A lot has happened since our last letter in July. US Fed apparently sent a “clear” signal to the market that its going to taper its $85 bln/mo asset purchase program. Sensex dropped 2000+ points. Indian Rupee sold off 13%. India’s fledgling bond market saw massive outflows. A run on India’s foreign reserves looked imminent. Sell side research started predicting USDINR at 70, then 80, even 100 by the end of the year. RBI allegedly intervened multiple times in the currency markets but to no avail. Economists and main-stream media invoked the 1991 BOP crisis and openly started asking the government about an IMF bail out. It was India’s Lehman Moment.
Then suddenly in the early days of September things started improving. The Rupee started stabilizing, US Fed decided not to taper after all and India got a new RBI governor with a rock-star resume. A couple of speeches, a US policy (in)decision, some idle chatter by the government around opening up bottlenecks and everything was back to normal. Sensex almost gained back what it lost and so did the Indian Rupee. However, these market rallies belie an economic picture that’s getting bleaker by the month.
According to our sources that reside "in the trenches" business is tepid at best. These sources are running small industry units mostly around manufacturing and services. They seem to be the hardest hit. Order-books, that had shrunk to about 4-6 months during the depth of the 2008-09 crash now stand at 1-2 months. Such state of affairs is quite commonplace today. Businesses that had borrowed money to fund expansion over the past 3 years are finding it immensely difficult to pay interest on this borrowing owing to the high rates, as well as keep their machines running owing to the small order book. We feel that there is more economic pain ahead. As is usually the case, this economic pain is somewhat built into the market prices for certain businesses. Our job, as always, is to find solid, lasting businesses that are being grossly and unfairly mispriced in today’s market. We are treading carefully but we are treading nonetheless.
The latest addition to our portfolio is Hindustan Zinc (HZL), a firm jointly owned by the Indian government (30%) and Sesa Sterlite (65%), a subsidiary of the UK’s Vedanta group. HZL is one of the largest and lowest cost producers of zinc on the planet. Zinc is an industrial metal used for steel making, die-casting etc. With China slowing down recently and persistent growth pangs in the West, steel and hence zinc has suffered significant price correction. HZL, being a zinc producer and an Indian mining company, suffered a double whammy of sorts resulting in a 40% YTD drop in price when we found it. The stock was implying far lower zinc prices than the prevailing as well as historical average world zinc prices. The company is debt free and has about $3.5 bln of cash (1/3rd of its market cap) on its books. There are two other items of interest that make this investment especially attractive. Firstly, the parent company is highly indebted and needs HZL’s cash to pay off some of that debt. This can only happen if HZL gives a huge dividend or the government sells its stake to the parent. Both these events will be highly profitable for minority investors. In fact the way Indian securities laws are set up the later event can result in a substantial windfall. Secondly, the government is in dire need of money and looking for assets to divest. Hence an HZL stake sake is likely a low hanging fruit. We anticipate some resolution to this situation within the next 6-12 months. Meanwhile, we own a business with solid growth prospects, best in class margins and a 30%+ return on capital. These heads we win, tails we lose a little situations are exactly what we look for while investing.
In closing, we acknowledge that Indian economy is going through some serious issues right now. However, these issues are neither novel nor just endemic to India. Time will tell whether last decade’s India growth story was a result of fundamentals (demography, high savings rate, urbanization, open markets etc) or just global credit expansion. We suspect it’s a bit of both though more of the former. Meanwhile we will stick to what we know works and let fundamental research and valuation be our guideposts.
Please reach out to us with any questions or concerns.
Notes & Letters
A collection of our thoughts, views, and excerpts from our investor letters.