Skyscrapers need deep foundations

India’s stock markets have undoubtedly done quite well over the long-term: a recent report indicated that over the last 25 years, the Nifty 500 index delivered significantly better annualised returns (12.56%) than Warren Buffet’s renowned investment firm Berkshire Hathaway (9.52%) — and in USD terms at that!

Moreover, the likes of Morgan Stanley are of the opinionthat India exhibits several factors that could keep its market outperformance going for at least the next five years, if not longer.

Now, the usual narrative attributes this long-term outperformance to factors like domestic flows or high GDP growth. However, such factors are merely surface-level explanations. A deeper reason for India’s outperformance might be the fact that a large proportion of its companies actually have strong fundamentals.

Let’s back up a bit. The key question all stock investors ask is: why should we expect higher returns than those offered by bonds? Well, any extra returns that stocks can provide stem from the ability of corporate management teams to generate returns that exceed their cost of capital. Therefore, the primary driver of stock prices over the long term is the returns that shareholders earn on their capital.

Such returns are often quantified using a metric called return on equity (ROE), which gauges a company’s profitability and its efficiency in generating profits. All else being the same, companies with a superior ROE are more likely to deliver higher returns than their peers.

So what happens if we look at the ROEs of Indian companies and compare them to those of foreign companies? The results are illuminating.

It turns out that India ranks second only to the US when it comes to the number of firms that have consistently achieved an ROE of over 20% for more than a decade. This strong performance in terms of ROE is probably the true engine behind India's superior stock market results, suggesting that the underlying fundamentals are what truly matter, rather than the popular narratives surrounding market performance.

For more actionable insights backed by data and analyses, we invite you to read the latest edition of Netra in its entirety.