story and investors may do well to look beyond purely macro catalysts.

"While the Reserve Bank of India (RBI) and the Indian government recently have been active with reforms supportive of economic growth, we believe it is of the utmost importance to look beyond the purely macroeconomic story and to the valuation landscape," WisdomTree research analyst Christopher Gannatti said in a research note.

Gannatti points out that consumer discretionary, financial services and industrial names returned 40 percent or more last year and that Indian staples and health care names impressed with sector-wide gains of 30 percent or more. Predictably, those returns have elevated the P/E ratio on the Sensex, which is now 16.6.

"Notably, there are only two sectors with P/E ratios above 20x: Consumer Staples at approximately 33x and Telecommunication Services at approximately 27x," said Gannatti.

"I believe the Consumer Staples sector may be the sector within the Sensex that is the most at risk of a potential correction, as it is the sector with the highest expectations for long-term growth."

Fortunately for investors, the marquee large-cap India ETFs are not heavily allocated to staples stocks. For example, the WisdomTree India Earnings ETF (NYSE:EPI) devotes just 3.7 percent of its weight to the consumer staples sector. Staples account for just 7.5 percent of the PowerShares India Portfolio's (NYSE:PIN).

Still, it is worth noting that once-inexpensive Indian stocks now command a premium relative to the broader emerging markets space. That means Indian firms must generate earnings growth that investors deem as satisfactory to keep meriting rich valuations.

"The MSCI Emerging Markets Index has a P/E ratio of approximately 12.4x, while India's market cap-weighted benchmarks were all approximately 32%35.5% higher," Gannatti noted.

Valuations are a tad better with PIN, which currently has a P/E ratio of 15.21 and a price-to-book ratio of 2.41.

EPI is even more attractively valued. The largest India ETF by assets had a P/E of 10.76 and a price-to-book ratio of 1.76 at the end of the fourth quarter, according to WisdomTree data.

Year-to-date, EPI is dealing with a small loss while PIN is higher by about two percent. That said, Indian small-caps have shown noticeable weakness as the Market Vectors India Small-Cap ETF (NYSE:SCIF) and the EGShares India Small-Cap ETF (NYSE:SCIN) are off 5.55 percent and 4.55 percent, respectively.

Given the elevated volatility in Indian small-caps, conservative investors looking for exposure to the market may be best serve by sticking with large-caps. Should Indian large-caps lead the country's equity markets higher this year, EPI could be the way to play that trend.

Eschewing traditional weighting methodologies, EPI's constituents are ranked by earnings and possible new additions to the ETF's underlying index "must demonstrate positive earnings on a cumulative basis over the four quarters prior to the annual Index screening date," according to Gannatti. That could play in investors' favor if Indian stocks receive positive catalysts this year.

"I believe India is one of the most underappreciated and underinvested countries of the often-cited BRIC' basket of countries," said Gannatti. "Given its large population, India has a great long-term growth story, and there are a number of potentially positive catalysts brewing from government reforms to monetary policies. This combination could have the potential to positively affect equity performance."

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