India will continue to be investors’ go-to choice for the foreseeable future because it is still the fastest growing major economy in the world and has “some great companies with among the best balance sheets,” says Jon Thorn, co-founder and director of India Capital Fund Management Ltd. Edited excerpts from an interview:
As an investor, when you look at corporate fundamentals in India—are you excited? India now has many positives—an improving external environment, stronger consumption, robust public capital expenditure…
I am excited, and yes, I believe that earnings will rise; some already have. The background economic picture, going back now nine years is not a particularly pretty one, but that is in the past. The stronger macro numbers that we are seeing now are simply the aggregate of micro data at companies—but we are in the early stages of what we think is a long term and secular growth uptick.
The dispersion between companies is also greatest at the start of an up-cycle, and then more companies join the party.
As an investor you make the biggest returns when a company gets up off the floor. From skepticism or downright negativity, when that converts to optimism, then the biggest stock price gains are made. But those gains can only be sustained by solid research.
We have built our own database of company financials and we do in-depth research on the ground in India. The low-index overlap, research driven approach has produced results for our investors: we have compounded by over 300 basis points (bps) more than the Index over 22 years.
Unlike many foreign investors, the Fund always buys stocks directly in the market and avoids using the so-called P-Notes—Participatory Notes—which are access products issued by banks offshore. Now, tightened regulation is leading an increasing number of brokerages to stop issuing P-Notes. We want the direct company contact; and we don’t trade much.
To what extent do you see an earnings pick-up, and would that accelerate into a bigger recovery?
EPS (earnings per share) growth for the market this past quarter with over 90% of companies having reported is near 12%—the relatively high figure is due to one index company whose EPS went to +2.09 this quarter from-28.63 in the previous quarter—after having been negative for the past few quarters. Earnings weakness is a reflection of the general economic softness we have seen in India and especially the failure of a new capital investment cycle to start. However, for our fund we saw 15% YoY (year-on-year) EPS gain, after having seen some strong quarters for our companies.
What are the sectors that you are overweight on among Indian equities?
We are overweight banks, financials and vehicles. We are underweight pharma, FMCG (fast moving consumer goods) and IT (information technology). We like the domestic economy, and we are also avoiding the impact of changes to US regulations, which will likely impact IT and pharma especially.
How much of a concern is the fact that oil prices seem to be inching upwards?
Yes, I think we would like to see oil as low as possible! India is a major oil importer so the higher the oil price is, the higher inflation and FX (foreign exchange) outgo is. India is also a very inefficient user of its oil imports, although that is improving, so that is a double hit. But at these prices, the marginal impact of a rise is small, but at above $70-80 a barrel, then more pain starts to happen.
As household balance sheets in India expand, are you betting on discretionary stocks like autos and retail?
We think there will be a strong rise in consumer spending—three reasons for that. Firstly, personal debt levels are low, among the lowest in Asia, and secondly, and demographically, the relative size of the demand pie is also growing—young people buy things, and India has around a quarter of the young people in the world. It always surprises me that people talk excitedly, or rather used to, about the size of the China consumption market while having little idea about how to access it, especially profitably.
India is different in that it is both accessible and similar to the developed world. But not all Indian discretionary stocks have done equally well—for example, gains in the auto stock in the ICF have far outpaced the sector’s performance. So stock selection still remains key, and that is based on direct research.
The third reason is that consumers in India want the same things that consumers in Singapore and other places want—branded clothes, cool experiences, and the latest technology that they can afford.
The old days of accessing the Indian consumer market by buying, for example, shampoo companies, is long over—shampoo is a commodity, but Gap, for one, is not.
Last week, Reserve Bank of India (RBI) not only left policy rates unchanged, but also hinted that interest rates might actually go up. What does that indicate?
We are confident that the capex cycle will start, but both the base effect and the existence of stronger demand would itself signal that inflation is not guaranteed to keep falling, it’s not unidirectional. Rising demand means inflation, as demand often grows faster than supply. India has a supply problem, not a demand one.
But we don’t see it as an end to rate cuts: we will have to see the inflation path. I think it’s more accurate to see it as a pause. Oh, and all those commentators who wrote off the RBI as a tool of the BJP (Bharatiya Janata Party) after (Raghuram) Rajan left; how does a pause look? That anti-RBI view was never a rational monetary analysis—how could one know that?—but more of a political one.
