INCO: The Consumer Remains The Jewel In India’s Crown (NYSEARCA:INCO)

Few equity markets have performed anywhere near as well in India in recent years – and for good reason. The country saw some very impressive economic growth numbers yet again (even by its standards), with real GDP surging to +8.4% YoY through Q4 2023 and prior quarters’ growth revised higher in tandem (to +8% YoY). Plus, the forward-looking services and manufacturing purchasing managers’ indices (PMI) remain in strongly expansionary territory. Along with a national ‘Household Consumption Expenditure Survey’ that confirmed the breakneck speeds at which consumption expenditure has grown across both rural and urban households (nearly tripling over the last five years), the stars remain in alignment for Indian consumer names.

Admittedly, pricing is also optically high for the all-important consumer sector, with the ~40x trailing P/E for Columbia India Consumer ETF (NYSEARCA:INCO) being a case in point. But it’s worth noting that even with INCO rallying strongly since I last covered the ETF (see prior coverage here and here), its multiple is virtually unchanged – a reflection of the underlying earnings momentum of its constituents.

Take the largest INCO sub-sector, automotive, for instance, which grew earnings well over +30% YoY last fiscal quarter. As for staples sub-sectors like food products, bottom-line YoY growth is running lower but with plenty of visibility into their mid to long-term runway. And perhaps most importantly, INCO’s portfolio of high-quality structural winners backed by some very powerful tailwinds, look poised to reinvest well above their cost of capital for the decade to come.

Expect some volatility into elections next month, though, for long-term-oriented investors willing to pay up for quality, INCO remains a great vehicle to play the ‘crown jewel’ of India’s growth story.

INCO Fund Overview – Quality Indian Consumer Pure-Play but Mind the Liquidity

The Columbia India Consumer ETF, managed by Columbia Threadneedle, remains the only US-listed pure-play tracker of India’s consumer sector. The ETF tracks the Indxx India Consumer Index, a market cap-weighted thirty-stock basket comprised of India’s largest and most liquid consumer names. In line with its underlying index, INCO also implements a 4.9% single-stock concentration limit, enforced via an annual reconstitution and rebalancing process.

The major plus here is INCO’s intact ~0.8% expense ratio (0.77% gross; 0.75% net of fee waivers) – a slight ~5bps over more straightforward India trackers like the iShares MSCI India ETF (INDA) (see coverage here). Low fees come with a tradeoff, though, and in this case, it’s liquidity, as reflected in INCO’s relatively wide 0.25% median bid-ask spread (vs. 0.02% for INDA). INCO also tends to deviate quite a bit from its underlying NAV (a 50-100bps delta isn’t uncommon), so investors moving large volumes will want to be mindful of execution.

INCO Portfolio – Even Heavier on Discretionary Ahead of Annual Rebalancing

By sub-sector, the INCO allocation has shifted even further toward consumer discretionary at 60.5% (up from ~59% previously) – a result of the sub-sector’s relative earnings outperformance this fiscal quarter. By comparison, consumer staples is a smaller 39.5%, adding more cyclicality to INCO’s earnings profile.

Digging deeper, the key industry drivers of the Q1 cyclical gain were Automobiles and Automobile Components, both of which now contribute a larger 40.5% on the back of 30-40% YoY profit growth for the major manufacturers this fiscal year-to-date. The other big cyclical industry component, Hotels, Restaurants & Leisure, was another big gainer at 8.0%, again reflecting the discretionary spending momentum in India. Staples names in the Food Products and Personal Products industries saw slower earnings growth this time around and, as a result, have ceded share at 15.8% and 9.7%, respectively. While concentration is high for now, INCO is due for a rebalancing soon, and thus, I expect the cumulative auto/auto components allocation will be readjusted accordingly.

