The rapid growth in the Chinese and Indian economies over the past decade is widely known to investors. Yet not many have been able to translate such macroeconomic tailwinds into substantial investment gains. One simplistic explanation for this might be that the stock markets of both of those countries are opaque at best and not easily accessible. While there might have been some truth to that a decade ago, China’s and India’s stock markets are large and growing more accessible every day. More importantly, there is an abundance of what we think are great companies in both countries’ equity markets. These companies are not just great Chinese companies, or great Indian companies, but companies that would be considered great anywhere. At MarketGrader, we refer to these as ‘growth compounders.’
Investors seeking to harness the growth in China and India have been perhaps fishing in the wrong pond; or more precisely, in the wrong side of the pond. By this we mean they have been focusing on accessing these markets through the wrong investment strategies. These strategies might have given them access to China and India, but mostly by looking through the rearview mirror at what has brought these countries’ economies to where they are today rather than what will propel growth in the future. Put differently, investors typically own funds that track benchmarks heavily tilted towards the largest companies in both countries, which are, by definition, yesterday’s success stories.
Why GDP Growth Doesn’t Necessarily Translate into Investment Gains
In the decade ended last December, China’s GDP more than doubled (up 108%) and India’s almost doubled (up 92%)1. Meanwhile, the CSI All Share Index (the Chinese market’s broadest benchmark), gained only 17% in the same 10 years. The CSI 300 Index, perhaps China’s most widely followed benchmark, did even worse, gaining 12% on a price return basis2. India fared a little better, although there is no total market benchmark in India to provide a comparable example. The country’s most popular index, the S&P BSE Sensex Index, earned a price return of 54% over ten years but with significant concentration risk (the four largest companies in the 30-stock index account for over 40% of its weight)3. A broader index, such as the MSCI India, which accounts for approximately 85% of the country’s aggregate market capitalization4 did worse, earning a mere 27% return over 10 years. Therefore, investors owning investment vehicles tracking the broad, or popular Chinese and Indian benchmarks have clearly not been able to translate the extraordinary economic growth rates in the two most important countries within emerging markets into investment gains.
Focus on the Companies, Not the Markets
Contrary to what pundits might say, predicting global macroeconomic trends well into the future is futile if not impossible. Calculating the trajectory of interest rates, inflation and global growth, to name just a few variables, is extremely difficult, not to mention the impact geopolitical events and unforeseen crises (such as the current pandemic) have on financial markets. Equity investors focused on long-term capital appreciation have little or no control over such variables. What they can control, though, is which companies to own and the prices they pay for them. MarketGrader’s business is to help investors identify what we consider to be superior companies that compound growth at consistently higher rates than the average company—or the market—as well as the prices at which it is reasonable to buy them (GARP). This doesn’t mean searching for cheap stocks, though, as there is a significant difference between buying cheap stocks, with limited upside, and buying long-term growth compounders at a reasonable valuation.
The process of identifying growth compounders begins with the analysis of every publicly traded company in the equity universe, which for China and India totals more than 6,600 companies. We don’t analyze the companies in the aggregate as a single asset or rate them relative to their peers. Instead, we apply 24 fundamental metrics to each of them, dividing all indicators into four categories: Growth, Value (GARP part of the analysis), Profitability and Cash Flow (Quality part of the analysis). Each one of the 24 indicators is assigned an individual grade and all 24 grades are aggregated into a final MarketGrader Score (MG Score TM) between zero and 100. We then rate as ‘BUY’ all of those with an MG ScoreTM greater than 60 and as ‘SELL’ all of those with an MG ScoreTM below 50. The remaining companies are rated ‘HOLD’.
Some of our 24 indicators vary based on industry, sector or size in order to account for differences across companies (for example, the balance sheet of a large Chinese bank looks very different from that of an Indian software company), yet all indicators always adhere to our GARP + Quality approach. In the end, the system’s goal is to identify sustainable growth compounders with the following characteristics:
- Consistent top to bottom line growth—not just explosive short-term growth—with sustainable margins and high cash flow generation.
