Notes from the Road:
- In a deglobalising world, characterised by decoupling supply chains and ‘China Plus One’ policies, India is an opportunity.
- Four years after my last research trip, I came away from company meetings feeling that notable changes were underway in the country, particularly around digitisation, manufacturing and housing.
- The broader use of mobile phones and plummeting data costs have made the internet accessible to even the poorest in society. Moves to continue this digitisation push are widening the opportunity set, with eight start-up IPOs raising US$2.5 billion in 2021.
- The government is also encouraging companies to develop and manufacture products locally, supported by US$33 billion in incentives.
- The real estate market is a further source of interest. A contraction in liquidity to Non-Bank Financial Companies and a consequent pick-up in consumer confidence, as well as affordability at 20-year highs, is proving supportive.
No, it isn’t strange
After changes upon changes
We are more or less the same
After changes we are more or less the same.1
Simon & Garfunkel, ‘The Boxer
I recently travelled to Mumbai, New Delhi, Pune and Bangalore to kick the tyres on a number of our 4Factor holdings, and also took the opportunity to visit a number of interesting companies unearthed by our investment process. Quite a bit has changed since my last research trip four years ago, and I summarise some recent strategic drivers as well as the potential sector and corporate beneficiaries in the following pages.
A self-reliant India
In May 2020, prime minister Narendra Modi issued a clarion call to the nation by kick-starting ‘Atmanirbhar Bharat Abhiyaan’ - the ‘self-reliant India’ Campaign, with the goal of making the country and its citizens economically more independent. One of the five major priorities is the economy. The aim is to achieve a US$10 trillion GDP by 2030, which is more than triple India’s estimated US$2.85 trillion output in 20212. Given this highly ambitious target, it is hardly surprising that I came away from the 26 company meetings feeling that notable changes were underway, particularly around digitisation, manufacturing, and housing.
Digitisation in overdrive
Historically, a major challenge India faced has been the sheer lack of financial inclusion amongst its 1.38 billion population. This changed dramatically in 2014, when Modi pushed through the ‘Jan Dhan–Aadhar– Mobile’ (JAM trinity) transformation. Jan Dhan saw the opening of 18 million bank accounts in a single week3, and it cleverly coincided with the introduction of Aadhaar, the world’s largest biometric unique-ID system, embracing 1.3 billion citizens. The binding ingredients were the humble mobile phone and plummeting data costs, following Reliance Jio’s 2016 entry into the telecoms market, which have made the internet accessible to even the poorest in Indian society4. This provided the basis for linking bank accounts, currently numbering 700 million5, and made India the world’s largest cash transfer market. Thanks to this recently created infrastructure, the government has been able to transfer subsidies directly into the bank accounts of the most vulnerable in the population.
The latest iteration of digitisation happened earlier this year, called Open Network for Digital Commerce (ONDC). While it is still in the development phase, the aim is to permit this network to display products and services from all participating e-commerce platforms in search results, across all apps on the network. This would support smaller merchants as well as rural consumers by levelling the playfield against Amazon and Flipkart, who collectively command c.60% market share6. The government’s broader target is to raise e-commerce penetration from 8% currently to 25% in the next two years6.
From an investment perspective, digitisation has widened the opportunity set. Five years ago there were only four Indian listed e-commerce businesses, but in 2021 there were eight start-up IPOs, collectively raising US$2.5 billion in public markets7.
No longer a manufacturing pygmy
Consider the following: India is the world’s ninth-largest economy and the third largest by purchasing power parity. Yet manufacturing accounts for only 16% of GDP, compared with the services sector’s 52%8. The country represents only 2% of global manufacturing output, a tenth of what China contributes9. Evidently, India heavily under-indexes here – but why is this even of consequence? There are two reasons. Firstly, the rate of growth within the manufacturing sector is a crucial component in India’s economic outcomes. To capitalise on its demographic dividend10, India must create nearly one million jobs per month over the next decade – and in so doing, lift large parts of the population out of poverty8. Secondly, in a deglobalising world, characterised by decoupling supply chains and ‘China Plus One’ policies, India identifies an opportunity.