The ETF’s single-stock allocation has also skewed further toward India’s automotive franchises, with the three leading manufacturers, Tata Motors (TTM), Bajaj Auto, and Mahindra & Mahindra (OTC:MAHMF), taking up larger shares of the portfolio. The other major change is the addition of food delivery platform Zomato (FOOD) to the INCO top-five, along with jeweler Titan Co Ltd (TQTQY). Also notable is the decline in blue-chip staples franchises like Nestle India (NSZTY) following relatively slower fiscal earnings results. While many of INCO’s top names have exceeded their concentration limits for now, the fund is due for a rebalancing soon, which should also keep the single-stock allocation better spread out.

INCO Performance – The Fastest Horse in the Race

INCO hasn’t suffered too many down years throughout its history, and this year is shaping up to be another good one, having already gained +6.3% to-date in NAV terms (+6.4% in market price terms). Note that this comes off a blockbuster 2023, which saw the fund outperform the rest of India with a massive +34.1% NAV gain. This outperformance has been remarkably consistent – even through a COVID-impacted five-year stretch, INCO only suffered one very modest down year (-7% in 2022). Consecutive years of positive returns tend to add up, and as a result, the fund has now compounded at an impressive +11.3% pace since inception in 2011 – well above comparable funds in India and the rest of emerging Asia.

But like every other passive Indian ETF, the tracking error is an issue. As impressive as INCO’s performance has been, its benchmark, the Indxx India Consumer Index, has actually outperformed the fund by over two percentage points per year. Note that this gap widens quite substantially during bull markets – last year, for instance, saw INCO give up over six percentage points relative to its underlying index performance. While concerning, this tracking error is really an unavoidable ‘hidden’ cost associated with accessing India, a market with high transaction costs, volatile currency movements, and a rather unfavorable tax regime for foreign capital. So in addition to the headline expense ratio, investors will need to be comfortable with underwriting the full extent of costs (visible and invisible) that come with INCO.

Income shouldn’t be much of a consideration when investing in India; this is a growth market, after all. That said, INCO does differentiate itself from other ETFs in how it funds its distribution, as most of the yield comes from realizing capital gains rather than income. Thus, the sustainability of the current low-single-digits yield is really tied to the fund’s performance, which is, in turn, tied to the earnings growth of INCO’s constituents.

While I wouldn’t buy INCO for the yield, there’s plenty to support more capital gains, as India, now the most populous country, comes into a massive ‘demographic dividend’ and rising incomes flow through to consumer earnings over time. Also worth noting are the impressive returns on equity sustained by India’s consumer blue-chips, where low-double-digits is the norm (triple-digits for the likes of Nestle India) – a reinvestment rate unmatched in the rest of emerging Asia. Even more capital-intensive discretionary names like the major auto makers reinvest well above their cost of capital and sustain very strong earnings growth, more than offsetting any cyclical drawbacks.

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Source: Author, Columbia Threadneedle, Market Data

To be fair, some of these positives are reflected in the portfolio’s pricing, but a ~40x trailing earnings multiple doesn’t seem so pricey when you also factor in the INCO portfolio’s 45% forward earnings growth and near 30% return on equity. I’ve stressed for a while that there’s more than enough here for INCO to grow into its valuation and the +13% appreciation over the last three months, solely on earnings growth and with no help at all from multiple expansion, is case in point. Expect more of the same in the years to come as the fund continues to compound alongside the earnings of its blue-chip constituents.

The Consumer Remains the Jewel in India’s Crown

Fundamentally, the Indian growth story remains as attractive as ever, led by the rise of the domestic consumer. Both lagging (GDP growth) and leading (PMIs) macro indicators point to more growth ahead, while at the micro level, sector-wide earnings have continued to compound at very impressive rates. INCO’s portfolio of consumer blue chips screens attractively as a vehicle to ride this wave on virtually all fundamental aspects, with the only catch being the price. At ~40x trailing earnings, INCO is priced multiple turns above the benchmark Nifty index; in return, though, the fund offers a higher-quality, more predictable earnings base, as well as best-in-class reinvestment rates. Near-term earnings momentum isn’t too bad either, as recent quarterly reporting has shown. Net-net, I remain as comfortable underwriting an INCO position today as I was last quarter, particularly ahead of a catalyst-rich next few months.