Growth slowdown, geopolitics unnerve Indian market

In India, investors have been spooked by the deceleration in GDP growth to 5% (monsoon deficits and the credit crunch in rural India being the primary culprits), the vulnerability of the export economy (now, accounting for 20% of GDP) to the global slowdown, the stock market overhang from pledged shares being held as collateral and the government’s self-inflicted wounds (specifically, the tax surcharge on high-networth and foreign portfolio investors and the heavy-footed response to the credit squeeze on the smaller non-bank finance companies).

At the risk of sounding like a broken record, this is the time to acknowledge the risks, but — to take the long view — focus on fundamentals and intentionally invest in companies that are structurally growing share at the expense of weaker competitors in a growing economy.

• The fear and uncertainty in public markets is palpable, as is the frustration at significantly heightened volatility, and numerous short-term trading strategies failing to preserve capital;

• The irony, of course, is that the last six months have seen a significant uptick in both foreign direct investments (FDIs) and strategic ones in India as MNCs and venture funds (from Walmart, Amazon. com, Duracell, Alibaba Group Holding, Tencent Holding, Saudi Aramco and BP to SoftBank Group, Blackstone Group, CDC, Invesco, Steadview and Wellington) have looked to opportunistically take advantage of the selloff in public-listed assets; and

• Even more striking, controlling shareholders increased their stakes in 134 of the listed S&P BSE 500 companies last month.

Has GDP growth bottomed?

We believe that growth troughed at 5% in the June quarter. We expect the government to continue to introduce targeted fiscal and monetary stimulus, specific relief measures for the agrarian economy and the recapitalisation of public sector banks.

• Government expenditure bottomed at 2% of GDP during the June quarter: We expect government expenditure to normalise at 8% of GDP over the next 12 months, providing a significant impetus to the real economy;

• The Reserve Bank of India has delivered four consecutive rate cuts: Given the surplus interbank liquidity and the new guidelines on benchmark base lending rates, we expect RBI’s messaging and rate actions to be more effectively transmitted over the next 12 months;

• The recently announced merger of 10 public sector banks and their effective recapitalisation is a clear statement of intent to avoid the “walking dead” syndrome and to allow public sector banks to start to lend again;

• The rolling-back of the retrograde tax surcharge on capital gains, proposed in the July budget, was an acknowledgment of a misstep and the willingness to “fix” the mistake;

• Further easing of FDI norms in contract manufacturing, coal mining, digital media and single brand retail — clear recognition of the opportunity to continue to attract manufacturing sector FDI (and jobs) as a viable alternative to China;

• The commitment to streamline the goods and services tax refund process, with outstanding GST refunds to be paid within 30 days, will significantly ease working capital constraints from small and medium-sized businesses;

• It is hoped that allowance for accelerated depreciation benefits and the deferral of auto registration fees will jump-start a new commercial vehicle replacement cycle; and

• Further simplification of the Know Your Client norms for the issuance/renewal of foreign portfolio investor licences. The rupee is trading cheap relative to our real effective exchange rate fair-value estimates of about INR70/USD.

We have seen a sharp growth slowdown, regulatory indecisiveness, policy mid-steps and earnings disappointments in some of the large index constituents.

The primary risks: (i) further competitive devaluations (our base case is for the RMB to trade closer to 7.30/USD with increased two-way volatility); and (ii) a sharp spike in crude prices in the event of a deterioration in geopolitics in the Middle East.

Our base-case assumptions are supported by our expectation of growth having troughed in the June quarter, US$430 billion ($590.7 billion) in foreign currency reserves, a modest sub-2% current account deficit, inflation well in check, the demand/supply-driven pull-back in global energy prices and, importantly, the recent growth-restorative measures announced by the government.

Stock focus: Max Financial

The stock we would like to highlight this month is Max Financial Services, the controlling shareholder of Max Life, India’s largest independent (that is, non-bankowned) private life insurance company. After almost two decades of investments, the private Indian insurance sector has established scale (at the expense of the erstwhile government monopoly), and is on the cusp of multi-year profitable growth. Max Life has systematically developed the highest-quality insurance book in the country, with high persistency ratios across the board, and a strong network leveraging both bancassurance as well as independent agent distribution.

The stock has underperformed the market and its peers over the last 12 months on the back of concerns over the changes in the holding company structure (with Mitsui Sumitomo Insurance Co swapping its stake in the operating business, Max Life, into the listed company, Max Financial), concerns over pledged shares by the founding shareholders and uncertainty over the bancassurance tie-up with Axis Bank. This temporary overhang has, quite frankly, diluted the market’s appreciation of the strong growth fundamentals, systematic market share gains and structurally superior profitability of the operating business.

With the regulators enforcing open architecture in the distribution channels, we expect Max Life to grow its gross premiums at more than 25% annually over the next three years versus the market’s more muted expectations of about 15% growth.

• The sector growth dynamics are compelling on the back of rising awareness/ penetration levels;

• Management’s focus on traditional protection products, deliberately limiting the equity-linked business, has paid rich dividends, allowing the company to grow its book of business through periods of weak/volatile equity markets; and

• We expect to see Max Life’s gross premium growth tracking substantially above the market, allowing sustained market share gains.

We expect new business premiums to improve by 500 basis points over the next three years to 25% — the market is currently projecting flat margins.

Over the past decade, Max Life has deliberately eschewed flashy top-line growth to emphasise the selling of higher-margin protection products.

Improving persistency rations, operating leverage and conservative actuarial assump tions make us comfortable projecting returns on embedded value at more than 20%+ (management’s goal is to actually deliver on a 25% return on embedded value).

The bottom line: Our conviction is that as growth troughs, as in prior cycles (this is the fourth “slowdown” in the last two decades: March 2000 to December 2002; June 2008 to March 2009; September 2011 to March 2014; and June 2018 to when?), the Indian market is poised for meaningful outperfor mance in absolute and relative terms.

• We expect a revival in government spending and on infrastructure and rural development, in particular, the recapitalisation of public sector banks, and a further rationalisation of the GST tax slabs;

• We expect a more efficient transmission of the RBI’s clear messaging on easing rates over the next 12 months; and

• Sustained FDI flows, corporate mergers and acquisitions, and creeping acquisitions by controlling shareholders attest to increasingly attractive valuations for listed equities and, in particular, in the small- and mid-cap universe.

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.