Revving up selective investment opportunities in India

Tantallon Capital
Tantallon Capital3/18/2023 05:16 PM GMT+08  • 8 min read
Revving up selective investment opportunities in India
Eicher Motors is the manufacturer of the iconic Royal Enfield line of premium motorcycles, and light and medium commercial vehicles. Photo: Bloomberg
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The Tantallon India Fund closed 2.16% lower in February as markets finally appeared to give up hope that the US Federal Reserve is close to being done with interest rate hikes and as the investors sidestep financials over the uncertainty of potential exposure to the Adani Group.

Amid the noise, by staying focused on the fundamentals driving sectors and stocks, our bottom-up convictions continue to underpin our portfolio construction, yielding a cogent narrative.

• Industrials. Our portfolio clearly articulates our strong conviction in India’s significant industrialisation opportunity over the next decade or so. India now is where China was when it joined WTO in December 2001 and is positioned to benefit from efforts to relocate global supply chains away from China. All these thanks to its strong IP protection regime, low-cost engineering talent pool, labour reforms, and the recent Budget making explicit the Modi government’s commitment to infrastructure capex and job creation with spending on roads, rail, ports, clean water and irrigation projects, and in renewable energy and grid infrastructure, to facilitate an export-oriented economy, energy security and the green energy transition.

• Consumer discretionary. Our expectation of above-nominal GDP wage growth and rising disposable incomes and discretionary consumer spending is the corollary of the government’s tax and policy initiatives to develop India’s manufacturing base and to sustain job creation for India’s 20 million students entering the workforce yearly. We are focused on identifying and investing in product and service differentiation, the ability to invest in brand and distribution moats, and the beneficiaries of sector consolidation and the formalisation of the real economy.

• Real estate. The opportunity is multi-faceted thanks to sector consolidation and deleveraging after a cash-constrained decade for developers, sustained wage growth and improving affordability as domestic mortgage rates appear to have peaked, rising discretionary spending provides greater visibility on foot traffic and spending at the new malls being developed, and as recovering demand for office and industrial/warehouse space dovetails with new REIT legislation and the quest for yield.

• Financials. We are starting to rebuild our exposure, taking advantage of the Adani-linked selldown in stocks. We believe that we are at the start of a benign new credit cycle and that the market will reward with premium multiples well-capitalised deposit franchises that are poised to take market share and protect margins on the back of superior distribution reach, effective digitalisation strategies, product relevance and cross-selling opportunities, and crucially, the credit culture, data analytics, and technology to price appropriately for risk.

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• Technology and IT services. We remain on the sidelines given our concerns about growth and valuations. We are aware of our potential “blind spot” as the sector remains a place to “hide” given steady-state run-rates on new business origination, positive earnings leverage to any rupee weakness, and bulletproof balance sheets. However, as we peel through the sector, we are hard-pressed to identify sustainably differentiated business models, and the incremental currency tailwinds and/or operating leverage to sustain line-of-sight to earnings growth compounding at least in line with nominal GDP growth.

• Consumer staples. We remain largely sidelined given the juxtaposition of high valuations and poor earnings visibility on the back of higher input commodity costs, rising competition, and the risk of an El Niño-impacted poor monsoon season impairing rural demand.

Chemical sector to benefit

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The Indian chemical industry is at a compelling crossroads of several durable investment thematics. These are (i) policy-driven industrialisation and import substitution; (ii) China+1 and the relocation of global supply chains away from China; (iii) the imperative for greater energy security and the green energy transition in the aftermath of the Russian invasion of Ukraine; (iv) resilient domestic consumer demand; and (v) sustained export competitiveness amid more stringent environmental and social standards being imposed globally. We were fortunate to have been early investors in the industry, and having exited the positions last year as we fretted over high multiple stocks and the likelihood of a global recession and demand destruction following the start of the war in Ukraine, we are now starting to re-visit our convictions given the substantial pullback in valuations across the sector.

