Summary

• After registering life-time highs in August, mainline Indian equity indices (Nifty, Sensex) underwent significant corrections in September. Indian mid and small cap stocks also corrected heavily towards month end.
• For the first time in several months India underperformed other emerging markets, with the financial and consumer facing sectors hit particularly hard. The month’s best performer was the externally focused Indian IT sector.
• Credit markets endured a liquidity scare due to concerns over margin pressure at non-bank financials as credit costs have risen following a default in the infrastructure sector (IL&FS). Government bond markets, however, cheered news that the government would borrow less than anticipated in the second half of fiscal 2019 with the 10 year government bond yield declining from over 8.2% to just over 8% at the end of September.

Fund activity

September witnessed both equity and currency market weakness, albeit the Indian rupee fell roughly in line with other emerging market currencies. Indian equities however suffered a poor month versus other emerging markets which is a change following a sustained period of outperformance since the early part of this year. Mid and smaller capitalised stocks suffered a heavy late month selloff, after posting some outperformance last month. The Fund marginally underperformed its benchmark in September, although against peers we ranked much better.

We undertook only one significant change to our holdings this month, which was the sale of Interglobe Aviation. Although this stock was a relatively recent addition to the portfolio (we initiated the position in November 2017) the stock performance since May has been disappointing. Whilst stock price action is clearly one important factor we monitor with all our positions, we are not usually compelled to act unless there are other fundamental factors behind the price action. In this case, there were a number of considerations that have arisen that had not been evident when we initiated the position. These include the crude oil price rising above levels that the market had previously anticipated (and hence squeezing margins), issues with recently delivered Airbus plane engines (delaying capacity expansion plans) and some changes at the management level that have caused some uncertainty. These factors have skewed the risk/reward balance negatively even after recent poor price action. There is no doubt however that the airline remains one of the best run in India and globally, and is exposed to an underpenetrated sector that is due significant structural growth in the decades ahead. We will be monitoring the stock for a change in the risk/reward balance in the months ahead.

Outlook

One other area with strong structural growth potential that has been rewarded by the market over the last couple of years are consumer facing sectors in general but in particular the consumer staples sector. Consumer staples in India have undergone a significant rating adjustment higher to levels the sector has historically seen. The fund has generally eschewed staples stocks as we have found valuations simply too expensive for the growth on offer. Whilst we have in fact recently added a staples stock to the portfolio (Future Consumer) this is a new entrant and a disruptor in the space. It was therefore interesting to see that the staples sector was one of the worst performers in September, although it is too early to say whether a bout of mean reversion has started.

The worst performing sector over the month was the financial sector, which generally is the largest sector in most of the major indices (it is over 21% of MSCI India). The MSCI India Financials sector fell over 14% (Indian rupee terms) caused primarily by the failure of IL&FS (not listed) which is an infrastructure related institution, and its knock on impact on credit markets. Additionally, India’s central bank has caused some volatility in a number of non-state owned banks recently, concerning senior management and ownership structures. 

IL&FS is involved in various Infra verticals, with heavy exposure to Roads, followed by Investments in Thermal power, Renewables and Transmission. The institution got itself into a funding mismatch by being too reliant on short term paper for borrowings whereas its projects are long term in nature (and hence cash flow takes a long time to materialize). While this mismatch is nothing new, the issue seems to have been caused by a delay in large payments from various government ordering authorities. For any prudent institution in this space, delays should be factored into normal business planning so it seems this is a case of poor operational risk management. However as IL&FS got into cash flow difficulties they have defaulted on various issues of short term paper, causing a liquidity issue in the credit markets. This then caused equity volatility in the Indian financial sector.

The good news is that the government and IL&FS shareholders have quickly stepped in to deal with this problem. A new management team, plans to infuse liquidity and a number of asset sales should resolve this challenge. Credit markets have responded to events and yields in the corporate bond market have eased. The impact on various listed financial stocks will likely increase polarisation towards better quality private banks who stand to benefit from increased loan demand, an area the fund has good exposure to.