Valuations begin to look more attractive ahead of elections next year.

Summary

• Indian equity markets fell in March, with small and mid-cap stocks again performing slightly worse than larger companies. Despite better performance in the second half of March, India has underperformed other emerging markets in the first quarter of 2018.
• It was a light month for macro data, but notable was February consumer price inflation at 4.44% which was less than expected. Falling food prices were the primary reason, and inflation is now well within the RBI’s target range.
• The Indian 10 year government bond yield fell over the month, after rising significantly since mid-last year. Easing fiscal and inflation concerns have helped, with the fall in yields beneficial to the state owned banks in particular who are large holders of government bonds.

Fund activity

We undertook two trades this month; the purchase of Carborundum Universal and late in the month the sale of ICICI Bank.

We used some stock price weakness we have been seeing with the sell-off in Indian mid-cap stocks to initiate a position in Carborundum Universal. The stock has significantly corrected from its recent peak, giving the Fund an opportunity to purchase a company showing good growth and significant operating leverage at attractive valuations. The company is focused on segments predominantly linked to growing economic activity with products like abrasives, refractories and other materials. 

We expect robust earnings numbers and 20% profit growth to continue over the next three years. The return ratios are healthy with zero debt and profit effectively converts to free cash flows. The business has high gross margins of 65% and great operating leverage over fixed costs. Exports account for 40% of revenues.

We have been looking to add companies that have significant operating leverage to India’s economic recovery and in particular ones with the management expertise and capacity to fully grasp the opportunities available. In addition this is a segment where there is competition from informal players, presenting the company with the possibility of market share growth as the informal sector comes under further government pressure.

Late in the month we decided to sell ICICI Bank, India’s largest private sector bank by assets and a stock we have held since 2013. Although we have been getting more confident that India’s banks had finally put the worst of the non-performing loan issues behind them and that loan growth was picking up again, we are concerned that a recent fraud at one of India’s largest public sector banks could cause wider problems. The fraud investigation appears to be broadening out to many other banks which will hit sentiment if indeed this is the case. The Fund has had an overweight exposure to corporate focused banks for some time and we believe it prudent from a portfolio risk perspective to change our stance to underweight for the time being.

Outlook

Following a period of rising consumer price inflation the release of weaker than expected February inflation numbers cheered India’s government bond market. We have been arguing for some time that inflation worries were being overstated due to seasonal food price moves and technical factors (a negative base effect due to falling inflation a year ago). The economy still has plenty of spare capacity, surplus labour and no wage pressure which is what should be expected after such a prolonged growth slowdown. The good news is that India’s 10 year government bond yields fell over the month in reaction to the inflation print as well as easing worries about the government’s borrowing requirements.

This good news is yet to translate into improved stock market performance - India has underperformed most other emerging markets over the first quarter. Although global concerns over potential trade wars have intensified, and the technology sector in the US (the market leader in this cycle) has started to come under pressure it is primarily domestic issues that are the reason for this underperformance. This has meant foreign investors have focused flows on China and other emerging markets with the result that foreign ownership of the broader Indian stock market stands at 18.7%, its lowest level since September 2013.

While it is unlikely that Indian markets will stage a dramatic recovery in the very short term, the recent underperformance has meant that valuations are becoming more palatable. We believe that further proof of the economic and earnings recovery that we have begun to witness over the last few months will set the market up nicely in the period ahead. A reviving housing market is core to the much awaited uptick in the investment cycle, and here the data is certainly looking more promising. This is a sector with much focus from government. With a busy election cycle ahead the government’s push to develop more economy housing will not only show intent to address the vast deficit of this housing category, but also generate some much needed job growth as well.