• Topdown, we expect the industry to generate incremental revenues of US$700 billion ($947 billion) over the next 15 years on the current base of US$180 billion, compounding at about 12% CAGR on the back of rising domestic disposable incomes and consumer demand, a preference for bio-friendly alternatives and the growing localisation of global pharma-intermediary and agro-chemical supply chains.

• The key risks that we continue to evaluate are (i) a prolonged global recession and the negative implications for potential further demand destruction, and for high multiple stocks; (ii) feedstock availability given lagging cracker capacity creation; (iii) unpredictable delays in securing local environmental approvals and adequate land to expand to meet global demand; and (iv) securing adequate domestic R&D talent.

• We are focused specifically on identifying managements and businesses committed to (i) environmental and regulatory compliance, (ii) building process chemistry skills, scale, and global cost leadership, and (iii) remaining disciplined with capital allocation decisions and leveraging scale and mix (with a greater proportion of speciality chemicals in the revenue mix) to drive profitability and returns.

To recap, we expect equity markets to remain extremely volatile as investors look to internalise moving targets on terminal interest rates and currencies, prolonged recession and demand destruction risks, higher geopolitical risk premiums, and Fomo trades that seem to change course, weekly.

With valuations having pulled back from their November highs, our bottom-up convictions yield a cogent narrative on the Modi government’s commitment to structural reforms, infrastructure development, fiscal discipline, industrialisation and job creation, and resilient domestic demand underpinning strong earnings/cash flow visibility for our portfolio holdings.

• We plan to take advantage of the volatility to increase our exposure to high-quality financials, industrials, infrastructure, and consumer discretionary stocks.

For more stories about where money flows, click here for Capital Section

Stock of the month

The stock we would like to highlight this month is Eicher Motors, the manufacturer of the iconic Royal Enfield line of premium motorcycles, and light and medium commercial vehicles. The motorcycle business remains the key driver of revenues and earnings and was built on a legacy going back almost a century to nurture an enviable lifestyle brand. Eicher is poised to leverage its brand, distinct styling, and higher engine displacement to expand its range of premium product offerings in both the domestic as well as export markets.

We expect Eicher to compound revenues at a 30%+ CAGR while the street is pencilling in a much more modest high-teens growth rate.

• Given our conviction in the new product cycle, management’s unwavering focus on the brand and expanding a high-quality dealer network, and the improved access to financing options, we believe that Eicher will sustain volumes compounding at 20%+ annually over the next three years.

• The launch of the new Hunter and SM650 models have been well-received and we expect that in addition to attracting a different market segment, as volumes scale, we will see a meaningful positive inflexion in the mix, in both the domestic as well as the export markets.

• We are encouraged by the recent investment in Stark Future electric motorbikes, providing access to a technology platform that should enable a smooth transition to mid-engine electric motorcycles in 2025.

• Similarly, we are encouraged by the green shoots in the industrial economy and anticipate the current traction in commercial vehicle sales to be sustained over the next two to three years.

• We expect Eicher to compound earnings at 40%+ annually over the next three years, almost double current consensus expectations.

• We expect mixed improvement as exports and new products (Hunter and SM650) scale up with strong operating leverage on higher capacity utilisation rates to drive 100 bps of operating margin gains annually over the next three years.

• Commodity disinflation may well provide an additional short-term uplift for margins.

• We anticipate ROE/ROCE to improve to 25%/30% by FY2025 from sub-20% currently and anticipate a higher dividend payout despite continuing to invest aggressively in branding and new product development.

The Tantallon Asia Impact Fund SF is a fundamental, long-only, Asia-focused, total return opportunity fund. The fund invests with a horizon of three to five years in a concentrated portfolio (30– 35 positions without leverage), market cap/sector/capital structure agnostic, but with strong conviction on the structural opportunity, scalable business models, and data-driven analysis of sustainability, innovation, societal trends, and material environmental and governance initiatives to drive profitability. Tantallon Capital Advisors is a Singapore-based entity set up in 2003. It holds a capital markets service licence in fund management from the Monetary Authority of Singapore

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