India: in slow ‘Modi’?

While it’s difficult to pinpoint the reason for India’s slowdown, the country cannot escape its harsh reality.

Over the past few years, India has experienced several major political and economic developments.
In 2019, Prime Minister Narendra Modi was re-elected with a stronger-than-before majority, despite weak economic growth. Although Modi has proven to be a decisive leader, some of his decisions have caused conflict. Contentious decisions include the introduction of the goods and services tax and the stripping of Jammu and Kashmir (a region formerly administered by India as a separate state) of their special status. Most recently, the introduction of the Citizenship Amendment Bill, which offers amnesty to non-Muslim illegal immigrants (but not to Muslim immigrants) from neighboring countries, has led to many protests around India.

Some government decisions have been blamed for exacerbating the economic slowdown.

In 2016, demonetisation was introduced and small denomination banknotes were discontinued. The aim of demonetisation was to reduce the circulation of cash obtained through illicit activities or counterfeit means. As a result, banking institutions received a flurry of deposits. The increased liquidity in the system led to an aggressive lending cycle by the financial sector. As is often the case, this reckless lending resulted in severe asset quality issues that spread throughout the sector. After initial cracks started to show, the collapse of financial conglomerate IL&FS, the defaults by Dewan Housing, and the governance and reporting concerns at Yes Bank, sent shockwaves through the sector. With many banks and non-banks having exposure to the various stressed assets, lenders’ risk appetites soured as the contagion spread and the slowdown in growth worsened.

Real GDP growth slowed to its lowest level in six years in September 2019, dropping to 4.5%.

In response to the slowdown, Modi has been proactively implementing reforms to encourage growth and investment. Corporate tax rates have been slashed, proposed tax hikes on foreign portfolio investors have been reversed, and there has been talk of privatising state-owned enterprises. Additionally, the Supreme Court ruling on Essar Steel provided a much-needed confidence boost in India’s bankruptcy courts. Various initiatives to help improve asset quality have been established, including a $3.5 billion fund to salvage stalled housing projects and a proposal to introduce a Troubled Asset Relief Programme (TARP), similar to the US after the global financial crisis.

All of the above measures send positive signals. However, our job is not to predict when economic growth will recover but rather to identify quality companies that can grow despite the macroeconomic background.

As active managers, we believe the current scenario presents an ideal opportunity for our investors.

We recently returned from a trip to India where we met with several financial companies’ management teams. Our key takeaways were:

1. The current pessimism has led to a de-rating in share prices across non-bank financial sector companies (NBFCs) in particular. This is creating opportunities to invest in good businesses at attractive prices relative to their long-term return potential.
2. With credit growth slowing and increased concerns over asset quality, quality companies are obtaining funding at more attractive rates. We believe this will allow these companies to position themselves for strong growth in the future.

The severe dent in confidence caused by the drastic slowdown in economic growth is most noticeable in the NBFC sector, which includes housing finance companies (HFCs). Banks and mutual funds have been reluctant to fund NBFCs and this has choked credit extension to the automotive and housing markets. Loan growth across the NBFC and HFC sectors has slowed in recent quarters. However, as shown in Figure 1, some companies have not experienced as severe a slowdown in growth as others. Two such companies are LIC Housing Finance Ltd and HDFC Ltd, both holdings in the Denker Global Financial Fund.

Figure 1: Growth has generally slowed across non-bank financial companies (NBFCs)

Source: Credit Suisse, Company data

Figure 2 depicts the rates at which NBFCs have been issuing commercial paper (CP) to institutional investors such as mutual funds. There are two clear categories – those that have been able to reduce the cost of CP issuances and those that have not. Cholamandalam and Bajaj Finance (predominantly automotive financiers) and HDFC and LIC have all differentiated themselves through lower CP rates. In our view, this is a clear indication of the quality and balance sheet strength of a company.

Figure 2: The market continues to differentiate across NBFCs

Source: Credit Suisse, Company data

We look for three factors to identify high-quality companies, and LIC satisfies our criteria. 

These are good business economics, quality management, and favourable valuations. Using this framework as the base of our investment process, we’ve identified the opportunity to gradually increase the Denker Global Financial Fund’s exposure to LIC (3.4% as at the end of December 2019).