Incentives may create an average annual revenue pool of Rs5-6tn
Annual average revenue pool of various sectors on 100% achievement of PLI targets (Rs-bn).
Source: Kotak Institutional Equities Strategy. June 2022.
This two-pronged agenda launched ‘Make in India’ in 2014, the government’s initiative to encourage companies to develop, manufacture and assemble products locally. As a follow up, the Production-Linked Incentive scheme (PLI) started in 2020, targeting 10 sectors, notably auto components, semiconductors, and, unsurprisingly for an
economy reliant on oil imports, solar modules. This was a significant step. To date, the government has committed US$33 billion in incentives over the next five years,
as well as introducing import tariffs on specific items. It is estimated that the average revenue pool from corporate activity if PLI targets are fully achieved will be US$64-77 billion, comprised primarily of domestic companies11.
Crucially, my meetings with the likes of Amber (India’s largest room air-conditioning manufacturer), Sona BLW Precision (auto technology company with a particular niche in electric vehicle components), and Dixon Technologies (electronics manufacturing services firm focused on LED TVs, lighting and washing machines) prove that value creation is already underway thanks to PLI. Dixon, for example, estimates that over 50% of its revenues in FY 2023 are likely to be PLI-linked, with the lion’s share of the upside coming from export-led growth12. In contrast, but of equal importance, was Amber’s assertion that in the near term, the cost benefit arising from import substitution (i.e. a higher proportion of home-made components) would have a larger impact on its profit and loss.
With return on capital employed higher than 20% for some of these companies, coupled with the inherent operating leverage in the business model, it is not inconceivable that PLI could drive an inflection in industry earnings growth whilst maintaining or even boosting returns…not your average manufacturing story.
‘(Roti, kapda,) makaan’
India’s political manifestos over time have typically featured some form of ‘roti, kapda, aur makaan’ agenda i.e., food, clothing and housing. With encouraging progress on food and clothing over the years, it is housing that has room for improvement, not least because the pandemic has underscored the importance of getting on the property ladder.
India’s residential housing market has faced challenges over the past 7-8 years: a lack of regulation, excess liquidity and egregious lending practices by non-bank financial companies (NBFCs) led to excessive speculation, corrupt practices, and incomplete projects. These headwinds ultimately culminated in the loss of consumer confidence. In contrast, my conversations with Macrotech Developers (Mumbai-focused real-estate company), Prestige Estates (Bangalore-focused real estate company) and HDFC Bank* (India’s largest private sector bank) suggest that circumstances have changed materially.
India housing affordability ratio (Home loan payment/Income ratio)
Source: Jefferies ‘Greed & Fear’. May 2022.
A large proportion of supply has exited the industry, either through oldfashioned bankruptcies or corruption, leading to promoter jail-time. For example, at its peak, there were close to 25 sizeable developers operating in Mumbai, but this has now dwindled to only five13. A major contributing factor has also been the contraction in liquidity, as the NBFC crackdown has led to a tightening of anti-money laundering practices and Know Your Client (KYC) processes for lenders. Notably, the Real Estate Regulatory Authority Act in 2016 improved industry transparency and best practices. The Act prohibited developers from taking more than 10% as an advance from home buyers, ensuring that builders put 70% of the funds collected into an escrow account for the use of construction purposes only, and introducing developer penalties for any delays in delivering the property. This has resulted in greater consumer confidence, coupled with affordability levels that are at 20-year highs, underpinned by falling mortgage rates, flat property prices, and incomes that have risen by 7-10% per annum, on average14. It is little surprise then that industry pre-sales are robust and inventory levels are testing 10-year lows, in most regions15.