Are you happy that the budget has not done anything to rock the boat?
The budget in our view was very strong. There were tax cuts for SMEs (small and medium enterprises) and the lower paid, there was a sharp 25% rise in infrastructure investment, now 20% of the budget, and there were strong measures for the expansion of affordable housing. Also the things the market was scared of, an extension of capital gains tax and more uncertainty over the application of gains taxation were, respectively, not present and specifically struck down. What’s not to like?
In addition, there was a confirmation that the fiscal deficit will be 3.2% (of gross domestic product) next fiscal year and 3% the following. Plus, there were no big pre-state election giveaways, as one has over many decades come to expect. India obviously cannot afford such pork barrel politics but has nevertheless done rather a lot of it over the years. That the (Narendra) Modi government was fiscally disciplined at this point and will likely be effective in its investment programme was rather pleasurable to see. I smiled a lot as I watched the budget on TV.
I can’t see why some commentators were unimpressed.
RBI deputy governor Viral Acharya recently said the central bank can look at a bad bank to resolve the banking industry’s bad loans. Is India headed for a $60 billion bad bank mistake?
The problem specifically is how do you resolve the problem of bad loans in government majority owned banks. The private sector banks are all fine, and some very fine.
The previous RBI governor had put in place some new measures, but this is, simply put, a chicken and egg problem.
Who has the balance sheet or the appetite to take those bad loans over, if not the government, and without that takeover, how can the government banks start to help the capex cycle by lending strongly again? There is no such thing as the balance sheet fairy. We are not making enough progress in the right direction at the moment, and without a new direction, or a new player, nothing much will change.
To expect a bad loan resolution to originate locally on the scale needed without the government is absurd, as no one has the balance sheet to do it, as is the idea that US buyout funds are clamouring at the door. The buyout guys will be less able to resolve these loans and so would obviously also pay less for them, even if they could buy them easily.
It could certainly go badly, but it can also go well. Whether it goes badly or well, will depend on how it is implemented, rather than because this is a bad idea per se. It has worked in other countries. I suspect that if Mr. Modi makes it clear that he is interested in how this is going—then it will have a better chance of success as I think we have all seen that he thankfully does not suffer fools gladly.
I would very much fear that in the old days an Indian government bad bank would itself be a very bad bank indeed, but I have greater hopes that today there is a clearer focus on results rather than sounding good.
Regarding the mechanisms that could make this happen, these could easily be enabling provisions and a law which would attract a budget allocation. It’s hard to see much real opposition to this; the benefits are surely obvious and universal. The RBI’s balance sheet would have to do some of the heavy lifting, and that would make it viable and doable.
Will domestic investors make up for the foreign investors’ flight from equities?
They already have. After demonetisation on 8 November the local buyers ploughed straight in after the market fell. The foreigners sold. Some weeks it has been almost dollar for dollar, foreigners selling to locals. We will see when the foreigners decide to return, at higher prices.
Will India continue to be investors’ go-to choice on the emerging market for the foreseeable future?
If you look at the top investment strategists and fund managers in Asia, most are strongly overweight India. Just to name two: Chris Wood at CLSA and Hugo Young at Aberdeen. They have done a lot of research and have the best access to corporates, and they like India better than anywhere else. It’s a simple trade: the strongest and accelerating growth in the world with some great companies with among the best balance sheets in the world. Plus India is going to stay that way for a long time. Currently the market is not especially cheap, but that will of course change if earnings start to come through.
With regard to demonetisation, is the worst behind India? By when do you expect the economy to be back to normal?
‘DeMo’, as it’s known, is already mostly over in cash terms, as the new cash has taken over from the old cash. I would say that by April or so we will not be talking about it any more. We will instead be talking about how much of the previous cash economy is now non-cash, how e-commerce has taken over a lot of transactions, and how e-payments are everywhere.
However, I think that biggest hit to earnings of some companies will be in this quarter, January-March 2017, as both panic spending and giveaways raised activity in November and December. We think there will be some dispersion and surprises for earnings outcomes, in both directions.
We will therefore, post demonetisation, be talking about an economy that has more in common with the developed world than with the emerging markets in terms of transactions. To the extent that is the case, and we would soon see, we would have been through one of the most remarkable financial and economic events in history.