The current correction in Indian markets is healthy and provides investors opportunities to accumulate good quality stocks at attractive valuations. Our structural bullishness on Indian markets outlook for the next 5 years continues to strengthen from the recent Macro & Micro Economic events. For any investor with a 3-5 year time frame, Markets are providing great bargains. Let's understand reasons as to why we are Bullish and are excited to accumulate on every meaningful correction.
Every Bull Market has several corrections during the course of its large up move just as how every Bear market has several strong rallies during the broader down move. During the last Bull Market (2003-07), we have had four 10%+ market corrections. In fact two of those corrections were 15%+ and one was a massive 30% correction from highs. These corrections strengthen the Bull Market by clearing the froth and keeps Market healthy as irrational expectations get tested regularly. We certainly believe that India is going through one of its biggest Bull Markets and the structural thesis of the up move is getting strengthened consistently. Let's see five prime reasons for our bullishness.
Cyclical Recovery aided by lowering Inflation & Weak Commodity Prices:
> Indian economy is going through a cyclical recovery on the back of improving economic sentiment, , restarting of stalled CAPEX, narrowing CAD, pent up demand etc. While it might be difficult to time the interest rate cuts, there are enough indications for us to believe that Interest rates have peaked and are expected to slide down going forward. There has been a marked improvement in Inflation drivers. A lower inflationary expectation will ideally lead to better Financial savings and this creates a virtuous cycle that will boost growth to our trend line growth of around 7-8%.
> The recent correction in Commodity prices also aides India's economic recovery by boosting Fiscal as well as Current accounts through higher subsidy savings and lower imports. Even though exports will be affected to some degree due to subdued global demand, majority of our exports have low price elasticity and are stable in nature. While Capital account might get affected with lower flows in the short term, India will be able to attract flows overtime with strong performance. Since commodities follow a mega cycle of more than 10 years, we could live with subdued prices for a long time and that will boost the inherent demand in the Indian economy.
We are in a cyclical recovery that will not just boost topline of companies but also bottom line with expanding Margins from lower input costs.
New Normal (or) Secular Stagnation in Global Growth, leading to glut of Capital:
> Few eminent western economists have written about the risk of secular stagnation in Global growth, primarily driven by softened Demand across developed markets. There are several structural factors at play from Demographics, Economic inequality to Indebtedness that will lead to sub-par global growth. As we are seeing already, Central bankers across the Globe will try to fight deflation by using both levers (lower Interest Rate & higher Monetary easing). This will certainly lead to a glut of capital in the Global markets that will continue to chase markets with decent returns.
> Bond Yields from Germany to Japan have fallen to the lowest in History with short term rates in a few markets in negative zone. This creates an environment for higher capital flows to countries such as India that is in want of capital and that can absorb huge amounts of capital while delivering healthy returns for Investors. India will also structurally be favored for Capital flows with its domestic economy oriented growth model compared with most emerging countries export based model.
India's decisive turn towards embracing Capitalism will aid flows:
> While we can debate about the pace of change of India's orientation towards a Market based economy, the direction of change towards capitalism is clear. There has been several initiatives taken in the last 2 years that improves the structural growth story of the country such as Subsidy reforms, Governance reforms, Increasing FDI limits, Opening up more sectors etc. Country is clearing moving towards a liberal Economic regime that will allow it to attract more flows and improve its per capita income from the current low levels to around 1.5 Lakh Rs in the next 6-7 years. This will create a vibrant domestic Market that can full fill the aspirations of our huge population.
> For the first time in India's history, we are having an environment in which all the 3 most important people in the Political system (Narendra Modi, Amit Shah & Arun Jaitley) as well the top bureaucratic team including CEA are pushing on a Pro-Business policy framework with lower government interference. Pressures on politicians to deliver on Development, Growth and Jobs would ensure that this is a irreversible change and India will improve its sustainable Growth rate. This along with structural factors such as Demographics, Social attitudes, Aspirations etc will ensure that India stays focused on developing its Economy.
Inflation Targeting and Monetary Framework to drive down cost of capital:
In addition to the good things happening in the Fiscal policy, the country is making decisive changes to its Monetary policy by moving towards Inflation Targeting. With the targets to be set around 4% +/- 2%, we believe that deeply entrenched Inflationary expectations among the economic agents in the system will decline consistently. This along with the improving transparency in Taxation will have huge impact on Indian public's Financial Savings Vs Physical savings debate. These changes along with an environment of low interest rates globally would drive cost of capital lower for Indian businesses. All these set the stage well for higher growth rates going forward.