Good business economics

When valuing a financial company, two inputs that we deem important are its normalised return on equity (ROE) and sustainable growth rate.

Good business economics are necessary to ensure a company can consistently deliver attractive returns to shareholders. Over the last four years, LIC’s loan growth has consistently been 15% while its ROE has ranged between 15% and 20%, largely due to the fluctuation in the asset quality cycle. Non-performing loans (NPL) have ranged between 0.45% and 1.55% over the period. This has translated into a compound annual growth rate (CAGR) of 22% in shareholder value over the same period.

India’s housing market is extremely underpenetrated and providing housing for all Indians is one of Modi’s key objectives. For this reason, we believe double-digit growth is still achievable despite the current slowdown. We also believe that the NPL cycle is peaking and should start improving in the coming quarters.

The stability in loan growth combined with the findings of our company research strengthens our conviction on what we deem LIC’s sustainable growth rate and ROE to be.

Quality management

LIC is considered a semi-state-owned enterprise, given that it’s 40% owned by the Life Insurance Corporation of India (India’s state-owned insurance group and investment corporation). This provides us some peace of mind in that LIC has an extremely large shareholder of reference and parent company, which translates into solid management. Over the many years we have travelled to India, we have regularly met with the Chief financial officer, who we rate highly. He has worked at the company for 22 years and is only 47 years old. His experience and understanding of the business further supports our conviction that the quality of management is high. The CEO position, largely a figurehead in many governmental organisations, has not been as stable. Nevertheless, the current CEO, who has been in place since April 2017, has been employed in the LIC group for over 30 years.

Favourable valuations

Even though LIC is trading at near all-time lows, based on a forward price to tangible book value basis, it has delivered a CAGR of 22% over the last four years, as mentioned above. While price metrics alone are not an indication of value, Figure 3 illustrates the overly pessimistic sentiment presiding over the sector and why we believe current valuations provide an attractive entry point.

Figure 3: LIC is trading near all-time lows, based on a forward price to tangible book value basis

Source: FactSet (January 2020)

In times like these, our years of in-depth research and face-to-face discussions with management and local analysts pay off.

We focus on researching and understanding businesses and the people who manage them, the risks they face, and the environments in which they operate. We aim to identify companies that will grow through tough times and reward investors who invest for the long term. Figure 4 shows the performance the Denker Global Financial Fund has generated for investors since its inception in 2004 – an excellent example of how our approach has benefitted investors.

The Denker Global Financial Fund has an increased exposure to these well-researched opportunities in India.

We spend a lot of time applying our disciplined investment process to assess what we believe to be a company’s intrinsic value. When the price trades below this value and there is a sufficient margin of safety we buy the company. We’ve identified a number of these opportunities in India recently, increasing the Denker Global Financial Fund’s exposure to India to 9.15% as at the end of December 2019.

Figure 4: The Denker Global Financial Fund has outperformed its benchmark since inception

Source: Morningstar, Denker Capital (31 December 2019)
Inception date: October 2004. Annualised return is the weighted average compound growth rate over the period measured. Cumulative return is the aggregate return of the portfolio for a specified period. The highest annual return in the last 10 years was 30.3% and the lowest was -17.2%. These are based on a calendar year period over 10 years.

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The Denker Global Equity Fund, Denker Global Dividend Fund and Denker Global Financial Fund are sub-funds of Sanlam Universal Funds Plc, a company incorporated with limited liability as an open-ended umbrella investment company with variable capital and segregated liability between sub-funds under the laws of Ireland and authorised by the Central Bank. The Manager of these funds is Sanlam Asset Management (Ireland) Limited (Beech House, Beech Hill Road, Dublin 4, Ireland, Tel + 353 1 205 3510, Fax + 353 1 205 3521) which is authorised by the Central Bank of Ireland, as a UCITS Management Company, and an Alternative Investment Fund Manager, and licensed as a Financial Service Provider in terms of Section 8 of the FAIS Act. Sanlam Collective Investments (RF) (Pty) Ltd is the South African Representative Office for these funds.

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