(Aug 19): The Tantallon India Fund closed -4.58% in July. The fault lines between tweets have finally been exposed, with the renminbi breaking its RMB7:US$1 floor. The harsh economic costs of a protracted trade conflict, the unprecedented mass demonstrations in Hong Kong challenging China’s hegemony, the rolling conflicts in the Middle East and the uncertainty posed by Johnson-ian bluster and bravado in the UK would suggest that geopolitics are likely to further erode fragile investor confidence.
In India, the proposal to scrap Article 370, rescinding the special rights and privileges of “permanent residents” in the disputed border state of Kashmir, while transformative and bold and in line with Prime Minister Narendra Modi’s explicit election agenda, has been a “surprise” at a time when the slowdown in the real economy has already generated significant investor angst. It has certainly been another challenging summer.
Reflecting on the extreme volatility in the markets over the last few weeks, the negatives are:
• Volatility is up — in spades. There has been US$3 billion ($4.16 billion) in “foreign selling” in July alone;
• Global growth is challenged, and with exports now tracking at 20% of GDP, India — and the rupee — is not completely immune to the risks posed by trade conflicts, competitive devaluations and geopolitics;
• Smaller banks and non-bank finance companies are being forced to “clean up”; however, given their capital and liquidity constraints, funding for small and medium-sized enterprises, the agrarian economy and marginal consumption has been significantly cut back; and
• The overhang from entrepreneurs’ having pledged their shareholdings as collateral to fund “other” businesses has come home to roost, and the markets have been particularly severe with small and medium-sized companies — not because of the fundamentals but on account of the risk of entrepreneurs’ being forced to divest stock at distressed prices.
Expecting stimulus
The positives are:
• Cognisant of a slowing economy and weak consumer sentiment, and the negative feedback loop to the budgetary proposals to increase the effective tax burden for the wealthy, and in particular, for equity investors, we expect the government to introduce targeted fiscal and monetary stimulus to drive fixed-asset capital formation, specific relief measures for the agrarian economy and the recapitalisation of the public-sector banks;
• The Reserve Bank of India cut repo rates by another 35 basis points (bps) at the policy meeting on Aug 7 — the fourth rate cut in a row. Given the surplus interbank liquidity, we expect the RBI’s messaging and rate actions to be more effectively transmitted over the next 12 months;
• Government expenditure troughed at 2% of GDP during the June quarter, held back by the elections. We expect government expenditure to normalise at 8% of GDP over the next 12 months, providing a significant impetus to the real economy; and
• Strong foreign direct investment (FDI) flows and overseas inflows into rupee fixed-income instruments have helped alleviate the foreign equity outflow.
Explaining Kashmir and Article 370
Article 370 is the constitutional provision (inserted by presidential decree in 1954 as opposed to being a formal parliamentary amendment) underpinning India’s emotive, complex relationship with Kashmir, the only Muslim-majority region on the subcontinent to join India at the time of partition in 1947.
• For 65 years, Article 370 has reluctantly allowed the state of Kashmir a certain amount of autonomy — its own constitution, a separate flag and freedom to make laws regarding local citizenship, including restricting ownership of property, and government employment and grants to deemed Kashmiri citizens;
• Stung by the continued insurgency in Kashmir (with more than 300 people being killed in the last six months alone) and Pakistan’s inability/unwillingness to rein in terrorist activity in Kashmir (operating from “safe” camps immediately across the Line of Control), Modi made revoking Article 370 a central plank in the Bharatiya Janata Party’s 2019 election manifesto; and
• Scrapping Article 370 therefore does away with Kashmir’s semi-autonomous status; and the introduction of the plan to break up the current state of Jammu and Kashmir (J&K) into two separate “union territories” (Jammu and Kashmir, which will retain its legislature; and Ladakh, a sparsely populated region to be ruled directly by India’s central government) will explicitly increase the central government’s control over the valley.
Modi’s decision to revoke Article 370 has provoked much consternation, support and outright opposition, almost in equal measure — domestically and internationally.
• Modi’s mandate and his penchant for calibrated risk-taking should have suggested that fulfilling his campaign pledge on Kashmir would be a priority. To be fair, though, we are surprised that he acted so early in his term when addressing the slowdown in the real economy would appear to have been of the highest priority; and
• The flip side is that, with the credibility of J&K’s “mainstream” political parties having been severely eroded in the face of mounting violence, and evidence of significant state-level corruption, with Pakistan desperately looking for substantial debt relief and financial aid packages from the International Monetary Fund and the US, and with China focused on its trade war with US President Donald Trump and the demonstrations in Hong Kong, it is the opportune time to change the status quo.
It is too soon to hazard even an educated guess as to how the history books will ultimately judge Modi’s decision to abrogate Article 370 — and there are simply too many moving parts to even pretend otherwise.
That said, in the weeks ahead, we should: (i) expect more violent insurgency in J&K; (ii) a robust challenge in the Supreme Court questioning the constitutional validity of Modi’s decision to abrogate Article 370; and (iii) significant criticism in the international media/forums as Pakistan and China look to marshal opposition to Modi’s determination to reframe the “debate” over Kashmir.
Asian Paints to benefit from infrastructure plans
The stock we would like to highlight this month is Asian Paints, the largest paint company in India, which operates in both the decorative and the industrial coatings segments. With more than 60,000 dealers across the country, Asian Paints is primed to benefit from the continued buildout of urban infrastructure and rural housing, the revival in urban discretionary spending and an improving product mix.
Over the next three years, we expect revenues to grow at a compound annual rate of more than 15% versus the market’s projected revenue growth in line with nominal GDP growth of 11% to 12%.
• Having boosted capacity by 50% with two brand-new plants coming online, Asian Paints is primed to take advantage of its dominant brands presence (30% market share of the domestic paint market, thrice larger than its nearest competitor, with revenue per dealer 60% higher than competition), the nascent demand from the government’s “housing-for-all” initiatives in rural and semi-urban India and the significant upside in the “repainting” segment (which accounts for more than 90% of overall decorative demand in the country);
• The recent Goods and Services Tax (GST) slab reductions have opened up several new market segments, and management is singularly focused on driving market-share gains in the distemper, putty and emulsion segments at the expense of the unorganised sector;
• We expect earnings to compound at more than 18% annually over the next three years versus consensus projections in the range of 10% to 12%;
• A benign input cost environment will be supportive of higher margins; however, we have to yet to model in any upside since we expect management to use price to drive sustained volume growth and higher plant utilisation rates; and
• We expect to see 50bps of operating margin improvement over each of the next three years as capacity utilisation ramps up in the two new plants, and as management’s deliberate focus on brand positioning and product recall drives volume growth and improving product mix.
Given capex having peaked and significant free cash flow, we believe there is good impetus to model an improvement on the current 45% payout ratio.
Ample liquidity
As negative as sentiment seems to be currently, we can point to at least three occasions in the last six years (August 2013, December 2016 and November 2018) when sentiment was even worse.
• With ample domestic liquidity, we expect a more efficient transmission of the RBI’s clear messaging on easing rates over the next 12 months;
• We expect a revival in government spending, the recapitalisation of the public-sector banks and a further rationalisation of the GST tax slabs; and
• Valuations are attractive, especially for the small and mid-cap universe, attested to by a spate of corporate M&A and continued FDI inflows.
We would simply underscore our conviction in India’s idiosyncratic growth opportunity and, specifically, the opportunity in financial services, consumer discretionary and real estate.
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 management’s ability to execute. Tantallon Capital Advisors, an advisory company, is a Singapore-based entity set up in 2003 that holds a Capital Markets Services Licence in Fund Management from the Monetary Authority of Singapore