RBI governor, Rajan, has also been focused on improving the Financial system from broadening Financial Inclusion to creating a Healthy lending ecosystem. With a good regulatory framework and healthy FOREX resources, India can withstand the volatilities of Global financial markets which will see increased frequency of Boom and Bust cycles with increased asset bubbles being the side-effects on the Monetary easing worldwide. With a strong man at the forefront of Government and the Central Bank, India does have a higher ability to withstand external shocks and this decreases the tail risk premium to Indian stocks substantially.
Seven Long Years of Market Consolidation sets a strong Base :
Indian Equity Markets have been through a long phase of underperformance. Equities has delivered a meager 3.5% CAGR returns over the last 7 years. The returns on broader markets including Small Caps and Mid Caps is even more pathetic. This has ensured that Indian retail investors have moved away completely from stock Markets. Over this phase, there has been a significant shift in shareholding from weak hands to strong hands in the market. Markets have rewarded quality well and bad businesses, bad Managements have taken a severe beating.
Indian markets are quoting at reasonable valuations all round. Even with this year's rise, we are still near historical average valuations for Indian equities. The cyclically adjusted valuations are actually lower than historical averages as we are currently at very low Margins for Corporate India. As Indian growth picks up, we will see operating leverage kicking in and several companies exhibiting strong earnings growth. Indian markets has all the ingredients for a Bull Market - Valuations, Sentiment, Policies, Earnings, Flows etc. Hence we will expect investors to BUY good businesses at attractive valuations. It is easy to get lost in the noise that comes from Financial markets each day and ignore these huge positive changes that are happening.
While these are our Macro views, our stock selection and portfolio strategies are purely based on Bottom-Up process. There are only a handful of businesses that can benefit sustainably from the Macroeconomic positives without passing every benefit to customers or getting hurt by competition. Thus it's very important that Investors stick with quality businesses and invest with a long time frame. Investors should look for businesses that can amplify the economic positives while the risk of downside is minimal. These stocks when held for long term can continue to compound at higher rates, enabling investors to grow their wealth multifold. We are currently bullish on stocks such as City Union Bank and Heritage Foods. These are great 5 year Investment opportunities.
City Union Bank (CUB) : The stock is one of the most efficient ways to play the economic recovery. It is a well managed franchisee (10 year average ROE - 20%+, NIM's - 3%+, Peak Gross NPA's < 2%) that is focused on lending to MSME segments. It benefits immensely from the overall economic recovery (Lower NPA's, Gains on Bond Portfolio etc) and the policy impetus from the Government (Make in India, SME Manufacturing focus etc). There could be an added bonus of Valuation Re-Rating from increasing bank consolidation (as seen with the ING-Kotak merger). Bank is well funded with CAR's of ~ 16% and has several quality investors backing the stock. Management team headed by Mr. Kamakodi has delivered well on execution and has strong growth plans for the next 5 years. We estimate that the bank should be able to post 480 Cr Rs of profits by the end of FY-16. While the recent capital raising will keep return ratios suppressed for the next few years, ROA's will eventually bounce back to 1.6-1.8% levels and ROE's to 20%+ levels. The stock is currently available at around 11X Price/ Earnings and 1.7X Price/ book on FY-16(E). With a strong balance sheet and attractive Co-Investor profile - CUB should deliver higher risk-adjusted returns for Investors from current levels.
Heritage Foods : It is one of South India's leading dairy brand. The company has built strong procurement capabilities, processing capacities and distribution network (Moats) that allows it to earn strong ROCE's ( >50%) on its dairy business. This business is a cash and carry business, leading to strong cash flows aided by a negative working capital cycle (Float). The company has been strengthening its Value Added Dairy Products portfolio that earns more than 12% EBIDTA margins compared with liquid milk margins of around 6%. This along with strong Industry tailwinds in terms of demand growth will enable the company to grow its profits strongly over the next 3-5 years. Dairy industry has seasonal and temporary volatilities that affects companies such as Heritage once in a while. This along with the Retail division of the company which has been a cash guzzler has led to overall mediocre results. Our calculations show that this Dairy franchisee adjusted for cyclical issues is available at around 6X EV/ EBIDTA multiple on conservative estimates which is extremely low on both absolute and relative valuations. The Management has been clear in saying that the Retail division would be spun-off to a separate entity by FY-17 which would be an added bonus for Investors.
(Contributed by Gokul Raj, Head Of Investments, HBJ Capital)
