The Tantallon India Fund closed 3.99% lower in April, marked by significant intra-month volatility with two disappointing earnings releases as higher costs eroded margins and continued redemption-driven selling by foreign institutional investors. We are glad that this one is in the books.
First, some top-down layering on the markets and the risks as we see them:
The US Fed’s pivot to tighter monetary policy given persistent inflation has been reflected in violent price action over the last few weeks in global Treasury markets and US mortgage rates.
In line with what we have been writing, market expectations of where Fed funds rates are likely to be at the end of 2022 have trebled since the start of the year to about 300bps, with US mortgage rates now exceeding 5%. Could we see a four-handle on the Fed funds rate by the end of the year?
Importantly, responding to inflation data and expectations, the Reserve Bank of India (RBI) has fast-tracked policy “normalisation”, starting to reverse 250bps of policy-easing over the last two years by hiking the repo rate by 40bps to 4.4% (the first rate hike since August 2018) and raising cash reserve ratios (CRR) for the banks by 50bps.
We expect the RBI to front-load policy action and are comfortable modelling another 125bps in repo rate hikes over the next 12 months.
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Interest rates are headed higher. This is good news for the strong deposit franchises but not good news for over-leveraged balance sheets and high-multiple stocks. It is even worse news for high-multiple stocks that “disappoint” on margins, earnings and guidance.
Now in its third month, Putin’s brutal war in Ukraine will scar generations. With no end to the war in sight, the 24/7 news cycle has laid bare the absolute horror being visited upon defenceless Ukrainian families. However, we have yet to fully internalise the generational refugee crisis we have on hand or the alarming possibility of Putin “escalating” the war into a full-blown conflict with Nato.
The sharp drawdown in food stocks as Ukrainian and Russian agricultural (grains, cereals, edible oils) and fertiliser output is constrained, has exposed the fragile underbelly of globalisation. While positive for farmers in rural India, we are confronted with a significant humanitarian crisis across Asia, Africa and the Middle East.
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Putin has (probably permanently) redrawn geopolitical, economic and military alignments across Europe, Asia and the Middle East. In the face of rising geopolitical tensions, military spending will trump development spending.
The absolute compulsions around energy security have muddied the waters on energy transition and this is before we can even start to fully calibrate the economic fallout and the negative implications for domestic political stability in Russia and the rest of Europe as the war drags on and sanctions bite deeper, and for European industrial output and consumption as Europe begins the painful process of weaning itself off decades of dependence on Russian gas.
The resurgence in Covid infections globally (with new, highly transmissible variants that seem to be evading current vaccination protocols) and the fraught calculus on China’s zero-Covid stance have negative consequences for growth, supply chains, capital allocation policies and reported earnings (as global supply chains are forced to build duplicative local capacity to ensure the security of supply) and political stability. Watch this space.
Keeping powder dry
Internalising the negative layering and focusing on our portfolios, we are carrying a substantially higher cash position (about 30%) than we are normally comfortable with, reflecting significant market uncertainty and our efforts to intentionally cull stocks where earnings might be vulnerable to higher input costs over the next 12–18 months.
Fake market headlines notwithstanding, we are convinced that we need to move on from the Covid champions who bask in the glow of negative interest rates globally and the narrative of profitless “disruption” funded by long-duration “mark-to-myth” risk appetite.
We sense that our portfolios will need to be “different” over the next couple of years and we are looking to take advantage of the volatility to intentionally and patiently redeploy capital.
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Given sticky inflation, rising bond yields and a flattening yield curve, growing dividend income will likely anchor total return expectations for the market.
Data and our experience over multiple cycles suggest that the only effective strategy to counter persistent inflation is to identify and invest in companies with modest debt, resilient margins and rising free cash flows that would be supportive of both adequate (re)investments as well as a rising stream of dividends.
On the back of higher agri-commodity prices, rural incomes across India are inflecting positively.
China+1 has provided domestic Indian manufacturing with a significant boost as global supply chains allocate increasing capacity to India. Industrialisation is creating jobs while urbanisation is sustaining continued momentum in the services economy.
Modi’s focus on infrastructure development as a prerequisite enabler for sustained growth and employment creation is starting to bear fruit.
The effective control of energy prices by cartels has again anchored political and capital commitment to renewables, biofuels, complex refining, LNG terminals, and the electricity grid and gas pipeline infrastructure.
As vaccination rates pick up and the economy opens up, domestic leisure consumption and tourism-related travel are also likely to surprise on the upside.
Indigenisation of defence spending is a priority given the (now) uncomfortable (and unsustainable) historical dependence on Russia for weapons systems.
With Covid-related provisioning in the rear-view mirror, well-capitalised banks and finance companies will benefit from a steepening yield curve and strong loan growth on the back of higher working capital financing requirements, mortgages and retail spending.
Stock highlight of the month
The company we would like to highlight this month is Bharat Electronics (BEL), an Indian defence company specialising in radar and guided-missile systems, avionics, and satellite communication and surveillance systems. BEL is the flagbearer of the government’s “Make In India” initiatives. Having substantially upgraded its manufacturing facilities, and augmented its core strengths in R&D, engineering and systems integration, BEL is the key beneficiary of the push to significantly upgrade India’s air defence capabilities and make their indigenous.
We expect BEL to deliver on revenues compounding at 20% annually over the next three years versus consensus expectations of revenues compounding at 10% annually.
On the back of the visibility we have on the current weapons/systems being deployed (Akash missiles, Himashakti, ADCNRS, EW systems, mountain radars, Atulya, QRSAM and MRSAMs), we conservatively estimate BEL is likely to see an annual order inflow of US$3 billion ($4.16 billion) annually over the next three to five years.
Recent policy changes with targeted import bans and incentives for import substitution, and specific government-to-government enabled technology partnerships, will likely see our current estimates being exceeded.
We expect BEL to deliver on earnings compounding at 25% CAGR over the next three years, with consensus estimates still pegged in the low teens.
Higher commodity prices and semiconductor shortages are a clear short-term risk and will likely yield some volatility to reported quarterly earnings, however, strong operating leverage as capacity ramps up and the localisation of semiconductor production in partnership with Hindustan Aeronautical Limited (HAL) will buffer margins.
Importantly, given the increasing complexity of weapon systems and improving mix, we are comfortable projecting 100bps of margin accretion annually.
The higher-margin, non-defence portfolio (currently tracking at 15% of sales) is also likely to surprise on the upside.
Very strong free cash flows and a net cash balance sheet of US$2 billion will likely support a higher dividend payout currently at 50%.
To sum it up
Persistent inflation eroding consumer spending and forcing more restrictive monetary policies, the war in Ukraine forcing significant geopolitical, trade flow and energy security realignments, continued margin and cash flow “disappointments” from component shortages and higher input commodity prices, and China’s obdurate zero-Covid lockdowns impairing growth, almost certainly guarantees volatile markets in the near term with a negative bias.
With the RBI having commenced the “normalisation” of monetary policy, alongside the consistent bid from domestic institutional and retail investors validating the structural opportunity in Indian equities, we are starting to patiently deploy capital in companies where valuations are attractive relative to the strong visibility we have on idiosyncratic earnings and cash flow growth.
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 portfolio (25 to 30 positions which are not levered), 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, the advisory company, is a Singapore-based entity, set up in 2003, and holds a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore
