Thursday, June 7, 2012

>STRATEGY: Staying away from the “fright club”

Summary: There are three very good reasons, we believe, for not joining the “fright club” against India being orchestrated by parts of the brokerage community. Firstly, a significant part of the ongoing economic slowdown has been caused by the fact that the supply of equity to the promoter community has been cut off by the European crisis (rather than by the Government of India). Secondly, a number of regulatory institutions which have come to the fore over the past two years (eg. CAG, Competition Commission) will help the Indian economy going forward even though they might result in short term economic costs. Thirdly, India’s GDP data is so compromised that drawing any conclusions about the state of the economy based on this data could result in poor investment decisions.

We reiterate that this is a good time to invest in India as valuations are the most attractive that they have been in a decade (leaving aside the quarter following the Lehman bankruptcy).

It is common knowledge that the Indian Government has played its hand badly over the past four years. For example, with regards to coal scarcity, most of the damage was self-inflicted as the Environment Minister dithered on the “go/no go” areas and then instituted an over zealous process (and arguably faulty) process of checking emissions in the vicinity of Coal India mines. The totality of these measures has probably set back Coal India’s production by 5-7% per annum. Another example of self-defeating intervention is the hasty introduction of GAAR
in the Union Budget. 
However, is the Indian Government so influential that its blunders have bought our economy to its knees? We do not think so. Three other factors have played a powerful role in India’s humbling.

Firstly, a range of problems which prima facie appear to be caused by the Government’s “policy paralysis” are arguably linked to the global seizure in risk appetite.

 The “under-the-table” model was used in the noughties to lubricate our political and bureaucratic system as aggressive promoters sought to build construction, infrastructure, real estate and mining empires. Now many of these promoters simply do not have the means to use this model on such a scale (partly because with the QIP/IPO market shut the most obvious route for financing such large backhanders is gone).

 Promoters these days are quick to blame “policy paralysis” for their inability to get projects off the ground. However, some basic number crunching and discussions with financiers suggest that in many instances these Power, Infra, Real Estate and Mining companies are deliberately throttling the project back because they do not have equity available.

The second reason for not joining the “fright club” is that a number of regulatory institutions which have come to the fore over the past two years will help the Indian economy going forward. The actions of a number of regulators, most notably the CAG and the Competition Commission (CCI) are an obvious antidote to the excesses of the noughties. Whether it be CAG’s pathbreaking report on the 2G maater of the CCI’s landmark action against DLF
for the alleged abuse of its dominant position in Gurgaon, it is hard to blame the Government for these actions.

In the Natural Resources sector almost all the titanic promoters seem have hit a brick wall in New Delhi as they run into an array of opponents in the form of: (a) The CAG which is publishing report after report on different aspects of malfeasance in this sector; (b) The Environment Ministry which is no longer willing to give clearances to projects; (c)
The Supreme Court which is unwilling to let illegal mining continue and which has advocated the use of auctions for all natural resource allocations henceforth; and (d) The relevant Ministry (be it Coal, Petroleum or Mining or Steel) which is unwilling to play ball. It is hard to imagine that our enfeebled Executive is behind such a coordinated blocking of a range of powerful companies.

If the Competition Commission continues its crusade against abuse of dominant positions by market leaders in industries from Real Estate to Cement to Sugar to LPG Cylinders, this should help improve economic efficiency. If the CAG continues its practice of scrutinizing public spending and regulatory decisions in the manner that it has over the past two years, it will revolutionise the way the Indian Government works. Without such interventions from well
meaning regulators and from a powerful judiciary, India could go the way of numerous “banana republics” in Latin America and Africa.

The final reason for not joining the fright club is that our GDP data is so compromised that drawing any conclusions about the state of the economy based on this data could result in poor investment decisions. First and foremost, India’s GDP data is subject to inexplicable retrospective revisions of a material magnitude. For instance, investment demand growth numbers have been revised upwards from 5% YoY and -4% YoY in 1QFY12 and
2QFY12 respectively to 15% YoY and 5% YoY respectively. Secondly, there is limited synchronization between trade data as shown by the national accounts data and the same variables captured by the RBI. And thirdly, the share of ‘discrepancies’ in the CSO’s GDP growth data has risen by 50% from FY05-08 to FY12 (from -9% of the change in GDP to 42% of the change in GDP!).

Clearly, the economy has slowed down sharply. Whilst we were amongst the first to signal such a pronounced slowdown (refer to our macro research from exactly a year ago), we had become more optimistic about the Indian economy in January this year. Our optimism is not being borne out by the current state of the economy but, once
again, this is because the paralytic state of affairs in Europe means that a big swathe of the Indian economy simply does not have equity to fire up the capex cycle. Policy somersaults in New Delhi can’t do much to change that reality.

Investment implications
A significant part of the blame for the dramatic slowdown of the Indian economy lies not with domestic factors but with the freezing of risk appetite in the wake of the European crisis. Our economist, Ritika Mankar, estimates that at least a third of the collapse in India’s growth can be attributed to the slowdown in investment growth which in turn is most profoundly affected by the global risk environment given India’s capital scarce nature. Whilst investment growth accounted for 50% of India’s GDP YoY growth over FY05-08, this share has now fallen to 20% in 4QFY12. Our own modeling process suggests that the global risk environment is the most important determinant of India’s growth engine (30x times more powerful than the repo rate).

This “blame attribution” is important. If investors pull out of India believing that there is something “systemically” or structurally wrong with the country, they will lose a great opportunity to participate in the Indian recovery which will come when global risk appetite recovers. This is main reason why we at Ambit refuse to join the “fright club” of brokers who are sounding dire warnings about what will happen to India if the Government does not do X, Y or Z.
We reiterate that this is a good time to invest in India as valuations are the most attractive that they have been in a decade leaving aside the quarter following the Lehman bankruptcy. We note that over the past decade the 12 month returns from investing in India when valuations are as low as they are now have always been strongly positive - see table below.

We also believe that by focusing on “Good & Clean” (G&C) companies investors can comprehensively outperform the sagging Indian indices. Since inception in March 2011, our G&C portfolios have outperformed the BSE500 by over 20% (on a free float market cap weighted basis). Our latest G&C portfolio (has outperformed the BSE200 and the BSE500 by 52bps and 48bps respectively since publication on 3rd May.