During the second half of 2018 we were busy stock searching, and soul searching. Stock searching resulted in two new positions, which we describe at the end of this letter. Not much changed in the soul department. We still believe that India has tremendous ground to cover. It’s overflowing with young, hard-working, and ambitious people. Yet it is so grossly underserved. Sure, many of its citizens are poor, but that’s just half the story. The other half – the real half, is the breathtakingly poor systems of governance India has endured for seven decades. That second half is now getting fixed; in its own haphazard Indian way, but in a big way nonetheless. And that is truly exciting.
Take, for example, India’s new bankruptcy process introduced two years ago. Out of the first twelve cases, which made up one-fourth of the banking system bad debt, half have been resolved. In each case the promoter who ran the firm into the ground is out. This may not sound like a big deal to those familiar with a developed market framework like Chapter 11. But for India this is absolutely radical. Large promoters tend not to lose their fiefdoms in India, despite serially defaulting. You get the loans evergreened, you shove the cases into a painfully slow legal system, you buy your own distressed assets via related entities. You do what it takes but you never let go. The new bankruptcy process is an attempt to change all that.
Thus far close to 800bn Rupees have been recovered. Another 1.2trn is imminent. More importantly, every time a promoter tries finding loopholes the law-making body tweaks the law. It’s vigilante-justice and it’s ugly, but it’s working. Other such examples include the recent Goods and Services Tax, and the Real Estate Regulation Act. Every one of these regulations will be agonizing in the short run. For decades, people have conducted their business a certain way; that old way is becoming prohibitively expensive.
2018, for instance, was a bumper year for corporate governance scandals. First, a few dozen auditors resigned without signing off on their clients’ annual financials. Then some bankers got sacked. A few of them will likely get prosecuted for encouraging the cronyism. In a couple of high-profile cases, owners who were unable to settle bank loans fled the country and are now fighting costly extradition battles. Companies with stock-pledges are getting pummeled, which is forcing the pledgees to liquidate the stock collateral, further pressuring the stock price. Weak corporate governance, for long considered the cost of doing business, is now a front-and-center issue.
We don’t know how long the malaise will last. But we know this: a) it will eventually result in a far better business climate, and b) it will throw up some big winners, and big losers. Our investment process, designed specifically for this, will stay the same. The only slight tweak we’ll make is to put an even greater emphasis on the promoter quality. In this long-drawn business transformation we only want to partner with folks who have a demonstrated track record of shareholder stewardship. They will be the winners.
One final point; this is election year in India. Things are about to get populist and socialist-like, which tends to spook the markets. Already, the Congress party has promised a minimum income guarantee. As elections draw closer (April – May) things will get noisier. We take great care in making sure that our companies and their promoters are not overly politically levered. So the earnings prospects of our portfolio companies will not change, but their stock prices can swing considerably. We are not terribly worried about that.
In closing, these are exciting times for India. While the country remodels itself, a few well-run Indian companies will make spectacular amounts of money. We intend to make the best of this immense opportunity. As always, we are grateful for you to be a part of our journey.
HDFC is India’s largest, most diversified, and best run home mortgage lender. Over the past two decades, HDFC has incubated several subsidiaries, most of which are now leaders in their own respective verticals. These subsidiaries now contribute ~40% to consolidated profits. We have tracked the parent and its subsidiaries for several years now. The parent has maintained a steady 18%+ ROE and an equally steady growth profile for quite some time now. Subsidiaries, like the HDFC bank, have done even better. It’s a stock we have for long wanted to own but we never found the price to be right. The recent IL&FS crisis finally gave us a chance to enter at a reasonable price.
Real estate in India is currently going through a tough period. The last upcycle ended in 2012 followed by a predictable slowdown. This slowdown has only gotten worse owing to the curbs on black money, an aggressive real estate bill, and the new tax code. We like the sector and own two positions in it (Godrej Properties and Ashiana housing). The cycle will eventually turn like it always does. Except this time the builders left standing will be the ones with long track records of on-time delivery, solid balance sheets, and ethical business practices. The sector, in other words, will emerge greatly de-risked. In a country where 2/3rd of the population is below 35, homeownership rate is low, and joint families are giving way to smaller households, residential demand is here to stay. Moreover, the mortgage penetration is so low (sub 10%) that runway for a company like HDFC is practically unlimited. Accordingly, we plan to hold this position for quite some time.
IDFC First Bank
IDFC First Bank, a midsize general purpose lender, is result of a recent merger between IDFC bank and Capital First. Some of you perhaps remember that we used to own Capital First stock at one point. It was a non-bank financial company spun out of the Future Group, which was fixing its balance sheet by selling non-core businesses. The financial company was sold to Warburg Pincus, named Capital First, and taken public. Warburg brought in V. Vaidyanathan (Vaidy) to run the company. Vaidy subsequently grew the company multifold while keeping its risk in check. He’s a seasoned banker who once was in line to be the CEO of ICICI Bank, India’s third largest private bank at the time. We got to see him in action over the years and have been nothing but impressed.
By early 2018, the stock had risen from 185/share to a 1000/share with Capital First valued around $1.5bn. Warburg at this point was looking to move on, and Vaidy was looking for bigger and better things. Both the problems were solved by merging with IDFC bank, a small depository franchise owned within a troubled infrastructure lender. Warburg now has a lower stake in a larger company (they will exit their investment, like any PE firm does, at some point), and Vaidy is now running a bank. Existing management is gone. We like the combined entity. It will have a lower cost of funds (deposits) yet it’ll have the advantage of a decent size retail lending book. Importantly, we like that that Vaidy will run the show. The recent IL&FS crisis gave us a chance to enter at a good price. Capital First stock, which has now become IDFC First Bank stock, traded down to half its value and we bought the combined entity at less than book. This is not a full position for us yet. We will actively track new management’s execution and based on that will add or subtract.