SINGAPORE (Dec 13): The Tantallon India Fund closed down 0.87% in November, with markets oscillating in the face of a weak domestic and external demand environment, slowing GDP growth, the growing asymmetric risks of the protests in Hong Kong and the lingering uncertainty with regard to trade sanctions, fragile geopolitics, customs union breakdowns and the “push” for crude production cuts ahead of the Aramco IPO.
Despite the slowdown in GDP growth to 4.5% in 3Q2019 and the lowest in seven years, the Bombay Stock Exchange Sensex Index is up 12.7% year to date. However, the dichotomy between the narrow (exchangetraded-fund-flows driven) market and the broader markets is particularly vexing, given that the small- and mid-cap universewhich underperformed the big caps, has delivered on substantially superior revenue visibility, earnings, cash flows and dividends.
Having spent much of the past month meeting with managements and dissecting quarter-end financials, we would highlight the following:
• The economic slowdown is cyclical — not structural — in part owing to the sharp curtailment of credit to the rural and small and medium-sized enterprise sectors (given the stress in poorly capitalised public sector banks and smaller non-bank finance companies), in part owing to a tepid new fixed asset investment cycle as well as the significant slowdown in global trade.
• While a weak demand environment weighed on revenue growth (which was at a four-year low), lower raw material costs and the lower tax rates drove margin accretion (+200bps) and earnings growth (+15%) well ahead of market expectations.
• Management commentary focused on improving visibility of a growth recovery ahead.
• The consumer companies made the case for a 2H recovery, given improving credit conditions in rural India and strong festival demand for discretionary items.
• The auto original equipment manufacturers highlighted strong festival demand, significant pipe-line inventory adjustments and a new product cycle to drive demand post the introduction of the new emissions norms in April 2020.
• Banks and finance companies balanced residual concerns on asset quality versus credit recoveries, strong loans growth expectations (given loan approvals made, and in the pipeline) and improving net interest margins to drive strong earnings growth.
• The drags were in the pharmaceutical space (competitive intensity on generics pricing) and IT services (where the outlook for global banking and retail verticals remains extremely poor).
Central bank policy key for markets
As our attention shifts to 2020/21, we have been reflecting on perceived investor market expectations and portfolio positioning, and what it might mean for our portfolio.
With the US Federal Reserve, the European Central Bank, Bank of Japan and People’s Bank of China committed to a path of synchronised easing, appropriately reflecting concerns on trade wars, sanctions, geopolitics, escalating violent street demonstrations and customs union breakdowns, the markets continue to “climb a wall of worry”.
Persistent ultra-low/negative interest rates and the quest for any yield explains the strength of the USD, in equities with sustainable dividend visibility and in myriad risk assets.
A note of caution: The recent spike in volatility in global markets as expectations wax/wane with regard to a trade accord between the US and China (and yes, the tensions over Hong Kong and Xinjiang notwithstanding, both US President Donald Trump and Chinese President Xi Jinping need a “win!”) highlights the significant risks inherent in the “weaponisation” of tariffs and sanctions (US/China, South Korea/Japan, US/Iran, European Union/UK/Brexit, US/ EU, US/Russia), of the potential for the gross misreading of political will and the compulsions of domestic politics (US/China, US/ Iran, EU/UK, US/EU, US/Russia), and of the implications of a manufacturing recession and potential job losses in an election year triggered by a protracted trade dispute. The margin for error is narrowing.
Specific to India, despite the relentlessly negative narrative and the hand-wringing in the western media and by the talking heads on local television channels, Indian equities would seem to have bottomed in September with Prime Minister Narendra Modi’s transformational corporate tax rate cuts. Is the “bad” news in the price?
Time in the markets would suggest that when stock prices push higher despite persistent negative headlines, we are likely to be on the cusp of a significant inflection point, both in terms of investor sentiment and stock price performance.
Analysing the recent data on the most recent three months of foreign fund inflows into Indian equities (after the panic selling in July and August) and the current defensive portfolio positioning in the major domestic mutual funds, we expect the markets to continue to grind higher as benchmark sensitive investors are forced to aggressively “add” risk and as the rally broadens to the fertile mid- and smallcap universe reflecting the emerging green shoots in the economy.
Bajaj Auto proxy for domestic demand
The stock we want to highlight this month is Bajaj Auto, India’s largest manufacturer and exporter of two-wheelers and three-wheelers, with well-branded and differentiated product offerings in the entry-level, economy and premium segments.
The three-wheeler business (in which Bajaj enjoys an 80%+ domestic market share) is the cash cow, driving industry-leading margins and profitability. The global partnerships with KTM (which is today, a 48%-owned associate company), Kawasaki, Triumph Motorcycles and Husqvarna round out the portfolio, providing access to technology, marketing muscle and scale, enabling Bajaj to start to effectively compete in the 350cc+ premium and sports motorcycle segments. The recent foray into electric scooters, reviving the Chetak brand, provides significant optionality on the electric vehicle opportunity in India in the medium term.
We expect Bajaj Auto to compound revenues at a 12%+ compound annual growth rate over the next three years, almost double consensus’ market expectations of about 6% CAGR. We believe that the market is underestimating management’s explicit commitment to growing domestic volumes and to intentionally investing in growing market share across all three segments.
The export business is poised for significant volume growth in Africa, Latin America and, in particular, Asean, given the recent commissioning of the Malaysian plant allowing for tariff-free exports across Asean. We are much more constructive than the market on the upcoming product launches from the niche Triumph, Husqvarna and KTM portfolios over the next two years. Bajaj’s intent is to be a low-cost, high-quality export manufacturing hub, allowing for meaningful market share gains in the global markets.
We expect Bajaj Auto to compound earnings at an 18%+ CAGR; market consensus is looking for earnings compounding at a sub-10% CAGR. The growth in volumes and the superior profitability of the three-wheeler segment (Ebitda margins of 27%+) will support blended Ebitda margins in the 16%+ range.
We expect significant scale benefits, as the new export capacity is commissioned in India and Malaysia, augmenting the structural uplift in margins on the back of the new product launches in the higher margin, niche KTM, Triumph and Husqvarna brands. Any depreciation of the rupee (reflecting inflation differentials) will be further supportive of margins and profitability, given that exports account for close to 50% of volumes.
Valuations remain attractive
In conclusion, our conviction is that India has charted an alternative growth narrative: We expect policy decisions to revive growth and the earnings cycle, while ongoing structural reforms will support risk appetite and market multiples.
We expect the real economy to revert to a +6% to 7% GDP growth glide path, seemingly anticipated by a steepening domestic yield curve. We expect growth to be catalysed by further structural reforms on land, labour and privatisations, recovering private sector capex, accelerating government expenditure on infrastructure and rural welfare, targeted policy intervention to boost systemic liquidity and sustained domestic consumption.
Our base case remains for our portfolio holdings’ delivering on earnings and cash flows compounding at 15%+ annually (on the back of sustained market share gains, strong operating leverage and tax “savings”). Our significant convictions are in the financials, consumer staples and consumer discretionary stocks and in the industrials and building materials companies.
Valuations for listed equities are attractive, and in particular for the small- and midcap universe, back-stopped by the sustained bid from domestic investors, a significant uptick in both foreign direct and strategic investments and creeping acquisitions by controlling shareholders 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, holding a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore.
