India remains a favourite with fund managers

• Expect more seemingly random “shifting” interest rate, duration, forex and equity market expectations, and as a result, schizophrenic “rotation” between markets/sectors/styles. Given “data-dependent” central banks, markets will likely continue to be whipsawed between “high-for-longer” and recession concerns haphazardly alternating with peak interest rate extrapolations for leveraged/cyclical/low profitability stocks.
• The only constants through the volatility: Increasingly unpredictable, high margin-of-error labour, wage and inflation data points, election-related policy uncertainty in multiple geographies, brutal wars and accumulating geopolitical stress points, and the continuous deterioration of business fundamentals and business/consumer confidence in China.
• Our simple investment framework is built around interest rate/inflation/growth differentials, a USD risk-free rate of 4.3%, a weaker USD, and high-conviction structural growth in India, Japan, China+1, the green energy transition, and the picks and shovels essential to the AI infrastructure build-out.
• We remain most concerned about mounting policy errors in China and the risk of the escalation of the wars in the Crimea and Middle East with horrendously negative implications in terms of human suffering and loss of life but also for global energy prices and supply chains, inflationary expectations, and equity risk premiums globally.

Corporate earnings to grow by double digits

Having travelled extensively across the country and through the hinterland over the last several weeks, we would amplify the long runway and structural uplift opportunity in India.

• We expect India’s real GDP growth to compound at 7%+ annually over the next three years. Validated by the high-frequency data points we track and anchored against the cyclical recovery in capital formation, infrastructure development, industrialisation, rising employment and disposable income-driven consumption, we are on the cusp of a structural reset of lagging market expectations.
  
  • The manufacturing and services sector PMI clocked 54.9 and 59 respectively in December, a 21% y-o-y boost to direct tax collections for 2023, government spending on infrastructure registering 22% y-o-y growth and non-food credit growth coming in at 20.3% y-o-y.

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• We believe that corporate earnings for the BSE 500 are likely to compound at a 15%+ CAGR over the next three years, about 400 bps ahead of current consensus expectations, underpinned by strong nominal GDP growth, sustained demographics and rising disposable income-driven consumption, industry consolidation, rising utilisation rates, and stable/falling borrowing costs.
• We believe that earnings for our portfolio holdings are likely to compound in the 18%–20% range over the next three years on the back of the government’s specific goals to industrialise, indigenise and boost energy independence; strong volume/mix-driven operating leverage; sustained urbanisation and consumption dynamics; and moderating input cost inflation.

On the market broadly and on valuations specifically:

• The MSCI India was up more than 20% in USD in 2023. There was an 18% increase in earnings, a 2% increase in the forward market P/E multiple to 21.8x (up from 21.4x in January 2023), and a 1% depreciation of the rupee versus the USD.
  
  • Going back 30 years, earnings growth has driven more than 90% of Indian equity returns and we certainly expect the correlation to hold going forward.

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• That said, with foreign ownership in the BSE 200 at 21.6% (17.6% of the BSE 500) at a decade-low level and given our expectations of a weaker USD and a China+1 overlay, we would expect those asset allocation flows into Indian equities to be sustained.

Stock highlight of the month

The stock we would like to highlight this month is Thermax, an early-cycle industrial, strongly leveraged to the recovery in industrial capital expenditure, with robust free cash flow generation and a consistent payout ratio of more than 25%.

Over the last five years, management has pivoted its legacy captive power generation business towards clean energy, energy transition, energy efficiency, and sustainability. Investments into waste-to-heat (W2H), waste-to-energy (W2E), biomass, solar EPC and management, battery solutions, zero-liquid discharge plants, water purification, wastewater treatment and air pollution control systems technologies have put Thermax in pole position to benefit from India’s green energy transition ambitions with the green portfolio accounting for about 75% of order book/revenues.

We expect Thermax’s consolidated revenues to compound at 20%+ annually over the next three years, versus the consensus expectation of revenues compounding at about 13% annually.

• We have good visibility on order book conversion into revenues over the next two years given the delivery of four flue gas desulfurisation systems.
• We are significantly more optimistic than the market currently is on India’s capex cycle; to put this in context, in the last capital goods upcycle (2003–2009), we saw Thermax’s order book compound at a 25% CAGR.
• Given the tenders/inquiries, domestically and overseas, and given technology/cost leadership, and management’s track record for on-time/on-budget execution, we also expect that the market will be positively surprised by the traction in Thermax’s emerging solar EPC, W2H/W2E and biomass businesses.

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We expect Thermax to compound earnings at higher than 35% CAGR over the next three years. Current consensus expectations are anchored to about 20% growth.

• We expect margins to improve more than 100 bps annually over the next three years given lower raw material costs, higher utilisation rates, mix improvement and strong operating leverage.
• With the portfolio shifting towards short-cycle delivery projects, we expect significant improvement in working capital, allowing for a 600bps+ improvement in ROE/ROCE.

Given the sharp rally in risk assets globally, and in particular, in the small and mid-cap space in India over the last few weeks, markets appear primed for a near-term correction as investors are forced to recalibrate positioning, the timing/extent of a US Fed pivot and the implications for interest rates, the USD and corporate earnings, and geopolitical risk premiums embedded in crude prices.

Given the likelihood of a renewed parliamentary majority for President Narendra Modi and policy/reform continuity, India’s growth fundamentals and corporate earnings outlook remain compellingly robust.

Underwritten by the sustained domestic bid for equities, we plan to look at taking advantage of the volatility to build on our exposure to Indian financials, industrials, infrastructure, pharmaceutical, utility, and consumer discretionary stocks with attractive valuations and good visibility on earnings/cash flow growth.

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