SINGAPORE (Jan 21): The Tantallon India Fund closed 0.46% higher in December, a quiet close in the face of substantial market volatility, affirming the underlying strength in Indian business fundamentals, nudging investors to take the long view as lower crude prices and attractive valuations allow for a reset in the risk/ reward equilibrium in Indian equities.
We would simply reaffirm our conviction in India’s secular fundamentals: High-frequency economic data continues to confirm the strength in domestic demand and a nascent capex cycle; we continue to be impressed by transparent policymaking, credible inflation-targeting monetary policy, and fiscal restraint despite the obvious temptation to loosen the purse strings significantly in the lead-up to the elections; and we remain encouraged by sustained domestic investor equity flows in the face of foreign institutional selling pressure.
The market’s concerns are centred around (1) the direction of crude prices (and the implications for the current/fiscal deficit and the rupee); and (2) the outcome of the next general election, which needs to be held by May, and whether Prime Minister Narendra Modi retains a parliamentary majority.
In contrast, buoyed by crude prices around US$60 a barrel and sustained demand, the Indian business community is building intentionally towards a new capex cycle (as evidenced by credit growth tracking at more than 15%) as industry capacity utilisation rates nudge past 75%.
General election year rally: Will mid- and small-cap stocks surge again?
• The last 12 months have been particularly painful for our portfolio’s small- and mid-cap tilt as higher crude prices and the fear of significantly tighter monetary policy to contain inflationary expectations and to support the rupee triggered a bout of extreme risk-aversion towards the small- and mid-cap universe.
* While the top 10 stocks by market capitalisation saw a median correction of 12% from their 52-week highs, the sharpest correction was in the small- and mid-cap space, where the median correction was in excess of 40%.
• Historically, in the 12 months following the general election, small- and mid-cap stocks have significantly outperformed the positive returns from the broad market. * In 2004, 2009 and 2014, in the 12 months following the general election, the Nifty 50 (top 50 stocks by market cap) posted returns of 39%, 20% and 19% respectively; and
* In comparison, in the 12 months following the elections in 2004, 2009, and 2014, the mid-cap universe delivered returns of 61%, 68%, and 40% respectively.
Identifying the key thematics driving our stock selection:
• The strong (that is, strong brands, strong balance sheets and effective distribution channels) are getting stronger, while the poorly capitalised, and the unorganised sectors are being marginalised — thanks to the implementation of the goods and services tax, the government’s efforts to reduce the size of the cash economy, financial intermediation, digitisation and significant sector consolidation;
• The upcoming general election will hone the focus on the rural economy, job creation, discretionary consumption, universal healthcare and mass housing;
• Rising industrial capex as industry utilisation rates surpass 75%;
• Lower crude prices will allow for lower inflationary expectations, a more stable rupee and for the Reserve Bank of India to ease systemwide liquidity; and
• Domestic equity flows to sustain market multiples and valuations for companies that actually deliver on sustained earnings and cash flow growth.
Crude oil price fall tailwind for India
Elsewhere, a snapshot of the external variables likely to have an impact on markets/ sentiment over the next few months:
• Crude oil prices do keep us on edge. The Saudi and Russian budget deficits would look a lot “healthier”, with crude at US$80/barrel. Conversely, from an India perspective, a 10% fall in crude prices shaves 20 basis points off headline inflation, while a US$10-a-barrel correction in crude prices narrows the current account deficit by 0.5% of GDP.
* With crude prices under US$70 a barrel, fair value for the rupee on a real effective exchange rate basis is in the range of INR68 to INR70 to the US dollar — for reference, the rupee traded as low as INR74.39 when crude surpassed US$80 a barrel;
• Whither the US dollar? A dysfunctional administration, Congressional gridlock, real estate prices starting to roll over and US Federal Reserve chairman Jerome Powell seemingly resetting expectations on “neutral” policy rates would point towards a weaker US dollar. Potentially, this is very good news for non-US assets, and emerging markets in particular;
• The trade wild card remains an overhang. Even prior to Apple’s “shock” announcement, it was clear that the increasingly blurred fault lines between genuine national security concerns, internet protocol theft/transfer, protectionism, industrial subsidies and commerce would weigh heavily on growth/earnings outlooks. Perhaps the sharp volatility in stock markets have an impact, where hitherto “grownup” advice has been ignored; and
• China will demand its share of the headlines. There is growing recognition by Chinese policymakers that the measures to “deleverage” and to “rebalance” the Chinese economy away from debt-funded manufacturing have seen the economy slow significantly, exacerbating the pressure points being brought to bear by US tariff action/proposals. Given China President Xi Jinping’s focus on maintaining political stability domestically, we should expect (i) fiscal and credit stimulus measures to buffer the domestic economy; (ii) further reductions in the banks’ required reserve requirements; and (iii) unfortunately, more rhetoric along the lines of Xi’s recent exhortation to maintain “combat preparedness” for conflict in the South China Sea.
