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By Jeremy Schwartz

Less than a year ago, India was considered to be part of a group of "fragile" emerging market countries that had large vulnerabilities that sent its currency into a tailspin and caused a spike in the equity volatility. During times of volatility, the focus tends to be less on individual companies' fundamentals and more on macroeconomic fears.

Opportunities typically present themselves during these times of heightened volatility and fear. When emotions can get in the way of making difficult portfolio allocations, WisdomTree's rules-based process makes adjustments to portfolios based on strict readings of the underlying fundamentals.

By using this rules-based fundamental indexing process at the most recent annual rebalance last September, the WisdomTree India Earnings Index (WTIND) added significant weight to companies selling at depressed relative prices, and those companies have performed very well during the market rebound. This process has added significant value to the WisdomTree India Earnings Fund (NYSEARCA:EPI), which is designed to track WTIND, by focusing on these lower-valued securities, as illustrated below.

A Focus on Earnings

WisdomTree believes fundamentals such as dividends and earnings offer more objective measures of a company's health, value and profitability than stock price alone. Because India is a low-dividend-paying country, WTIND screens and weights its constituents by earnings.

While the majority of Indian indexes are market market cap-weighted-meaning they tend to give more weight to companies that sell at higher prices than those that offer stronger fundamentals-the WTIND index methodology is designed to help magnify the effect of earnings on weights and total returns. Companies with low price-to-earnings (P/E) ratios typically receive higher weights. Additionally, as I discussed here, the WTIND also strives to represent the broadest cross-section of investable and profitable companies in the marketplace.

The focus on stocks with lower P/E ratios has worked particularly well since the last annual rebalance for the WTIND, as illustrated below.

P/E Quartile Performance

(click to enlarge)

Low P/E Ratio Overweight Drove Outperformance - WTIND's overweight exposure to low P/E stocks added more than 10% of outperformance compared to the MSCI India Index. This is impressive considering it accounted for almost two-thirds of the total 15.7% outperformance during the period.

More Weight in Lower P/E Ratios - WTIND had over 2.5x more weight in firms with the lowest P/E ratios. Evenly impressive is the fact that WTIND had almost two-thirds of its weights in firms with a P/E ratio less than 16.5x earnings, compared to the MSCI India Index, which had more than two-thirds of its weight in firms with a P/E ratio greater than 16.5x earnings.

Lower P/E Ratio Firms Outperformed - Firms within the lowest quartile outperformed firms in the highest quartile by more than 55% within both WTIND and MSCI India. Although the performance differentials among quartiles for the Indexes were similar, WTIND was able to outperform over the period as a result of its overweight to stocks within the lowest P/E quartiles. When sentiment gets very negative, the market often moves more than changes in fundamentals - in this case the earnings. Rebalancing back to those fundamentals may then be rewarded when positive sentiment returns, as we have seen in last nine months.

No Weight In Negative Earnings - Since WTIND screens companies for inclusion based on earnings, the Index will remove all unprofitable companies at its annual reconstitution. While company earnings may fluctuate between screening dates, we think this annual screening factor helps the Index manage valuation risks.

Weighting by Earnings Focuses on Lower P/E Ratios

Given how low-priced stocks contributed to the performance, let's discuss how the Index continually focuses on this segment of the Indian market at each annual rebalance. In order to garner significant weights in the Index, the index methodology requires that a company grow its profits rather than increase its market capitalization. As a result, we can generalize the impact of the rebalance as follows:

  • Typical Additions in Weight - Firms whose share prices may have performed poorly or stayed flat but whose earnings increased.
  • Typical Reductions in Weight - Firms whose share prices may have performed quite well but whose earnings growth was negative or flat.

This rebalancing process is a key differentiating element of WisdomTree's indexing approach and one that WisdomTree believes will continue to provide value over time.

Conclusion

The landslide victory by Narendra Modi and his party in the Indian prime minister election has garnered much attention and celebration in equities. A concern with such large gains in a short period is that the market may become expensive. WisdomTree's earnings-weighted approach helps to focus on lower-priced segments of the Indian market, and the Index rebalances each September to help manage the valuation risk from the big winners. For those looking for continued improvement in India, EPI - which can be considered a broad representative of the Indian market and economy, but also employs a process to manage equity valuation risk - could be an attractive way to gain exposure to India.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty.

This Fund focuses its investments in India, thereby increasing the impact of events and developments associated with the region, which can adversely affect performance.

Investments in emerging, offshore or frontier markets such as India are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments.

As this Fund has a high concentration in some sectors, the Fund can be adversely affected by changes in those sectors. Due to the investment strategy of this Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund's prospectus for specific details regarding the Fund's risk profile.

Jeremy Schwartz, Director of Research

As WisdomTree's Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel's head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper "What Happened to the Original Stocks in the S&P 500?" and the Wall Street Journal article "The Great American Bond Bubble."

Source: India: A Focus On Earnings Leading To Large Gains