SINGAPORE (June 18): The Tantallon India Fund closed down -4.66% in May, after expenses. It has been a particularly difficult month for small and medium-sized companies that have been sold down rather indiscriminately — despite fundamentals on the ground continuing to improve as evidenced by the strong GDP print, very positive corporate commentary and a very strong earnings season.
We would point specifically to (i) the spike in crude oil prices, and the implications of significantly higher energy prices for inflationary expectations and, therefore, for tightening monetary policy, and (ii) US dollar strength and the prospects of higher real interest rates as the primary catalysts for the heightened risk aversion setting the tone for markets broadly.
Our conviction stays intact: With the earnings cycle having inflected, we would urge investors to stay focused on the fundamentals, and to take advantage of the correction in valuations to invest intentionally in India’s transformative growth runway.
Having just returned from spending two weeks in India, we are struck by the sharp disconnect between stock market participants and corporate India.
• Almost without exception, asset allocators, fund managers, the sell side and the media talking heads would seem to be focused on the potential loss of flows/monetary policy support for equity markets broadly, the potential for damaging trade conflicts exacerbating the existential challenges being posed to customs unions globally and the uncertainty over the outcome of the next general elections.
• In sharp contrast is the quiet confidence being articulated by companies on the ground (across sectors and the market cap spectrum) on underlying domestic demand, rising utilisation rates, credit availability, political and fiscal stability and, importantly, in a nascent industrial capex cycle.
For the March quarter, India posted real GDP growth of 7.7%, accelerating from the December-quarter run rate of 7% real growth. Amid the noise and the panic of stop-loss selling, what seems to have been “lost” is an economy that is visibly demonstrating resilience, and the prospects of a sustained, demand and capex-driven growth cycle.
Despite the short-term growth challenges to the real economy posed by demonetisation and the implementation of the goods and services tax (GST), anchored by public spending, investments and private consumption, the real economy grew 6.7% for the fiscal year ended March 2018.
We expect India’s real economy to compound at a 7.5%+ run rate over the next three years on the back of a strong recovery in manufacturing and industrial capex, continued buoyancy in the services sector, recovering exports and the uplift in rural incomes and consumption.
Earnings cycle recovery intact
We retain strong conviction on the Indian earnings cycle having decisively inflected and in our portfolio companies delivering on earnings growth compounding at 15%+ over the next three years.
• Yes, private corporate capex and profitability as a percentage of GDP is at its lowest level since 1996 — against a backdrop of weak commodity prices, and the disruptions of demonetisation and the implementation of GST.
• Yes, a simplistic filter on the index would suggest continued “earnings disappointments” — primarily on account of anaemic utilisation rates at the industrial heavyweights, and the travails at the public sector banks, which are making provisions for their non-performing loans.
• However, going deeper into the markets, what seems clear is that underlying volume growth, rising utilisation rates and strong operating leverage are being reflected in a sustained margin uplift and very strong earnings/cash flow growth.
υ Services, private sector financials, cement, steel, passenger and commercial vehicles, tourism, infrastructure, speciality chemicals, logistics, renewables, agriculture and niche IT services are demonstrating strong sequential volume/revenue growth and, importantly, resilient pricing/margins.
υ Production capacities are stretched and, as utilisation rates rise, we believe we are on the cusp of a new, extended investment cycle.
• For the record, for the fiscal year ended March 2018, our portfolio holdings delivered on earnings growth of 26%.
The Reserve Bank of India (RBI) has preserved its inflation-targeting credentials by hiking repo rates by 25 basis points (bps) to 6.25% at its June 6 monetary policy meeting.
As we had expected, the RBI has chosen to allay market concerns over “falling behind the curve”, by bringing forward the rate-tightening cycle in response to accelerating growth, heightened inflationary expectations following the spike in energy prices, and the back-up in US Treasury yields.
• In reiterating its “neutral” policy stance despite the rate increase, our sense is that the RBI is signalling that this will be a shallow, data-dependent, rate hike cycle.
• Assuming crude prices in a US$70-$80 band, and real GDP growth accelerating to sustain at 7.5%+, we should expect another 50bps of tightening over the next 12 to 18 months.
Company highlight: Cyient
The company that we would like to highlight this month is Cyient, an engineering and R&D software company focusing on specific niche segments: aerospace, defence, transportation, communications, semiconductors, medical devices and geospatial projects. The opportunity to grow not just their client base but their customers’ share-of-wallet is significant, as Cyient delivers on differentiated, custom solutions to global businesses committed to adopting artificial intelligence (AI), the Internet of Things (IoT) and, crucially, the imperative to analyse and react/respond in real time to big data. We anticipate a substantial rerating of the stock as the market recalibrates the business model. We expect Cyient to continue to deliver sustained revenue growth, with an improving mix and strong operating leverage driving profitability.
We expect consolidated revenues to compound at 18%+ annually over the next three years, with meaningful risk to the upside as the invest
ments in people and systems over the last five years start to bear fruit. Market consensus would seem to be projecting a more sedate 13% compound annual growth rate (CAGR) in revenues.
• An enviable client list (United Technologies Corp, Pratt & Whitney, Boeing) would suggest a step-function increase in the aerospace and defence business opportunity, given the upcoming product replacement cycles for the Boeing 737s and the Airbus A-320s, and the recently established joint venture to develop and manufacture unmanned aerial vehicles (UAV).
• The geospatial opportunity is significant, leveraging the decade-long relationships with Bombardier, TomTom and Ordinance Survey of the UK to deliver on navigation-based apps and solutions for the shared economy (ride-sharing, food and grocery delivery and package delivery services), signalling, service and safety solutions for mass transit systems, high definition maps and safety override features for autonomous vehicles, and detailed 3D geospatial models for 5G network planning and rollouts.
• AI and the IoT will be more than just buzzwords, as Cyient commissions turnkey, custom solutions for the likes of NVIDIA and Bosch, integrating complex firmware designs with safety and maintenance software that collects, collates, analyses and responds to a multitude of data inputs in nanoseconds.
Expecting CAGR of 20% for earnings
We expect profits to compound conservatively at 20%+ annually over the next three years (versus the market consensus that is building in a 15% CAGR). We believe we are on the cusp of a structural uplift in mix/margins over the next three years.
• Our conviction is that the market is yet to fully appreciate the incremental change in the business model from billing of time and material, to fixed price/outcome-based pricing models.
• There have been substantial investments made in the last couple of years in new capabilities (semiconductors, medical, defence), and as utilisation ramps up, we expect the intellectual property being generated by the different verticals to deliver on strong operating leverage and sustained profitability.
Conclusion
Despite heightened risk aversion, we would urge investors to take advantage of the market selloff to intentionally build exposure to Indian equities.
• On the back of Prime Minister Narendra Modi’s structural reforms and the RBI’s explicit inflation-targeting discipline, the real economy is poised to deliver GDP growth compounding at a 7%+ run rate over the next three years.
• Our portfolio holdings are demonstrating good visibility on accelerating revenue growth, margin uplift and on earnings and cash flows compounding at 15%+ annually over the next three years.
• The recent correction in valuations would suggest a compelling risk/reward given our benign outlook on inflation/interest rates, the potential upside from a multi-year investment cycle, and the long runway opportunities in industrialisation, urbanisation, consolidation, financial intermediation, digitisation of the real economy, enhanced agricultural productivity, and growth in rural incomes and discretionary spending.
The Tantallon India Fund is a fundamental, long-biased, India-focused, total return opportunity fund, registered in the Cayman Islands and Mauritius. The Fund invests with a threeto-five-year horizon, in a concentrated portfolio (25 to 30 unlevered positions), market cap/sector/capital structure agnostic, but with strong conviction on the structural opportunity, scalable business models and in management’s ability to execute. Tantallon Capital Advisors, the advisory company, is a Singapore-based entity, set up in 2003, and holds a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore.
