Actively compounding returns wins in India

Corporate profit to GDP has dropped drastically over the last 10 years. This is driven by weaker earnings for certain capital goods and heavy industry businesses as well as the provisioning against Non Performing Loans of banks.

Being selective on stocks is far better than being passively invested in a historic representation of capitalization. For example, India’s top 50 companies by market cap, represented by the Nifty includes a significant component of capital heavy industries like Power, Construction, Metals, Telecom, Real Estate and Oil & Gas. These industries haven’t earned their cost of capital over the last decade and make up one third of the economy. Yet they represent 31 of the 50 Nifty stocks.

India has typically had a strong linkage of GDP growth to corporate earnings. However, over the last 5 years, despite nominal GDP growth averaging 11.3%, earnings have only averaged 4%. However, this hasn’t stopped the Nifty Index rising 74%.

This indicates a significant P/E rating as global investors have flooded India’s large and liquid stocks. On a historical basis Nifty now trades on 24x, up from 16.5x in 2014. From here, earnings growth is needed to see price increases.

The chart below aligns a pick-up in economic growth to out-performance of mid-caps relative to holding exposure to the Nifty.

Typically, given India is a high growth region, you would ideally like to own a significant proportion of mid cap companies which are selected through primary research and taking heed of market opportunity, industry positioning, corporate governance, leverage to the cycle, free cash flow and level of debt.

Holding compounding growers which emerge to be large players in their industry is the secret sauce to succeeding in India, rather than owning the large and typically over-valued companies, which are favoured by large global fund managers for liquidity reasons and inability to do on the ground, primary research. 

India’s active management industry has performed with distinction relative to their benchmarks over rolling 3-yr periods. Over time this has averaged just over 4% annualized. However, we can see the impact of 2018 and the resulting alpha degradation. Typically, these managers have been highly skilled at finding companies which exhibit compounding earnings growth at an early stage and holding them till they reach the large to mega-caps.

It’s is our view that there are several reasons why local market investors can extract alpha over rolling 3-year periods. These factors include:

• General level of market inefficiency in mid and small caps relative to large cap companies. Given a significant amount of sell-side market participants, India’s top-50 by market cap usually has over 20 plus analyst covering the company. However, in mid and small caps the analyst coverage drops away rapidly, leaving ripe for alpha generated through primary research
• Local knowledge, insights and deciphering of cultural and market specific nuances make local stock selection teams a must. Rather than avoid companies due to lack of knowledge or liquidity, it is better to understand strengths in governance and founder ethos towards minority shareholders as that is where money can be made. In markets like India it is important to monitor related party transactions, valuations of asset sales and insider buys/sells, given significant founder ownership
• Identifying strong free cash flow generating companies which takes the vagaries of accounting out of the analysis. Typically, companies benefiting via market opportunity or industry consolidation can generate strong cash flow, particularly maintenance and regulatory costs are controlled.

Our view is that you should not invest in something you don’t understand well via a passive structure. A strong IP partnership with your active fund manager can really drive a far superior compounded result over the long term – particularly in a market like India. If you think about it, then why would you invest in already over-broked, large companies, that are a poor representation of India's future growth.  As an inefficient market outside the top 50, it is a market begging for primary research and price discovery.