The malaise afflicting the small and midcap companies has now spread throughout the market. In fact, this correlation-one event is not just restricted to India. Remember, in our 2017 annual letter, we mentioned how 42 out of the 43 markets we track rallied last year? This year 37 of those markets are down. Investors are running away from anything that’s not America, fundamentals be damned
When 88% of the world markets are bleeding red one must be careful pinning the sell-off on to India specific problems. Nevertheless, were we forced to offer a reason, our candidate would be the financial panic caused by IL&FS, a large project financing entity with approximately $12bn in debt.
IL&FS, in early September (almost exactly ten years to the day of Lehman’s bankruptcy) announced that it had missed payments on its short-term debt. Even though the company made its lenders whole within 3 days, the market knew that something was up. The company has more than $500m in payments coming due within the next 6 months, and not nearly enough cash to cover these. Its assets - cashflows from its toll roads, tunnels, bridges etc., are all long dated and heavily dependent on the government’s whims and fancies. These long- dated assets are financed with large amounts of short-term commercial paper (CP) that needs to be rolled over every so often. It’s a risky business in any country. Done in India, and financed with short-dated debt, doubly so. The default led to mass ratings downgrades, which led to markdown across all non-bank financials CP, which led to banks and debt mutual funds dumping some of it, which led to concerns that several financiers will not be able to roll over their debt. About 60% of all non-bank financial CP issuance sits on the books of debt mutual funds that are now facing redemptions. It’s all very Lehman-like, and even though the Indian financial system is not nearly as complex or interconnected as the US was back then, the situation is concerning. We are monitoring it closely. Thus far, companies that have their assets-liabilities appropriately matched are getting adequately funded. Credit is flowing, albeit at a higher cost. Earnings across the board will take a hit and the business of lending will likely slow down temporarily. However, credit penetration in India is so low, and the runway so long, that it will only lead to stronger players getting even more entrenched as the weaker ones exit. Our largest financials holding, Piramal Enterprises, is one of those stronger ones.
Apart from the IL&FS drama there’s also the problem of lower Rupee (down 5.3% q-o-q) and higher oil (up 7% q-o-q). We can always count on those two to explain any Indian crisis. Our view on the Rupee and oil remains the same - we don’t have a good one. Maybe it’s all happening because of Fed tightening (but haven’t they been doing so since 2015?), or maybe it’s due to OPEC (but wasn’t fracking supposed to solve all that?), or maybe it’s the tariffs, trade deficit, elections. We don’t know. Of course, a weaker Rupee and a pricier oil is bad for India but what exactly the Rupee or crude oil will do next is anyone’s guess.
In a quarter that’s been so volatile we have surprisingly little to write about our portfolio. It has changed little. The urge to act during times like these is extremely high, and we do want to fix mistakes as soon as we find them - we did so last quarter. But reacting to prices without regards for fundamentals is not our policy. After closing out the four problematic positions we detailed in our last letter we are left with businesses that continue to go from strength to strength. If they keep this up, the market will eventually reflect it in the stock prices. For now, we are focused on looking through this market debris and picking up great multi-year compounders if they come for cheap. We will have detailed updates on our businesses in the (upcoming) annual letter. Meanwhile, if you have any questions regarding this letter or your portfolio, please do not hesitate to ask.
Notes & Letters
A collection of our thoughts, views, and excerpts from our investor letters.