(Nov 18): The Tantallon India Fund closed up 1.96% in October on the back of resurgent global equity risk appetite and expectations of a nascent growth revival, further central bank easing and growing optimism over a trade deal between the US and China.
It is certainly worth pausing to reflect on the Indian market’s seeming “lack of conviction” — as reflected in recent data on foreign fund (in)flows and the current (defensive) portfolio positioning in the major domestic mutual funds — a recipe perhaps for the markets’ grinding higher into 2020 as benchmark-sensitive investors are forced to aggressively “add” risk.
Our (simplistic) reference points at 50,000 feet:
• Relative to developed-market bond and currency alternatives (case in point: despite deteriorating politics and economic fundamentals, the disconcerting strength of the US dollar reflects the absence of viable developed-market alternatives with positive yield), developing-market equity-risk premiums and the yield pickup in developing-market bonds are looking increasingly attractive; • Will they? Who knows? But, as we start to see the first signs of a more pronounced slowdown in the US, and given President Donald Trump’s mounting pressure points and the setbacks for the Republican Party in the recent elections, it does feel as though we are inching closer to a truce in Trump’s trade war; and
• Oil remains a broad proxy for geopolitical risk and, in particular, in the Middle East, and will certainly be front and centre in the Saudi Aramco IPO pitch. Fundamentally, however, the outlook for global crude demand remains subdued, while spiking inventory data would point to continued robust production.
More structural reforms
• Expect more structural reforms. Prime Minister Narendra Modi has exceeded expectations with the heavy lifting that has been done with the new bankruptcy code, the consolidation and recapitalisation of the public-sector banks and the significant tax code reform to bookend the institutionalisation of a digital economy and the implementation of the Goods and Services Tax (GST).
We expect the next round of reforms to focus on labour reforms to further incentivise foreign direct investments into manufacturing and new job creation, a new Direct Tax Code to streamline direct tax collection, strategic sales of public-sector companies, the continued rationalisation of GST rates/ mechanism, trade deals with the US, Japan, the UK and the EU, and policy measures to facilitate the liquidation of distressed assets weighing on the public-sector banks.
• A steepening domestic yield curve would suggest that the bond market is looking ahead to a growth reset and re-acceleration. We believe that growth has bottomed. Over the next two to three quarters, underwritten by further monetary easing, accelerating government expenditure on infrastructure, and targeted policy intervention (to restore liquidity to the smaller banks and finance companies, to revive the moribund real-estate sector and to address rural distress), we expect the real economy to trend closer to a growth glide path of 6% to 7%.
Further, Modi’s tax reforms explicitly tax-incentivises new capacity creation and sets the stage for a sustained, new investment cycle. We believe the reset in growth expectations and corporate risk appetite will see a fundamental revival in private-sector investments — the hitherto missing piece in India’s growth algorithm.
FDI and tax incentives to spur growth
• Modi’s reforms allow India’s industrial/manufacturing capacity to be globally competitive (post GST, post the bankruptcy code, post public banking sector clean-up, consolidation and recapitalisation, and post tax cuts). We would specifically point to the fine print: For new manufacturing investment capacity being set up, the effective tax rate falls further to ~17%, in line with the tax incentives being offered by China, Vietnam and Indonesia;
• Modi’s explicit focus is on job creation and real income growth. India’s demographic dividend demands ~20 million new jobs being created each year. We believe that discretionary consumption and financial intermediation will be a sustained, investible theme for our portfolio over the next decade;
• Halfway through the earnings season, we are finally starting to see the breadth of earnings revisions turning positive. Yes, the tax cuts help. Fundamentally, however, we are most encouraged by the resilience in domestic consumption, demonstrated operating leverage and a revival in both government infrastructure spending and private- sector capex as domestic risk appetite inflects positively; and
• Encouraged by the government’s focus on the real estate and the automobile sectors (on account of the positive spillover into the broad economy in terms of new job creation, income growth, sentiment and the propensity to spend/consume), we are currently spending a lot of time (re)assessing consumer sentiment, latent demand, affordability, access to financing, sustainable profitability and free cash flows, and risk/reward, given the sectoral derating over the last 18 months.
Shree Cement to benefit from infrastructure and land reform
The company we would like to highlight this month is Shree Cement, India’s third-largest cement company by capacity. For over a decade, Shree Cement has delivered the strongest and most consistent growth in the sector in terms of both capacity accretion (doubling capacity to 40 million tons over the last three years) and profitability. Management’s goal is to further double capacity to 80 million tons by 2025, at roughly US$85/ton in incremental capex (versus the industry standard of US$130/ ton, thanks to self-sufficiency in limestone reserves, existing land rights and the ability to implement cost-effective brownfield expansions), and to remain the low-cost producer in the sector.
We expect Shree Cement to deliver on revenues compounding at 15%-plus annually over the next three years versus consensus expectations of revenues compounding at ~10% annually.
• We are clearly more optimistic about the market — we expect cement industry demand to compound at 1.3x real GDP growth (that is, 10% annually) on the back of the government’s focus on infrastructure, affordable housing, urbanisation and large irrigation projects, and sustained rural housing demand.
Given Shree Cement’s ability to add brownfield capacity (quickly, efficiently and at low cost) and its regional expansion footprint (in the high-growth Eastern and Southern corridors), we expect its volumes to increase at a compound annual growth rate of 12%-plus.
• Given the delays in securing land and environmental clearances, we expect industry capacity accretion to significantly lag market expectations. We expect industry capacity utilisation rates to improve improve from ~60% currently to close to 80%-plus over the next three years, sustaining our expectations of prices improving at a 5% annual CAGR (relative to the 3.5% CAGR over the last 15 years).
We expect Shree Cement to compound earnings at 40%-plus over the next three years; consensus would seem to be looking for a CAGR of 18% to 20%.
• The market is likely to be surprised by both the upside risks to cement pricing and Shree Cement’s underlying operating leverage to pricing as management systematically improves the mix.
• We expect the company to remain the low-cost producer in the sector on the back of economies of scale and sustainable cost savings on energy, logistics, and transport costs.
Stimulating risk appetite
In conclusion, we believe that India has finally set the stage for an alternative growth narrative for itself.
• Underwritten by further reforms to stimulate domestic risk appetite and private- sector capex, further monetary easing, accelerating government expenditure on infrastructure and rural welfare, targeted policy intervention (to restore liquidity to the smaller banks and finance companies, to revive the moribund real-estate sector, and to address rural distress), and sustained domestic consumption, we expect the real economy to revert to a GDP growth glide path of 6% to 7% over the next three to five years;
• Our base case remains for our portfolio holdings delivering on earnings and cash flows compounding at 15%-plus annually (on the back of sustained market- share gains and strong operating leverage); the tax savings will be a further boost; and
• Valuations for listed equities are attractive, backstopped by the sustained bid from domestic investors, a significant uptick in both foreign direct and strategic investments, and creeping acquisitions by controlling shareholders systematically buying back stock.
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, an advisory company, is a Singapore-based entity set up in 2003 that holds a Capital Markets Service Licence in fund management from the Monetary Authority of Singapore.