- A sound capital structure that doesn’t impair operating growth, combined with high returns on invested capital and low capital intensity.
- Reasonable valuations relative to sustainable growth rates, and not based just on absolute, out of context, valuation multiples.
China and India Through MarketGrader’s GARP Lens
For more than two decades now, MarketGrader has been implementing the process described above to view global equity markets from a unique vantage point: through a GARP + Quality lens focused on the financial health of individual companies rather than on broad asset or sub-asset classes (such as large vs. small or emerging vs. developed economies). This experience has uniquely positioned us to identify growth compounders in large and diverse markets such as China and India where the traditional benchmarks fail to capture the real sources of growth. In China, for example, this applies to ‘new economy’ sectors that include consumer-related industries, health care and technology, now that the country’s GDP growth is being driven by consumption, services and valued added technology manufacturing. In India this applies also to the consumer segment of the economy, albeit at a much earlier development stage, as well as to the digitization of finance, software development and to the infrastructure being built to support a young and rapidly growing middle class. Our approach, however, is decidedly bottom-up, as it is strongly grounded on stock selection as described above. Simply, we believe that the important macroeconomic factors driving growth in these countries can be harnessed by owning the companies best positioned to profit from those trends and thus compound growth over many years. Our China and India Growth Leaders Indexes were built based on this approach. Selecting the constituents of these indexes requires both knowing what to include (the highest rated companies) and knowing what to exclude as illustrated in Figure 1.
|BUYs||492 Companies||371 Companies|
|HOLDs||533 Companies||465 Companies|
|SELLs||2,717 Companies||2,027 Companies|
Since MarketGrader began covering the Chinese equity market, our BUYs have averaged 16% of the universe and our SELLs have averaged 67%. In India the numbers are worse, with only about 10% of the companies rated BUY and about 75% rated SELL5. Thus, selecting from among only the highest rated companies our Growth Leaders Indexes are, by definition, comprised of a very different sets of companies, and in very different weightings, than the country benchmarks traditionally followed by investors in the past. The Growth Leaders are free float market cap weighted indexes, which allows them to participate in their underlying markets’ overall performance (or the market’s beta); however, every constituent’s weight is capped at 5% in order to avoid overconcentration in a handful of names. Figures 2a and 2b show the constituent breakdown based on MarketGrader Ratings for the benchmarks relative to our Growth Leaders.
*Breakdowns are weighted according to each index’s underlying constituents’ weights. When benchmark constituents are not rated, the aggregate sum for all ratings will be less than 100%. Source: MarketGrader.
Figures 3 and 4 present the performance of the MarketGrader China and India Growth Leaders. Clearly these benchmarks have been able to track much more closely the underlying growth of their respective countries’ economies. The MarketGrader China All-Cap Growth Leaders Index had a price-only return of 112% in the decade ended in December 2019, which actually exceeded China’s cumulative GDP growth of 108%. Meanwhile, the MarketGrader India All-Cap Growth Leaders Index had a price return of 84% during the same decade, not too far off the 92% cumulative GDP growth for India’s economy6. Coincidence? Perhaps. We’d rather think this is what harnessing economic growth looks like.
1 World Economic Outlook, International Monetary Fund.
2 CSI All Share Index and CSI 300 Index returns are price only, calculated in USD. Source: Bloomberg.
3 S&P BSE Sensex Index returns are price only, calculated in USD. Source: FactSet.
4 Source: MSCI
5 Historical ratings are based on quarterly averages dating back to September 2013, when MarketGrader initiated coverage of Chinese and Indian companies.
6 The MarketGrader China and India All-Cap Growth Leaders Indexes were first published on February 21, 2020. All prior returns are based on back tested performance figures, which are purely hypothetical and meant solely for informational purposes.
Note: Starting May 1, 2020, the VanEck Vectors China Growth Leaders ETF (NYSE Arca: GLCN) will track the MarketGrader China All-Cap Growth Leaders Index and the VanEck Vectors India Growth Leaders ETF (NYSE Arca: GLIN) will track the MarketGrader India All-Cap Growth Leaders Index.