Inflation and rising rates pressure markets; Hitachi Energy India in focus

• We continue to closely track the action in US Treasuries, and corporate high-grade and high-yield markets as good reference points on markets adequately pricing for risks, including the sharply increasing probability of a recession.
• Our hunch is that the only way the US Federal Reserve Board can achieve its “goals” on price equilibrium is by using “demand destruction”.
• Experience suggests we should expect markets to remain extremely volatile until the Fed signals that they are close to being “done” and are comfortable with the reset on trending inflation data.
• Accept the risk-on/risk-off schizophrenia in markets. The markets will remain “noisy” and volatile as investors internalise flows/valuations “adjusting” to lower growth/ margin assumptions and higher riskfree rates, leveraged positions being unwound, further supply chain dislocations, intermittent optimism over China “easing” counter-cyclically and “reopening” and Putin’s intentions for Ukraine and Europe.
• Although we are six months into the correction, we are not yet in capitulation mode. We still see far too much machismo in pundits “calling a bottom” and trying to “trade the rallies”.
• We should certainly be expecting more Target-type “resets” to “right-size” post-pandemic business models, balance sheets and inventories, even as persistent inflation, rising mortgage rates, and a slowing economy start to erode consumer confidence and purchasing power.

At the risk of sounding obvious:

• We are not trying to call a “bottom” and yes, the markets will “lead” economic fundamentals by 6–12 months.
• We are focusing on business and balance sheet resilience and its ability — thanks to product/technology/brand/distribution moats — to gain market share coming out of a slowdown.
• We are staying disciplined and calibrating growth expectations against our valuation framework.

Higher prices, higher bank liquidity ratios

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Specifically for India, we would highlight the following:

• Surging inflation on the back of higher crude and food grain prices has brought a swift policy response, and after a surprise intra-meeting rate hike and an increase in bank capital liquidity ratios in May, the Reserve Bank of India (RBI) raised rates by another 50bps at the June meeting. The messaging is clear: the RBI will remain vigilant on inflation, and we should probably expect another 75bps– 100bps of tightening over the next six months.
• The June quarter is the first quarter without any Covid restrictions since the onset of the pandemic. High-frequency indicators (PMI for manufacturing and services, export growth, buoyant tax collections, new job creation in the formal sector, electricity consumption and credit growth) for the quarter validate a robust economic recovery, which should gather momentum.
• Equally encouraging was the reported corporate profit pool, with the aggregate corporate profit to GDP ratio reaching 4.5% for the fiscal year ended March, a decade high.
  
  • On a trailing 12-month basis, aggregate corporate profits for the BSE500 rose 42%.
  • Industrials account for 45% of the aggregate profit pool, the highest in the past decade, auguring well for the nascent investment and credit cycle. In the last upcycle in FY2005–FY2006, industrials accounted for almost 60% of the aggregate profit pool.
  • In contrast, the share of “services, consumption and healthcare” dropped to a two-decade low of 28% of the aggregate profit pool.
  • Emerging from the non-performing loan cycle of the last five years, financials are back to contributing a quarter of the aggregate profit pool.

• The BSE500 trades at about 21x trailing earnings. •
• The lagging services and consumption and healthcare constituents of the profit pool are trading at ~33x trailing earnings.
• Industrials and financials (which constitute 70% of the aggregate profit pool) are trading ~17x trailing earnings.

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Stock focus of the month

The company we would like to highlight this month is Hitachi Energy India (HEI), the Indian subsidiary of Hitachi Energy that aggregates the power products businesses of ABB and Hitachi, including grid automation and integration, high voltage switch gears and breakers, transformers, SCADA control systems, substations, energy storage, cooling systems and energy usage planning and trading tools. Thanks to Hitachi’s comprehensive power grid track record, HEI sits in a sweet spot, a pure play on India’s energy sector and electrification capex, and in particular, the focus on grid investments and data centres.

We expect HEI’s revenues to compound at a more than 15% CAGR over the next three years while market consensus would seem to be pencilling in a sub-10% run rate, in line with the historical run rate.

• We are significantly more constructive than the market on the government’s production-linked incentive programmes encouraging industrialisation and job creation and are calibrating our growing conviction against the investments actually being made in infrastructure broadly, railways, data centres, and importantly, the investments in renewables and electrification.
• Sustained demand for High Voltage Direct Current (HVDC) transmission solutions connecting remote solar and wind power generation to the national grid.
• Electrification will remain a recurring theme, and HEI is a significant beneficiary thanks to its expertise in traction control systems for the railways, flash charging for e-buses, and automotive charging infrastructure.

We expect HEI to compound earnings at a 35% CAGR over the next three years although consensus is looking at low-teens growth.

• The systematic investments through the pandemic are poised to yield operational efficiencies, process optimisation and logistics savings, delivering on a globally competitive cost structure which should be able to absorb higher raw material input costs.
• We anticipate those mix improvements and strong operating leverage to drive more than 75bps of operation margin uplift annually over the next three years.
• We expect ROES/ROCES to expand by 500bps–800bps over the next three years and given the significant free cash flow generation, a higher dividend payout.

In conclusion

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• We are continuing to carry a substantially higher cash position than we are normally comfortable with, reflecting significant market uncertainty and growing recession risks in the developed world.
• That said, given the pullback in valuations, with the RBI having commenced the “normalisation” of monetary policy, alongside the consistent bid from domestic institutional and retail investors validating the structural opportunity in Indian equities, we are starting to patiently deploy capital in companies where we find valuations compelling relative to the opportunity set, with strong earnings and cash flow growth.

The Tantallon India Fund is a fundamental, long-biased, India-focused, total return opportunity fund, registered in the Cayman Islands and Mauritius. The fund invests with a three-to-fiveyear horizon, in a portfolio, market cap/ sector/capital structure agnostic, but with strong conviction on the structural opportunity, scalable business models and management’s ability to execute. Tantallon Capital Advisors, the advisory company, is a Singapore-based entity, set up in 2003, and holds a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore