The Tantallon India Fund closed 2.31% higher in October after markets chose to focus on robust corporate earnings that continued to track ahead of market expectations, the correction in energy prices and the Modi government staying the course on structural reforms.
However, broader markets remain “challenging”. Accounting much for the volatility were fund flows, forced covering of leveraged positions, month-end NAV-propping, Xi-watching and endless prognostications on geopolitical risk in Crimea and the South China Sea. Therefore, it is better to remain focused on the fundamental revenue/margin/valuation drivers for industries and stocks.
The Fed remains resolute in its data-driven response to inflation and inflationary expectations, even at the risk of an elongated recession.
Interest rates globally are likely to continue to trend higher over the next six to 12 months and as liquidity tightens, together with the continued strength of the US dollar, continued volatility across asset classes and potential financial stress in credit markets should be expected.
The crypto meltdown is a perfect case in point and is a warning shot across the bow to prepare for collateral damage and “unexpected” market accidents.
Still, significant volatility creates significant investment opportunities. India, the Asean, China+1, electrification and decarbonisation, and the beneficiaries of weaker currencies against the US dollar taking market share globally are compelling long-term investment thematics.
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How the Indian economy performed
India continues to “surprise” on the upside, in terms of structural reforms and a new private sector-driven capex cycle sustaining growth, good earnings visibility and sustained domestic equity inflows underpinning markets and stock price multiples.
Structural tax and labour reforms, explicit pro-cyclical industrial policies to encourage employment and an intentional scaling back of subsidies have anchored and funded crucial enabling infrastructure investments and a private-sector capex cycle.
We are seeing a sustained boost to industrial employment and corporate profitability (currently tracking at 4% of GDP, having doubled off Covid lows but still tracking below the 7% of GDP peak in the last cycle), meaningful pickup in tax collections and good fiscal discipline, structural increase in the domestic equity savings pool and step-function improvement in foreign direct investments allowing India to run a monetary policy less sensitive to US Fed action and crude oil prices.
October’s high-frequency indicators continue to highlight the divergence between external and domestic demand, with export growth weighing on rail freight, air cargo and electricity demand, while buoyant PMI in the manufacturing and services sectors are sustaining domestic demand.
It is worth noting that new vehicle registrations, bank credit growth, domestic air traffic and mobility indicators are currently tracking ahead of pre-Covid levels.
The unfortunate corollary is a significant pickup in particulate pollution in the industrial centres in the National Capital Region, Maharashtra, Gujarat, Uttar Pradesh, Karnataka and Andhra Pradesh. State governments are starting to enforce greater restrictions on fuel sources and emissions.
Input inflation headwinds appear to be easing with headline CPI in October moderating to +6.8% y-o-y from +7.4% y-o-y in September on the back of the correction in global commodity prices and crude prices, which raises the possibility of the Reserve Bank of India (RBI) inching closer to the end of its tightening cycle.
Year to date, equity inflows from domestic investors of US$39 billion ($53.8 billion) (40% of which is via the monthly Systematic Investment Programs) dwarf the US$18 billion of inflows clocked in 2021. Domestic equity flows have been positive for 20 consecutive months and explain the sustained bid for Indian equities, despite US$24 billion in net foreign institutional selling this year.
The key risks we are focused on remain (i) an extended US recession which would weigh on exports, (ii) further US dollar strength which would weigh on the balance of payments and imported inflation, and (iii) elevated energy and fertiliser prices which would boost inflationary expectations, forcing RBI to maintain the restrictive monetary policy, and (iv) equity market correlation with global risk appetite.
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Stock highlight of the month
The company we want to highlight this month is National Hydro Power Corporation (NHPC), India’s largest hydropower generator with an operational capacity of 7GW and another 6GW of hydropower and 1GW of solar capacity under construction. NHPC is one of the key beneficiaries of India’s focus on renewable energy and a shift towards green hydrogen. NHPC earns a regulated minimum return and management continues to exceed expected returns, optimising costs and working capital requirements, while systematically boosting its Plant Load Factor.
We expect NHPC to conservatively grow revenues at 25%+ CAGR over the next three years, ahead of the market’s more muted growth projections in the teens.
With the government having identified 150GW of hydropower potential, NHPC is arguably the biggest beneficiary of the government’s commitment to fast-track and commission brown and green field hydropower capacity expansions. Its installed base of 7GW provides baseline annuity revenues and we are more confident than the markets on the commissioning timeline for the Subansiri Hydropower plant. We are also more confident in the prospects of the two JVs set up to build proof-of-concept hydropower-driven green hydrogen plants.
We expect NHPC’s profits to compound at an 18%+ annual run-rate over the next three years while market consensus has pencilled in high single-digit growth.
Multiple delays in securing the necessary environmental clearances, political posturing and protests by local state governments have translated to equity capital being locked into “under construction” projects which do not earn a regulated return. As the pace of commissioning improves over the next 24 months, we expect to see a meaningful inflexion in earnings, albeit weighed down by higher depreciation and interest expense.
Given the explicit terms of the contracts between NHPC, local state governments and the RBI, we expect to see a meaningful improvement in NHPC’s receivables and working capital cycle.
Globally, hydropower plants run at 2–2.5x debt/equity ratios. At 1x, we believe that NHPC is significantly over-capitalised and as leverage ratios are optimised, we expect the market will be surprised by the improvement in returns on capital and equity
Remaining constructive
While expecting markets to remain volatile, we remain more constructive than consensus and are looking to take advantage of the volatility to build our exposure to Indian equities.
Anchored by structural reforms and a new capex cycle, we expect India to grow real GDP sustainably in the 6%–7% range.
We believe that the market is structurally underestimating corporate India’s strong operating leverage to a new capex cycle, industrialisation, infrastructure spending, and new job creation/consumption.
We are patiently building positions in the highest quality financials, capital goods, and consumer-facing companies where we have a conviction on earnings and cash flow visibility, and the recent market action has provided us with compelling expectations and a valuation reset.
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 (25 to 30 positions without leverage), 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