Visibility on revenues and earnings for Zee Entertainment
The stock we would like to highlight this month is Zee Entertainment Enterprises, India’s largest media company with a vast library of original, multilingual TV serial and movie content, a genuinely pan-India distribution footprint and an enviable brand. The library, the tested and proven content creation capacity, and the domestic distribution platform makes Zee a compelling partner for a global media company looking to invest in the Indian over-the-top space. Given management’s very specific criterion for an incoming strategic investor (technology to facilitate the OTT offering, international content to be bundled with Zee’s Hindi and vernacular content, access to global distribution for Zee’s content library, and the willingness to invest for the long term), we believe a strategic investor coming into Zee is highly probable and will underpin valuations, given good visibility on revenues/margins/earnings. We expect consolidated revenues to compound at close to 20% annually over the next three years, well ahead of the consensus expectation of revenues compounding at less than 15%.
• We are comfortable projecting advertising revenues compounding at 20%+ annually on the back of sustained GDP growth. Zee continues to gain viewership share across key regional markets, in addition to being the No 1 broadcaster in the largest, most profitable Hindi-language general entertainment segment;
• The recent Telecom Regulatory Authority of India tariff order enforcing pricing parity across offerings will benefit leading broadcasters such as Zee. The continued roll-out of digitisation in Tier-2 and -3 cities, coupled with the systematic launch of new regional channels, will underpin subscription revenues compounding at 15%+ annually;
• Over the next three years, as global satellite TV platforms target the Indian diaspora in South Asia, the Middle East, Europe and the US, we expect international subscription and advertising revenues to account for close to 10% of consolidated revenues; and
• At this point, we are building in no assumptions on the potential opportunity to monetise the content on the OTT platform, Zee5.
We expect earnings to compound at 20%+ annually over the next three years, substantially ahead of consensus expectations projecting an earnings compound annual growth rate of 12%.
• The revenue upside that we are modelling clearly differentiates us from consensus;
• In addition, given the opportunities for in-content branding/advertising, and the upside that we are modelling for subscription revenues, we expect Ebitda (earnings before interest, taxes, depreciation and amortisation) margins to be sustained around 30%, despite the significant new investments in content and Zee5; and
• With return on equity and return on capital employed tracking in excess of 20%, and free cash flows compounding in excess of 30% annually, we expect meaningful improvement from the current dividend payout ratio of 27%.
Conclusion
Looking back on 2018, we are sorely reminded that our conviction in smaller and medium-sized companies was overwhelmed by the market’s short-term concerns over higher crude prices and tightening global/domestic liquidity.
Looking ahead, buoyed by lower crude prices and easing liquidity concerns, fundamentals are starting to re-assert themselves; investors should take advantage of any uncertainty in the lead-up to the general election to increase allocations to Indian equities. In a growth-challenged world, particularly given the concerns on a slowdown in both the US and China, India’s structural reforms and domestic economy stand poised to deliver on sustained real GDP growth compounding at more than 7% annually over the next three to five years.
Corporate confidence in sustained volume/ revenue growth, and upside inherent in strong operating leverage, drive our conviction on our portfolio holdings delivering on earnings and cash flows compounding at 15%+ annually over the next three years.
Valuations have corrected significantly over the last few months, and the risk/ reward is compelling in the long runway opportunities in industrialisation, urbanisation, consolidation, financial intermediation, digitisation of the real economy, enhanced agricultural productivity 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 three-to-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, holding a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore.
