Risk-off for markets as RBI fights inflation

• Central Banks are prepared to “allow” demand destruction to re-establish price stability and the market’s recession fears are reflected in the global selloff in technology, commodity and economically-sensitive stocks; the selloff in US treasuries, global high yield and emerging market debt; the crypto meltdown; and the sharp selloff in currency and commodity markets.
  
  • 10-year US treasuries closed the quarter yielding just under 3%, a sharp pullback from the 3.44% levels in mid-June.
  • Powell’s path to 2% inflation is contingent on the myriad supply chain disruptions being speedily resolved while “hoping” that the front-loading of interest rate hikes adequately scales back demand from rate-sensitive sectors.
  • If this fails, the US Fed’s “unconditional” commitment to curbing inflation will impose more pain. In the last six months, futures have gone from implying a year-end Fed Funds rate of 0.8% to achieving a policy rate of about 3.5%.

We have spent the last several weeks looking less at our screens and focusing more instead on meeting with the management of many companies across the country.

Investment cycle, balance sheets intact

• At the risk of sounding complacent, we are reassured by the underlying strength in the Indian economy, resilient corporate balance sheets, and the government making pragmatic, thoughtful decisions on the trade-offs between sustainable levels of growth (to minimise the supply-side shocks following the war in Ukraine), managing the fiscal and current account deficits and currency volatility, and encouraging foreign direct investments to accelerate investments in industrialisation and infrastructure while empowering the RBI to tackle inflation head-on.
• The high-frequency indicators remain robust: Manufacturing PMI at 54.4, services PMI at 58.4, export growth tracking at +17% y-o-y for the June quarter, record GST collections at INR1.5 trillion ($26 billion), core sector loans growth tracking at +18% y-o-y, and non-food credit growth tracking at +13% y-o-y
• We are struck by the confidence articulated by multinationals in India about a multi-year investment cycle. They compared their business prospects in India favourably with their legacy businesses in China, thanks to cost competitiveness on the back of scale and low-cost Indian engineering talent, and they were committed to reinvest the uplift in margins and free cash flow back into expanding capacity in India.
• The multinationals rued the government’s recent decisions to impose import curbs on gold, export curbs on food grain and edible oils, and tax the profits of commodity producers and oil refiners. However, they were supportive of proactive policies to contain the fiscal and current account deficits and rupee volatility, minimise the subsidy burden, and contain inflationary expectations in the face of elevated import prices for crude, vegetable oils, fertilisers and seeds.
• Venture capital funding for Indian start-ups fell sharply in the June quarter to US$7 billion ($9.75 billion), down from US$11 billion in the March quarter — which is a positive thing. Speaking to several start-ups seeking funding, our sense is that the genuinely sustainable business models continue to receive plentiful funding while the mark-to-myth profitless growth narratives based on a wing and a prayer, do not qualify.
• Valuations have pulled back. With an earnings yield of around 6% and asset valuation in P/B terms starting to trade below long-term averages and at a discount to replacement value, we see a meaningful pickup in domestic M&A activity to drive consolidation and share buybacks funded through internal accruals.
• Key concerns articulated across our meetings were: Rates, Russia, recession and the rupee.

See also: Wall Street's uber bull Tom Lee makes next bold bet in ETF era

Stock focus of the month

The company that we would like to highlight this month is Dabur India, India’s largest domestic consumer goods company with a strong brand presence across home and personal care, F&B, and healthcare products. Dabur stands out with a portfolio of well-established Ayurveda brands, its scale and deep penetration into rural India, and sustained profitability that allow management to fund new product development, acquisitions and investment in marketing, distribution and technology through internal accruals.

• We expect Dabur’s revenues to grow at more than 15% CAGR over the next three years, well ahead of consensus estimates projecting growth of about 10%. • We have a strong conviction in Dabur’s new product innovation pipeline, the branded focus on naturopathy and Ayurvedic products, and the ability to leverage its distribution channels reaching 7 million outlets to grow its national market share in the personal, home, and health care categories.
• The recent pivot from juices (INR15 billion category) to drinks (INR90 billion category) is underappreciated by the market. The recent acquisitions at very attractive multiples in the herbal space in the US and Turkey will provide technology and brands, and flesh out the gaps in the personal and health care portfolios.
• The brand extension opportunity in infant products (a space that Johnson & Johnson has just withdrawn from India) and processed foods (pickles, pastes, sauces) is significant. We have yet to work out the revenue opportunity from the investments that were made over the last three years.
• We expect Dabur to achieve earnings CAGR of 20%-plus over the next three years while the market’s expectations are for a more modest 11% CAGR.
• We are more sanguine than consensus on the short-term outlook for margins. Unlike the peer consumer group which is exposed to significant commodity price volatility, cost increases in Dabur’s primary input of herbs and fruits have been measured. Additionally, Dabur’s Ayurveda portfolio retains significant pricing power and has been demonstrably less prone to down-trading through past economic cycles.
• We believe the market is structurally underestimating the economies of scale and the synergies across distribution channels, media buying and corporate overheads, and the uplift from the government’s recent introduction of production-linked incentives for processed foods.
• The new brand extensions launched in baby products and processed foods will structurally improve the mix and margins.

See also: Lion Global Investors and China Merchants Fund Management collaborate on world’s first SGD-traded emerging Asia ETF

Overall conclusion

We expect markets to remain extremely volatile in the short-to-medium term, however, interest rates and equity risk premiums have started to better calibrate the now-inevitable growth slowdown or potential recession in the developed world. We are encouraged to start building positions in companies where we believe current valuations allow us an adequate buffer to look through potential near-term earnings volatility and to focus instead on the longer-term runway for growth, alongside a consistent bid from domestic institutional and retail investors.

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 3-5 year horizon, in a concentrated portfolio (25–30 unlevered positions), market cap/sector/capital structure agnostic, but with strong conviction on the structural opportunity, scalable business models, and in management’s ability to execute. Tantallon Capital Advisors is a Singapore-based entity, set up in 2003, holding a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore