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Last Updated : May 13, 2019 08:50 AM IST | Source:

Viewpoint | Why US equities could be a great addition to your portfolio

Fundamentals indicate that US firms are facing lower risks, higher efficiency and can potentially invest the shareholder capital at much higher rates

Vikas Gupta

Consider the following chart. It shows the total returns (including dividends) over the last 10 years (March 31, 2009 to March 31, 2019) for two different indexes representing two different equities markets.

One of them represents Nifty50. The other is a global index. Which one is which?

Table 1_Vikas

Most Indians would think of the blue line with the higher returns as the one representing the Indian markets. However, contrary to popular opinion the Indian equity markets do not provide the highest returns compared to other major markets.

Rather, the blue line represents the S&P500. Both the returns are calculated in Indian Rupee (INR) terms.

During this period, in INR terms, the S&P500 delivered a total return of 16.9%, while the Nifty50 delivered a total return of 14.1%.

This is a result which would surprise most Indians. And an allocation to US equities would have benefited the portfolios of most Indians. However, most Indian investors do not have access to this data and end up comparing the INR returns of Nifty50 which includes significant non-real returns coming from inflation with the USD returns of S&P500 which has very little contribution from inflation.

Hence, data comparing both the returns in the same INR terms would make it like-to-like and be meaningful to Indian investors since they think and compare assets in terms of INR returns.

This higher return naturally leads to the question of whether the higher returns were accompanied by higher risks. The mathematical measure typically used to compare risks of two portfolios is the standard deviation representing one measure of volatility.

Table 2_Vikas

The S&P500 delivered the higher returns with much lower standard deviations, i.e. it was lower risk, higher return portfolio. Naturally, the Sharpe ratio of the S&P500 was also higher. The Sharpe ratio represents the risk-adjusted returns of a portfolio.

Table 3_Vikas

For the Indian investor, the default portfolio is Nifty50. So, it also helps to consider the alternative portfolio. How does the S&P500 compare vis-à-vis Nifty50?

S&P500 has a Beta of 0.03 relative to the Nifty.

This means S&P500 is completely non-correlated with Nifty. It is a great diversifier to an Indian equities portfolio! Addition of S&P500 to an Indian portfolio would reduce the relative volatility of the portfolio significantly, i.e. the beta as well as the standard deviation.

What is the Alpha of the S&P500 portfolio relative to Nifty50? Alpha is the excess return generated by a portfolio adjusted for the riskiness or Beta of the portfolio. If the Beta of S&P500 is higher than 1 then a higher return of the S&P500 is just compensation for the extra risk. However, S&P500 has Beta of 0.03 and still delivers higher returns than S&P500. Adjusted for the same riskiness or Beta as Nifty50, the S&P500 is calculated to deliver an excess return of 9.7%.

We can infer from the above that addition of well-selected US equities to an Indian portfolio could provide higher diversification, lower risks, lower volatility, and higher expected returns.

Before concluding let us a have a peek at the fundamentals of the US markets vs the Indian markets.

Table 4_Vikas

The Return on Equity (RoE) of the US market is much higher than the Indian market. It is clear that the US companies enjoy stronger moats and can invest shareholder capital at higher returns as compared to the Indian companies. This is all the more interesting given that Indian companies operate in a high-inflation environment and thus are helped with a higher base rate of return.

The sales to asset ratio is similar between the two markets and shows that the amount of sales generated from investments in assets is similar across the two markets. So a rupee of assets would generate around 0.7 to 0.8 rupees of sales for both the markets.

The gross debt levels in the Indian markets are slightly higher but not significantly so. However, the net debt, i.e. gross debt adjusted for cash on the books, clearly shows that the US companies are much less leveraged and have much higher levels of cash and liquidity as compared to the Indian companies. This provides a strong footing for them to survive any potential economic downturns.

Further, the operating margins are also superior for the US companies signifying that they are managing their costs more efficiently and probably have better pricing power.

The net margin differences which are very large are the result of the lowered tax rates that the US companies now enjoy.

Thus, we can conclude that the fundamentals, too, indicate that the US companies are facing fundamentally lower risks, higher efficiency and can potentially invest the shareholder capital at much higher rates.

We have shown in this article, how the fundamental and portfolio risks are lower with the S&P500 portfolio as compared to a Nifty50 portfolio. However, there are a few risks the Indian investor in US equities should be aware of.

Unfamiliarity with US economy, markets and companies is the main risk that the Indian investor faces. This can be remedied with more exposure and reading on the US markets. Over a period, the readings and subsequent familiarity would lead to more understanding and appropriate responses to market movements without resorting to panic-driven responses which are typical when one invests in unfamiliar instruments or asset classes.

Another risk over the near-term is the rupee appreciation risk. In the short-term of 0-3 years, the rupee can appreciate vis-à-vis the dollar and hence some returns from the S&P500 would be cancelled out.

However, the data is clear that over longer periods of time, the rupee depreciates due to the large differences in inflation between the two countries. This adds to the returns from S&P500 and is favourable. However, investments for short horizons, i.e. less than 3 to 5 years are exposed to both higher markets risks and currency risks.

We suggest that an Indian equity investor should consider adding US equities to their equity portfolio. Of course, before that, they should analyse, possibly in consultation with their financial advisor, whether such an addition suits their needs and risk profile.

(The author is the chief executive officer and Chief Investment Strategist of OmniScience Capital.)

Disclaimer: Equity investments are subject to market risks. Global investments entail currency and country risks. The above is not a recommendation to buy, sell or hold any of the stocks or sectors mentioned. We and our clients might have exposure to the above-mentioned stocks or sectors. Please consult your investment advisor and assess the suitability of investment products for your circumstances before investing.
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First Published on May 13, 2019 08:50 am
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