SINGAPORE (Feb 25): The Tantallon India Fund closed 6.16% lower in January; volatility in global markets and rising risk aversion have served to aggravate fragile investor sentiment over the outcome of the upcoming general election, on small and medium-sized companies and particularly in connection with loans made to major shareholders with pledged shares as collateral.
The irony, of course, is that the recent selloff has had very little to do with business fundamentals — consistent high-frequency data points and the December quarter earnings releases would affirm that we are at the start of a new investment up-cycle, credit growth and profit margins are inflecting higher, the correction in energy prices would seem to have nudged inflation (and inflationary expectations) lower, and valuations are increasingly attractive relative to our benign outlook on inflation and the prospects for sustained growth.
Keep a watchful eye on political scene
The Bharatiya Janata Party’s poor performance in the state elections in November and December has encouraged the Opposition to look to create alliances ahead of the next general election, which needs to be held by May. The various talking heads project any number of potential outcomes; what we are certain of at this point is that no one really knows.
Our working assumption is that Prime Minister Narendra Modi will retain a functional majority in Parliament — despite his well-publicised missteps with the introduction of GST and demonetisation, and the failure to deliver on his stated goal of creating 20 million new jobs a year (the economy is currently tracking at 12 million to 14 million new jobs a year versus the historical run-rate closer to more than three million annually).
There is no doubt that Modi remains a polarising figure for the media and within the business community; you really like him, or you really don’t. The recent articles in the international press, in particular, have stridently proclaimed Modi’s imminent political demise, while demonstrating limited depth and texture in the analysis.
In addition, to be fair, we are probably at one end of the spectrum in viewing with significant cynicism the myriad pre-poll alliances being touted by ideologically and deeply conflicted opposition parties. A virulently anti-Modi platform, with little thought to realistic options or detail, is hardly sustainable.
Our view is that the Indian electorate has always been relatively thoughtful and nuanced — and takes its electoral responsibilities seriously. Despite the natural anti-incumbency bias, the fatigue in rural India over stagnating rural incomes, and millennial disenchantment at the pace of job creation, our sense is that Modi’s street credentials and personal integrity are intact, and that the recent budgetary measures to reduce taxes and boost rural incomes and consumption will be positively received.
The bottom line is that, in four decades, this is the first Indian administration that has not been swamped by allegations of corruption and crony capitalism. Modi’s reforms are transformational, and the impact on the bottom-of-the-pyramid is real. Given the lack of credible options at the national level, we believe Modi will be re-elected prime minister, albeit with a reduced majority.
What if we are wrong, and BJP does not come back to power in May?
If history is any guide, the market’s initially negative reaction will devolve quickly into an assessment of (i) the strength of the institutions, (ii) whether the reform process will stall or, worse, be reversed, and (iii) the outlook/sustainability for growth.
Our absolute conviction is that Modi’s reform measures have been thoroughly institutionalised and will not be reversed — from GST implementation, to the Real Estate Regulation Act, the new bankruptcy code, the Debt Resolution Tribunal, the transparent public auctions of state assets and, importantly, the direct transfer of subsidies to the bottom of the pyramid (as opposed to the debilitating subsidy programmes over the past five decades).
So, yes, we should expect more stock market volatility over the next three months. Over the next 12 months, however, as in previous election cycles, as India’s growth cycle unfolds, we should also expect the market to explicitly focus on and reward strengthening business fundamentals, and for small- and mid-cap stocks to significantly outperform the positive returns from the broad market.
In 2004, 2009 and 2014, in the 12 months following the general election, the NIFTY 50 (the top 50 stocks by market capitalisation) posted returns of 39%, 20% and 19% respectively.
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.
Lower rates, easier monetary conditions
The correction in crude prices has translated into a significant pullback in headline inflation and inflationary expectations. With headline inflation now tracking and projected well below the Reserve Bank of India’s inflation targeting band, RBI is in a position to reduce interest rates. [On Feb 7, RBI cut its repo rate (the rate at which RBI lends money) by 25 basis points to 6.25%.]
Yes, the struggling, lower-quality, non-bank finance companies claim the headlines in the popular press but, from our perspective, having visited companies on the ground, system liquidity has clearly stabilised, as evidenced by improving credit disbursement and stable domestic bond yields.
The key now is whether the outlook for energy prices/headline inflation/inflationary expectations remains benign and, if it does, we would not be surprised if RBI cuts rates further.
Thermax is proxy for sustainability play
The stock we would like to highlight this month is Thermax, a professionally managed capital goods company focused on industrial heating and cooling, captive and co-generation plants, water system management, air pollution control and speciality chemicals. Thermax significantly revamped the business model during the current down-cycle, diversifying geographical and product mix, and emphasising short-cycle products that will smoothen order book volatility. Thermax stands out as an early-cycle industrial, strongly leveraged to the recovery in industrial capital expenditure, conservatively run with a net cash balance sheet, robust free cash flow generation and a consistent 30% dividend payout policy.
We expect consolidated revenues to compound at more than 20% annually over the next three years, versus consensus expectation of revenues compounding at 15% annually.
The current 1.3 times book-to-bill ratio and a strong pipeline of new order bids give us excellent visibility on the next 18 months of orders, revenues and margins. As in past election cycles, we expect a signi-ficant ramp-up in domestic-order inflows after the general election in May.
The new Indonesian manufacturing plant opens up a significant opportunity in Asean for the captive/co-generation vertical; the early feedback from Asean customers would suggest significant upside to consensus expectations.
In addition, we expect the industrial heating business to deliver sustained growth over the next five years as management’s investments in sales and marketing, leveraging its low-cost engineering capacity in India, start to show results in other emerging markets in Asia, Latin America, Africa and Eastern Europe.
We expect earnings to compound 30% annually over the next three years; consensus expectations are anchored in the 18%-to-20% range.
Through the most recent downturn (with revenues falling as much as 30% at one point), management has continued to invest in upgrading, and in new capacity in its industrials, steel, cement and speciality chemicals verticals: Gross fixed assets have increased 50% since the last peak. We believe the market is significantly underestimating the inherent operating leverage as capacity utilisation ramps up.
On the back of the recovery in domestic industrial capex, and higher export volumes driving mix improvement, we expect operating margins to improve 50bps to 75bps annually over the next three years.
Conclusion
Buoyed by lower crude prices, easing liquidity concerns and recovering consumer demand, fundamentals are starting to reassert themselves. We would urge investors to take advantage of the uncertainty in the lead-up to the general election to increase allocations to Indian equities.
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.
Our view on sustained volume/revenue growth and upside inherent in strong operating leverage underpins our conviction on our portfolio holdings’ delivering on earnings and cash flows compounding at more than 15% annually over the next three years.
Valuations have corrected significantly over the last few months, and the risk/reward is compelling.
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 and scalable business models and in management’s ability to execute. Tantallon Capital Advisors, an advisory company, 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