A word on the abundance of India’s infinity machines
The hallmark of any 4Factor portfolio is the underlying eclectic nature of its constituents. In our 4Factor Emerging Markets and Emerging Markets ex-China portfolios, we hold a variety of companies that are either highly valued with rapid-growth (e.g. Reliance Industries*), attractively valued with scale advantages (e.g. Hon Hai*), or resilient with a sticky customer base (e.g. Walmart Mexico*). It is companies in the latter category, what we refer to as ‘infinity machines’, that India has in abundance. For example:
- India’s largest private sector bank, HDFC Bank*, currently only serves 70 million customers relative to an addressable base of 500 million16, while its market share in deposits and loans is only 9.5% and 11.5%, respectively
- Only 2% of pulses, a staple in India, are branded, paving the way for consumer goods giant Tata Consumer Products Limited, to grow this category with its newly launched Sampann brand
- Only 6% of the population has taken a medical diagnostic test. A combination of rising incomes, higher insurance penetration, and greater health awareness is likely to propel leaders in diagnostic healthcare tests, like Metropolis Healthcare and Dr. Lal PathLabs.
As stock pickers, however, we carefully consider not only whether these businesses have inherent compounding power, but equally importantly, to what extent this is priced into valuations. It is this dispassionate approach to investing, where the 4Factor investment process marries deep-dive fundamental research with an objective, proprietary stock screen, that we believe helps us to build compelling portfolios.
Risks to India Inc
Whilst the subset of companies that I met with are experiencing strong operating momentum, the two relevant macro risks worth monitoring are inflation and geopolitics. On inflation, as a net importer of crude, India’s fortunes are to an extent tied to oil prices. On average, every US$10 increase in crude prices leads to the current account deficit widening by US$14 billion (or 0.5% of GDP)17. Notably, the Reserve Bank of India recently increased its FY 2023 inflation forecast from 5.7% to 6.7%18. Geopolitics is interlinked here, as India recently stepped up its purchases of Russian crude oil, thereby profiting from a 32% discount on Urals oil. Going forward it remains to be seen how India walk the tightrope between its economic alignment to the West compared to its geopolitical alignment to Russia.
From a 4Factor perspective, we focus our attention on idiosyncratic drivers. The pursuit of unearthing good quality companies trading at reasonable valuations, with improving operating momentum and increasing investor attention continues. Since returning from these company visits, it’s back to the annual reports.
1 Bridge Over Troubled Water. Columbia Records, 1970. Lyrics from the ‘missing verse’, arguably the most powerful verse in the song.
2 Piyush Goyal, Minister of Commerce & Industry, 8 July 2020.
3 A Guinness world record.
4 Per 1GB of data, India’s average charges are $0.68 vs China $0.52, UK $1.42, Hong Kong $2.30, and the US $3.33.
5 Kotak Institutional Equities Strategy. June 2022.
6 What is ONDC, India’s project for an open e-commerce network?
7 2021 Year in Review | Indian startups come of age with 8 IPOs in 2021.
8 Make in India: how manufacturing in India can become globally competitive.
9 Infographic: China Is the World’s Manufacturing Superpower.
10 The belief that India’s significant young population will lead to higher economic growth as it enters the workforce. In contrast, China’s
workingage population has begun to contract by 40mn. to 880mn.
Can China’s Communist Party defuse its demographic time bomb?
11 PIB, Kotak Institutional Equities estimates.
12 In a couple of years, 35-40% of Dixon revenues to come from exports: CFO.
13 Macrotech Developers, 2021.
14 Jefferies, ‘Greed & Fear’, May 2022.
15 Jefferies, ‘Greed & Fear’, May 2022.
16 Per management, the ‘upper-middle income segment’.
17 Indian trade, current account deficit seen widening, rupee under pressure.
18 Reserve Bank of India.
Specific risks Geographic/Sector: Investments may be primarily concentrated in specific countries, geographical regions and/or industry sectors. This may mean that the resulting value may decrease whilst portfolios more broadly invested might grow. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Derivatives: The use of derivatives is not intended to increase the overall level of risk. However, the use of derivatives may still lead to large changes in value and includes the potential for large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Concentrated portfolio: The portfolio invests in a relatively small number of individual holdings. This may mean wider fluctuations in value than more broadly invested portfolios. Emerging markets: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other system.
All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.