The Tantallon India Fund closed 4.65% higher in July, showing it was another good month that reflected strong quarterly results for our portfolio holdings, sustained flows into domestic equity mutual funds, and positive foreign institutional fund inflows.
We continue to have strong conviction in India’s ability to decouple from the volatility in global capital markets on the back of demographic tailwinds, a decade of policy reforms and fiscal discipline, and a private sector capex cycle amplifying the government’s investments in infrastructure and digitisation, which sustains industrialisation and job creation.
That said, the last few weeks saw schizophrenic trading in global markets which underscored the broad market’s lack of conviction on anything. Liquidity and fund flow chasing index performance had seen markets post a significant recovery off the lows established in autumn last year, largely on the back of AI-driven exuberance and a view on a US soft-landing and imminently lower interest rates. It is now quite apparent that sentiment had been fragile at best and markets, which were looking for an excuse to sell off, suddenly found several reasons.
- The yield on US 10-year treasuries is staying above 4% despite the consensus of a soft-landing in the US with moderating consumer price inflation, employment data and inflationary expectations, and recent outright dovish commentary from three FOMC members endorsing rate cuts in 2024.
- Whether the forecast of a 4.5% yield is accurate or not, the Fitch downgrade, a heavy new issuance calendar, and the resilience of the US consumer are making it clear to the markets that the cost of capital is likely to remain elevated in the short-to-medium term and a 4%+ yield on the 10-year will be a headwind for equities broadly, especially for high-multiple stocks with poor earnings.
- Stop-loss selling has been indiscriminate in multiple markets, which constituted some quite inexplicable stock price action.
- Up to this point, President Xi Jinping has resisted meaningful stimulus to revive the domestic economy or private entrepreneur risk appetite. What is clear from the markets looking at the most recent 15 bps cut on policy rates to 2.5% — the steepest cut in three years — is that piecemeal policy measures are simply not going to move the needle because of weak consumption, collapsing investments, rising unemployment, deflation setting in, contracting exports and trade, plunging loans growth, and several of the country’s largest property developers and asset management companies on the verge of default.
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- Higher energy prices are inherently inflationary and will further complicate the calculus of inflationary expectations and disposable income as we head into the autumn period.
Having spent the last couple of weeks on the ground visiting companies, we would like to make the following points:
- India is already in full-blown election mode and while the international press noisily speculates on President Narendra Modi having lost his “edge” and being held hostage by a right-wing pro-Hindu agenda, the view on the ground is that Modi is set to retain his parliamentary majority, albeit with a slimmer margin.
- Higher energy prices remain a key risk given the follow-on negative impact on inflationary expectations, discretionary consumption and profitability for the manufacturing sector.
- Headline inflation has spiked over the last six weeks on the back of higher energy and food prices due to weather-related damage to the vegetable and grain crops, potentially delaying the Reserve Bank of India’s easing cycle.
- The high-frequency data we track has risen to a four-month high with GST collections coming in at INR1.65 trillion ($27 billion) (+11.6% y-o-y), manufacturing sector PMI remaining steady at 57.7 in July vs 57.8 in June, services sector PMI accelerating to 62.3 (vs 58.5 in June, and the highest level since June 2010), credit growth coming in at +14.4.% in July (vs +16.2% in June), and sustained growth in rail freight, power demand, and air passenger traffic.
- Earnings for the broad market, aggregating roughly 15% growth y-o-y, continue to track ahead of expectations (with 70% of the BSE 500 having reported earnings for the June quarter thus far). Domestic industrials and financials have surprised most positively on the back of strong top-line growth and margin uplift, while materials companies have seen pricing and margins disappoint.
Stock focus of the month
The stock we highlight this month is Sterling & Wilson Renewables (SW), one of the largest solar EPC companies in India with a strong global footprint. Having largely run down its legacy portfolio of large and margin-dilutive projects, and anchored by the ambitions of its new major shareholder, Reliance Industries, SW is on the cusp of a new revenue/profitability cycle as lower solar panel prices and India’s explicit focus on substantially growing renewable energy in the overall mix, translating to significant new and profitable opportunities for SW to grow its order book.
We expect SW to compound consolidated revenues at a 100%+ CAGR over the next three years. Consensus estimates are looking for revenue growth in the 25% CAGR range.
- Top-down, India has spelt out clear targets on creating 500GW of non-fossil fuel energy capacity by 2030, driving renewables to 50% of the overall energy mix, with solar capacity specifically, to be ramped up from 70GW currently to 300GW. Ex-Reliance, assuming SW maintains its current market share, we expect new order wins of more than US$1 billion ($1.36 billion) for SW in India alone over the next three years.
- Given its track record and the current pipeline of new projects that they are bidding on in the overseas markets, we expect another US$1 billion in new order wins for SW in their international subsidiaries over the next three years.
Having incurred substantial losses over the last three years on the back of the non-profitable legacy order book, we believe that SW is on the cusp of registering profitability and free cash flow compounding well in excess of 100% annually over the next three years. Consensus estimates are currently still projecting accrued losses for the firm over the next three years.
- The shift in mix towards a higher proportion in the domestic order book will be naturally accretive to margins — because there is no legacy module pricing risk, higher margins and no working capital stress — and to free cash flows.
- Lower module prices will also be supportive of margins and diminished working capital requirements on the legacy international order book being completed while being meaningfully accretive on new order wins given the change in SW’s policies on bidding for international work without taking on module pricing risks.
- In addition, underpinned by strong free cash flow, over the next three years we expect the balance sheet to be completely de-leveraged yielding significant interest expense savings.
In conclusion
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Underpinned by a decade of intentional policy reforms and infrastructure investments enabling digitalisation and industrialisation, a benign domestic monetary and fiscal outlook, a resilient domestic capex cycle, strong demographic tailwinds, and a sustained domestic bid for equities, we believe the Indian economy and equity markets are poised to decouple from the slowdown in the developed world, and in particular, in China.
Macro and geopolitical headwinds globally remain a concern, and in particular, the risk of sustained higher energy prices.
We believe our portfolio holdings will compound earnings in the 18%–20% range 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
