The Tantallon India Fund closed 0.59% higher in July, a frustrating month in which markets aggressively sold down high-quality industrials, capital goods and defence companies over concerns that a more populist Modi government, constrained by coalition politics, would have to curtail spending on core infrastructure and defence projects while rotating into the perceived safety of the large-cap index constituents.
- Having parsed the details and the intent of the Annual Budget that was presented in Parliament, we remain sanguine on Modi’s fiscal and social spending priorities coalescing around industrialisation, indigenisation, job creation and targeted rural/agricultural stimulus, and in the credible budgetary glide path towards greater fiscal discipline and consolidation.
- Anticipating volatile markets, we plan to use the market pullback and rotation to build on our exposure to high-quality, idiosyncratic growth in industrial, discretionary consumption and financial stocks.
Acknowledging the dramatic spike in market volatility over the last few days:
- Having tracked “flows” across several prime brokerages and trading desks, it would appear that the twin shocks (complacent markets “waking up” to potential recession risks in the US and the Bank of Japan starting to tighten) have caught the markets off guard in an earnings season that has also “disappointed” elevated expectations.
- We should expect markets to remain volatile in the short- to medium-term.
- We plan to utilise the volatility and valuation reset to continue investing in our highest fundamental convictions.
Presenting her record seventh consecutive Budget in Parliament on July 23, Finance Minister Nirmala Sitharaman eschewed “gimmicks” and delivered on policy continuity, tax rationalisation across asset classes, and credible fiscal discipline and accountability while maintaining the government’s focus on core infrastructure development, industrialisation and indigenisation, job creation, clean energy, and targeted social spending on affordable housing and agricultural sector support. We would specifically highlight:
- Credible budgetary math projecting a very conservative (given trending tax collections through the end of July) 11% increase in government revenues, together with a 7.8% cut in fertiliser, food and fuel subsidies and a 10% increase in interest payments, yields a 4.9% and 4.5% fiscal deficit in FY2025 and FY2026 respectively, reiterating the government’s commitment to not crowding-out the private sector and setting the stage for a structural down-shift across the yield curve.
- Given the improving fiscal position, the government’s gross market borrowing requirements in the current fiscal year could be closer to INR14 trillion ($220 billion) (down from INR15.4 trillion the preceding year), eliciting a positive response along the domestic yield curve.
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We are particularly reassured by the “high-quality” budgetary spending goals (17% y-o-y on a high FY2024 base) anchored by increases in funding provided for state-level infrastructure projects and specific programmes to drive job creation, affordable rural and urban housing, and agri-commodity pricing support.
- The disappointment over spending targets on roads, highways, railways and defence not being revised higher in February was the source of the market’s angst.
- From a market perspective, the key negative was the unexpected increase in effective capital gains taxes, with short-term (from 15% to 20%) and long-term (from 10% to 12.5%) capital gains taxes being hiked across asset classes and the elimination of the inflation-indexation offsets that had buffered capital gains taxes on real estate transactions.
- We were surprised by the increase in tax rates. It makes sense in the context of the government maintaining a balance between greater fiscal consolidation and investing aggressively in enabling infrastructure. However, it will dampen market sentiment in the near term.
Halfway through the earnings season for the BSE500, the underlying pattern/strength in results would validate our conviction in sustained investment-driven GDP growth, a revival in private sector capex and credit cycles and selective discretionary consumption. We would highlight the following:
- The standouts for the quarter have been industrials, infrastructure, defence, utilities and capital goods stocks, reflecting strong growth in new order inflows despite the natural delays and uncertainty around the elections.
- Discretionary consumption has been mixed. Demand for premium real estate, air travel, groceries, and white goods has been surprisingly positive. In contrast, demand for premium two-wheelers, hotel bookings, QSR sales, apparel and staples has been sluggish.
- Exports have been mixed, with IT services and chemicals disappointing in growth and cautious commentary. At the same time, pharma companies reiterated robust prospects and moderating pricing pressure on sales in the US and Europe.
- Despite strong credit growth, banks and finance companies have shown nascent signs of credit stress in unsecured lending and some net interest margin pressure amid rising competition for deposits.
- Strong domestic volumes notwithstanding, pricing and mix erosion have weighed on margins and profitably for the domestic commodity companies.
- Across sectors, we are closely monitoring the impact of rising freight costs on the back of the container supply crunch and the dislocations to shipping lanes through the Red Sea.
We retain our conviction in India’s macro stability and business cycle, investment-led GDP growth compounding at 7%+ over the next three years and our portfolio companies delivering on sustained earnings/cash flow growth.
However, Indian equities will not be immune to near-term hyper-volatility in markets as perceived recession risks in the US and busted yen-carry trades will likely force a significant unwind in leveraged, crowded positions globally.
We are looking to take advantage of the volatility to continue improving the portfolio’s quality, building on our exposure to attractively valued, idiosyncratic opportunities in infrastructure development, industrialisation, energy security, indigenisation, affordable housing and consumer discretionary stocks.
Stock highlight of the month
The stock we would like to highlight this month is Divis Labs. Over the past three decades, this company has become a “preferred supplier” of active pharmaceutical ingredients (API) and Contract Research and Manufacturing Services (CRAMs) to both domestic and global pharmaceutical companies. Looking to take advantage of an at least US$10 billion ($13.2 billion) pipeline opportunity of molecules going off-patent in the next three years and fraying geopolitical relationships in a post-pandemic world, Divis has continued to systematically invest in greater backward integration and in scaling up domestic manufacturing capabilities, allowing the global pharmaceutical value chain to reduce its historical dependence on Chinese capacity.
We expect Divis to compound revenues at nearly 25% annually over the next three years, well ahead of market expectations of revenues compounding at sub-15% annually.
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- Given the sustained investments in cost-competitive new capacity and improving traction with global pharmaceutical companies, we are more optimistic than the markets on new product launches and market share gains.
- We are modelling strong mix uplift potential, given Divis’ focus on green chemistries and more complex APIs.
- In addition, we are ascribing higher value to the revenue opportunity ahead in peptides, GLP1 drugs, nutraceuticals and generic sartans.
We expect Divis to compound profits of over 35% annually over the next three years, while consensus estimates are tracking at a sub-20% CAGR.
- We expect the investments in de-bottlenecking and backward integration to improve yields further, reduce wastage, and drive significant efficiency and cost gains.
- We are modelling sustained mix improvements and strong operating leverage, driven by higher utilisation rates and more than 1,000 basis points of ebitda margin improvement over the next three years.
The Tantallon Asia Impact Fund SF is a fundamental, long-only, Asia-focused, total return opportunity fund. The fund invests with a horizon of three to five years in a concentrated portfolio (30–35 positions without leverage), market cap/sector/capital structure agnostic but with strong conviction on the structural opportunity, scalable business models, and data-driven analysis of sustainability, innovation, societal trends, and material environmental and governance initiatives to drive profitability. Tantallon Capital Advisors is a Singapore-based entity set up in 2003. It holds a capital markets service licence in fund management from the Monetary Authority of Singapore
