Nifty and Sensex indices post highs with India outperforming other emerging markets yet again.

Summary

• India’s Sensex and Nifty indices posted new life-time highs in late July, with India outperforming other emerging markets for the fourth consecutive month. However, Breadth continues to be poor with a handful of the largest stocks representing most of the gains over the last few months. Mid and small capitalised stocks continue to underperform as seen for most of this year.
• On 1 August India’s central bank (RBI) raised interest rates by 25bps for the second consecutive time, a move largely expected if not universally approved by market participants.
• The Q1 fiscal year 2019 earnings results have begun. Although it’s still early days, earnings appear to be beating expectations for over half the companies that have reported so far.

Fund activity

The Fund underperformed its benchmark in July as the ongoing underperformance in mid/small cap stocks hurt. The good news is that towards the end of the month it looks like selling pressure on this part of the market is easing off. Considerable damage has been done with the Nifty Midcap 100 index and Nifty Smallcap 100 underperforming the Nifty 50 index by 17.79% and 24.65% respectively (year to end July in US dollar terms), so we expect any rebound to take time.  

In addition Reliance Industries (MSCI India’s largest index constituent) gained over 21% in July to add US$24bn of market capitalisation and to become India’s most valuable company (over US$100bn at end July). Not owning this stock (the stock does not pass our governance and quality screenings) accounted for over half the Fund’s underperformance versus the benchmark in July alone.

We have used stock price weakness to add two new positions this month and made one sale. We sold Hindalco Industries, India’s largest integrated aluminium maker. We had previously sold part of this position in the last quarter of last year into strength and have decided to use recent stock price gains on the announced acquisition of US based Aleris for US$2.6bn. Although we think the reasoning is sound, over the medium to longer term we find the price somewhat on the high side and the debt burden significantly increased. We think the upcoming cycle will negatively focus on companies with high debt levels (due to rising cost of capital) and the slow-down in China to weigh on aluminium prices over longer term (despite structural positives for industry). Most of the positives for Hindalco have largely played out and the stock price is now more fully linked to aluminium prices. We prefer India businesses to be more exposed to the India story and should show operational leverage to an India growth revival.

Our two new positions fit the bill as India focused and will benefit from a domestic growth revival. Coal India is the world’s largest pure play coal miner, in a country that will continue to need coal as a source of power for decades to come. This is a more defensive low beta, high dividend yield (8%), net cash company that has been a large cap underperformer YTD, but in addition does have a decent earnings story over the next three years. We find current valuations provide a favourable risk/reward balance.

AU Small Finance Bank was our other buy. AU recently converted to a bank and listed last year. This is a supremely well run bank and is focused on lending to medium and small enterprises, an area that has huge growth potential and poorly served by existing financial companies. Despite the stock selling off into this current volatility, AU is expensive on most valuation metrics but with loan growth projected to grow at over 35% annually over the next five years, we take a long term view on the returns this stock offers.

Outlook

We commented last month about the RBI’s June interest rate hike and now we have another in quick succession. Whilst our overall view remains that these rate rises are not justified, when looking at current economic data there is no doubt that the central bank is being more forward looking than it has been in the past. On that basis, we believe that rate hikes have been front-loaded, and that the central bank will likely hike again in October before pausing for some time. While not explicitly mentioned, part of the reason for the hikes would seem to be in reaction to international events and the weakness in the Indian Rupee.

The good news is the RBI noted that high frequency data continues to point towards sustained domestic growth momentum in Q218. Consumption growth remains the key driver, while exports growth has improved in the quarter. On the investment side, capital goods imports and order inflows of engineering and construction companies have remained robust. The RBI committee also mentioned that the output gap is virtually closed, which suggests improving capacity utilization. Improving capacity utilization along with recovery in growth should lead to recovery in the capex cycle, a sign that has in the past been the catalyst to buy the Indian market.