Narratives vs. numbers: What’s the real story in China and India?

China and India are the two heavyweights in emerging market (EM) equities — two continental-size economies that account for approximately 45% of the EM equity benchmark.¹ For EM investors, getting these two right matters, particularly after the massive divergence in performance they’ve experienced over the past few years. But getting them right requires a deep understanding of the bigger picture — the narratives that have driven these recent returns have overwhelmed realities, in our view. Here’s how we view the opportunities in each market based on the narratives and the numbers.

India: Narratives matter, but so do numbers

The narratives driving such disparate returns are intuitive: a structural and cyclical growth renaissance in India, and unaddressed structural economic challenges in China. But these narratives have overwhelmed realities, in our view. Here are some of the numbers that help complete the picture for India:

• Indian equities — broadly — are excessively rich, in our view. While India has great cyclical momentum and a compelling long-term story, we are cautious about the euphoria and valuations, which leave little room for error. We are believers in the Indian renaissance story but find broad India equity valuations to be excessive relative to underlying fundamentals. 
• In many cases, stocks are trading on very high multiples. Indian equities are trading at nearly 27x price to earnings (P/E) multiple, which represents more than a 40% premium to aggregate EM valuations.²
• If you think US equities are a bubble, spend a week in Mumbai! Indian equities have trounced S&P 500 returns over the past three years and are trading on a significant premium to US equities.³
• Examples of excess valuations abound. Only heroic assumptions around revenue, earnings and cash flow growth can come close to justifying current market capitalizations, in our view. We believe valuations are particularly unhinged in deep cyclical industries — cement, infrastructure, power, automobiles. And nowhere are valuation excesses more evident than in the dramatic outperformance of state-owned enterprises, as shown in the chart below. 

China: Finding value amidst the slump

China is the mirror image of India. There is clearly not a lot to get excited about in the Chinese economy. China remains in a classic Keynesian “liquidity trap” in which an asset bubble (real estate) implodes and there is a rush across the economy to de-lever and rebuild balance sheets. Savings across the economy have increased, exacerbating China's excess capacity problem. Consumption has been weak and, therefore, excess capacity has been “dumped” around the world. Chinese policymakers have failed to properly diagnose the problem of insufficient domestic demand — and have seemingly been unwilling to address China's underlying structural problem, which is the need to shift its economic growth model away from excessive reliance on investment. 

But here is what we would add to the narrative about China:

• Smaller growth percentages still add up to meaningful numbers. It is worth underscoring that a 2% real growth rate in China — which is likely a realistic portrait of where the economy is today — would generate $360 billion in incremental growth, which is nearly 50% higher than India's incremental gross domestic product.⁴ 
• The challenging narrative has overshadowed opportunities. The challenges of China have been more than adequately reflected in its faltering equity performance, in our view. And though China has a growth problem that needs to be addressed, the reality is that it also has some of the greatest investment opportunities globally, in our view. In many instances the challenging narrative of China's economy has completely obscured the compelling numbers associated with these companies.
• Despite our underweight, we are very bullish on our Chinese holdings. Today, we believe China offers structurally attractive companies with durable growth, sustainable advantage, and significantly improved returns to shareholders at uniquely attractive prices. Our investments in Tencent, H World, PinDuoDuo, and AIA represent companies in attractive growth segments, where competitive discipline has improved, market share gains are evident, margins and cash generation have also improved dramatically, and boards are returning historically high levels of cash to shareholders.⁵ While we are considerably underweight in our portfolio allocation to China versus the MSCI EM Index benchmark, we are very bullish on what we own in China. 

What’s the next big story for EM equities?

EM equities have been “all about India” over the past few years — a refuge for EM and global investors against a backdrop of considerable uncertainty (the path of US interest rates, China’s economy in a funk). India has become an expensive market driven by narrative, rather than numbers. While we also dream big, our investment process demands rigorous attention to valuation. 

The big next story for EM equities, in our view, is the potential for broad outperformance against developed markets. And this involves the lifting of two clouds that have lingered for some time — US interest rates and China. We are cautiously hopeful that improvements on both are imminent. 

• US interest rates. We believe a backdrop of lower sovereign US rates may translate into significant outperformance for large swathes of EM equities — led by stronger currencies in Korea and Taiwan and better growth (and much lower real rates) in Latin America and Southeast Asia. 
• China’s economy. China's policymakers are slowly beginning to show signs of “getting it.” And while the woes in China are well known, the cluster of companies we focus on have been largely neglected by international investors despite significant fundamental improvements.

Now is the time to get excited again about EM equities, in our view. And now is the time to calibrate narratives around India, which has benefited from clouds elsewhere.