(July 15): The Tantallon India Fund closed 0.19% lower in June, with anxiety over multiple trade conflicts, heightened concerns over a potential military conflict with Iran and expectations of a more populist tilt in the Indian Budget keeping investors on the sidelines.
We are disappointed that the Budget was not more bold with targeted infrastructure and rural spending, given the sharp slowdown in the real economy. That said, we are encouraged by the fact that Prime Minister Narendra Modi has chosen to stay fiscally disciplined.
The Budget is rational and goal--oriented, stressing sustained and inclusive growth, the reduction of stark income inequality, the systematic build-out of a digital ecosystem to create a cashless economy, accelerated infrastructure and affordable housing investments, the recapitalisation of the public-sector banks and stability in the non-bank financial services and small and medium-sized enterprise (SME) sectors.
We expect robust capital flows and lower real interest rates to be supportive of higher multiples as the corporate earnings cycle inflects positively to the upside.
Reasonable, fiscally prudent Budget
The narrative in the recent Budget and Government Economic Survey focused explicitly on investment and export-led, sustainable, inclusive growth. The budget math is “reasonable”, attested to by the 2% appreciation of the rupee versus the US dollar since the Budget. We are particularly encouraged by:
• Demonstrated fiscal restraint (as opposed to resorting to short-term debt-funded fiscal stimulus and unsustainable subsidies) in maintaining the fiscal deficit at 3.3%;
• The explicit focus on bringing down real interest rates and the cost of capital;
• The recapitalisation of the state-owned banks;
• The commitment to ensure adequate systemic liquidity in the non-bank financial services and SME sectors; and
• The reduction in the corporate tax rates for SMEs to 25% in order to stimulate new capacity creation and employment.
The negatives in our view are:
• The surcharge levied on the highest tax bracket, potentially dampening domestic high-net-worth investor risk appetite;
• The proposal to increase the minimum free float listing requirements from 25% to 35%, creating an unnecessary potential overhang for stocks in the short term; and
• The absence of specific measures to revive the property sector — the government’s focus on affordable housing, while laudable, does not have the multiplier effect that we had hoped for.
There is a slowdown at hand: The data points we have tracked over the last month of travel would suggest that the real economy slowed precipitously in the last few weeks of the June quarter.
• The primary culprit seems to have been the delayed onset of the monsoons, negatively impacting rural sentiment and demand.
• We would also point to the pullback in SME and rural lending, given the tight liquidity conditions for the small non-bank finance companies.
• Vehicle sales continue to be extremely sluggish, posting y-o-y declines for the first time in almost a decade as buyers digest higher vehicle prices following the imposition of more stringent emissions and fuel efficiency norms.
• Jewellery sales have also lagged expectations, as have sales of white goods and consumer electronics, pointing to significantly tighter liquidity conditions.
On a more positive note, following Modi’s decisive victory in the general election, domestic equity inflows rose to a three-month high. The locals believe!
• Equity inflows into domestic mutual funds increased to INR63 billion ($1.25 billion) in June (versus INR34 billion in May).
• Including exchange-traded funds, equity mutual funds reported inflows of INR119 billion (versus INR61 billion in May).
The key risks are:
• Tight liquidity conditions on the ground;
• Geopolitical uncertainty escalating into military conflict(s), unpredictable trade conflict outcomes and messy custom-union breakdowns will weigh on global growth and risk appetite; and
• Higher energy prices weighing on the rupee, and potentially restricting the government and the Reserve Bank of India’s (RBI) ability to deliver on fiscal and monetary stimulus.
Nestlé India offers growth with familiar brand names
The stock we want to highlight this month is Nestlé India, the Indian subsidiary of Nestlé, with a portfolio of dominant brands in the key categories of instant noodles (Maggi), instant coffee (Nescafé), chocolates (Kit Kat), baby foods (Lactogen) and condensed milk (Milkmaid). The new management’s focus on product innovation for the local Indian market and the commitment to deliberately invest in new categories and brands from its global portfolios to drive new category growth, product penetration and market share gains sustains our conviction in compounding top-line growth and margin expansion.
We expect Nestlé India’s consolidated revenues to compound at a minimum of 12.5% annually over the next three years, well ahead of market consensus anticipating top-line growth in line with real GDP growth in the 7%-to-8% range.
• We project product volume compound annual growth rate (CAGR) of more than 10% over the next three years. We believe the market is underestimating management’s clearly articulated goals (see above).
• We build in an annual 2.5%-to-3% increase in effective value realisation, given a relatively benign competitive environment in Nestlé’s key product categories and the ability to sustain mix improvement on the back of the new product launches. We believe Nestlé’s global product portfolio and brands are uniquely positioned to benefit from the increasing propensity of the Indian middle class to consume/spend on the back of rising disposable incomes, improving affordability and the proclivity for global brands. Frankly, we might well be underestimating Nestlé India’s inherent mix/pricing tailwinds over the next several years.
We expect Nestlé India to compound earnings at 18%+ annually over the next three years, well ahead of consensus estimates projecting a more modest 12% CAGR.
• Despite some raw material price inflation and the 100-basis-point increase in advertising and promotion expense that we are currently modelling, we expect sustained top-line growth, improving product mix and strong operating leverage to drive 100bps of margin accretion annually over the next three years.
• We believe the market is ignoring the deliberate investments that have been made over the past three years in the milk and nutrition categories to (i) improve product quality, (ii) improve product awareness and brand recall by building out distribution and the medical representative networks, and (iii) drive mix improvement through the introduction of healthier variants (Atta Noodles and Oats Noodles), and brand extensions in the emerging soups and sauces categories.
Modi reforms to continue
We expect that Modi will (i) accelerate his reform/development agenda, (ii) catalyse a new infrastructure-driven investment cycle, and (iii) deliver on sustained, inclusive growth, and job creation. We believe Modi’s priorities (investments, job creation, infrastructure, industrialisation and resolving farm distress), the recapitalisation of the public-sector banks and the commitment to ensure adequate liquidity for the non-bank finance companies will deliver on clear development goals in a growth-challenged world, sustaining a long-term tailwind for Indian equities.
• We would underscore our conviction in India’s idiosyncratic growth opportunity and, specifically, the opportunity in financial services, consumer discretionary and real estate, while minimising exposure to the sectors most vulnerable to a global slowdown: IT services, energy and generic pharmaceuticals. We expect our portfolio companies to deliver on earnings and cash flows to compound at 15%+ annually over the next three years.
• Valuations and the risk/reward are compelling, especially in the small- and mid-cap space, given our expectations of sustained revenue and earnings growth, the near certainty now of further easing by RBI and improving systemic liquidity.
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 in the structural opportunity and scalable business models and management’s ability to execute. Tantallon Capital Advisors, the 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
