CHARLES WALSH, PORTFOLIO MANAGER, GLOBAL EMERGING MARKET EQUITIES TEAM
CHARLES WALSH, EMERGING MARKET EQUITIES PORTFOLIO MANAGER, SHARES HIS LATEST VIEWS AND EXPERIENCES FROM A RECENT TRIP TO INDIA
It’s just over a year since the Non-Bank Financial Companies (NBFC) crisis began with the failure of the conglomerate IL&FS which defaulted on some of its debt obligations, leading to a full blown liquidity crisis. The consequences are still being felt, have been far reaching and in some cases unexpected.
The first order consequences have been felt by the low quality NBFCs whose low quality lending practices and asset liability mismatches were uncovered when the crisis hit. At the time, many were generating super-normal returns by engaging in high risk practices, the bulk of which involved lending to property developers then continually rolling over these high interest loans to disguise inadequate cash flows. The funding they were receiving from banks, insurance companies and asset managers dried up and the outsized returns collapsed. Several of these lower quality NBFCs are close to collapse themselves.
As noted above, the sector most reliant on this funding was real estate, in particular unorganized or non-listed developers. As a result of this liquidity crisis, industry experts state 60% of property developers in India have effectively shut down in the past year leaving many home purchasers with money invested in ‘stuck’ projects. This has a negative impact on an already depressed sector. Fortunately, a new fund has been set up by the government to fund these stranded projects, which should help the property market return to normal and benefit those consumers who have been affected.
The second order unintended consequence of the credit crisis has been to damage business and consumer confidence just at the time when economic growth was weakening. The reason being, the poorer quality NBFCs that are now struggling were also the ones providing a good deal of the loans to the cash-based society and those small and medium businesses without adequate paperwork to satisfy the stronger NBFCs or the banks. The cash economy is still a large part of India Inc and the reduction of financing for these businesses, whether for expansion or working capital, has an impact both on activity and on confidence.
So whilst there is now no shortage of overall liquidity and the more established quality lenders who we, in the Mirabaud - Equities Global Emerging Market and Mirabaud - Equities Asia ex-Japan funds tend to focus on, are taking market share, the overall environment is one of weaker growth as a result of reduced activity and confidence.
Overall economic growth has been decelerating and last quarter corporate results were perhaps saved from the earnings misses and downgrades by the surprise corporate tax cut in September.
The tax cut was aimed at attracting new foreign direct investment to set up new manufacturing facilities. For this to happen, though, it’s likely that further reforms on land acquisition and labour market flexibility would be needed. Moreover, other lower cost outsourcing destinations, with established supply chains and logistics, are likely to remain the natural choice for those looking to cost-down or diversify their manufacturing base. For now though, the reduced rates have, and will continue to be a useful boost to domestic profitability.
In general, activity surprised negatively over the quarter and the private capex cycle, absent for the past seven years, remains elusive. Low capacity utilisation in the manufacturing and industrial sectors combined with weak profitability means private investment is likely to remain muted for some time.
Household saving has also been shrinking, narrowing the funding sources available to corporates. This leaves it up to the government to step in with fiscal measures to support a waning economy, although they have also been notably absent from infrastructure projects since the election of early 2019. In fact, the reduction of government infrastructure and mining projects this year, as well as the late payment for those already underway, has had a damaging effect on the rural economy where infrastructure can be as significant a driver of incomes such as traditional farming.
Cyclical factors aside, real estate remains one of the standout long-term opportunities in India. There are around 280 million homes in India1, of which around 100 million are slums/shanties. Of the roughly 180 million remaining formally constructed homes, around 100 million of those are one or two room dwellings, in many cases being used to house entire extended families. As such there is huge real need for new housing. Affordability continues to improve following around 4-5 years of price declines against incomes that continue to rise. The fact that home prices seem to have finally troughed may inject more urgency into would-be home buyers' decisions. As noted, getting mortgages is not an issue for salaried and / or documented business owners.
1Population Enumeration Data (Final Population), Census Commissioner, India.
IT SERVICES COMPANIES A LONG TERM OPPORTUNITY
Another strong sector within India is IT Services. What began with the outsourcing model, designed to benefit from wage arbitrage and the vast number of Indian engineering graduates entering the workforce each year, has matured into a large industry tailoring technology-based solutions to global companies.
The addressable market continues to grow as technology becomes a larger part of everything from consumers’ lives to the way in which businesses enhance their capabilities. What's more, with the increase in digital solutions leveraging cloud computing, thus enabling far larger deals to be won, the share of this large and growing market being won by Indian players continues to increase.
Heavy rains towards the end of this year’s monsoon have left reservoir levels at historically elevated levels, meaning the winter crop should be very good. This should boost rural incomes and consumption from March - April 2020. If the government steps in to boost the economy via infrastructure spending this should help drive spending in the rural economy and could help to lift growth next year. There are also other steps the government may take to encourage outside investment following on from September’s corporate tax cuts now that they seem to have accepted the need for urgent and drastic action. Added to this, the recent cuts in the corporate tax rate are likely to be passed on to consumers in order to revive weak demand.
So despite the near term slowdown and credit-related issues India is currently experiencing, it’s possible that we are at, or near an inflection point for growth and activity. There remain companies of outstanding quality in areas such as real estate, financing and IT services that, in our opinion, represent great long-term investment opportunities. As ever, investing in India is not without challenges, be they the risks discussed or the valuations the market often ascribes, meaning our approach focused on quality, structural opportunity and sensible valuations should bear fruit in the long run.
Charles Walsh visited in India in November 2019, meeting with the below companies and industry experts, which all helped to inform his views and insights expressed in this document.
- Astral Poly Technik
- Bharti Infratel
- Bharat Forge
- Cadila Healthcare
- Century Plyboards India
- Dr Lal Pathlabs
- Eicher Motors
- Hero Electric Vehicles
- HDFC (Housing Development Finance Corporation)
- ICICI Lombard General Insurance
- Mahindra & Mahindra
- Oil & Natural Gas Corp
- Tata Consultancy Services
- Commercial Vehicle financing (Sanjay Mundra - Shriram Transport Finance)
- Property (Ashutosh Limaye)
- Ratings agency (Ananda Bhoumik)
- Rural markets (Mahindra & Mahindra Financial Services)
- Indian IT Services– Vikash Jain (Boston Consulting)
- India Financials – Aashish Agrawal and Prakhar Sharma
- India Strategist – Mahesh Nandurkar
- Global Economist – Eric Fishwick
- Global Strategist – Adrian Mowat
For information purposes only. This list does not constitute an endorsement or investment recommendation
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