This letter comes to you later than usual. We decided to wait for the government to present its 2019 budget, so that we could talk about and celebrate together some path-breaking reforms. We shouldn't have.
For folks not quite familiar with the annual tradition of Union Budget, here is a quick overview:
Every year, around the same time, the government presents an account of its revenues and expenses. It tells us the actuals for the last fiscal year (FY 2018-19), the approximations for the current year (FY 2019-20), and the forecast for the next year (FY 2020-21). In doing so, it tells us where the $380Bn or so it needs will come from, and what will it be spent on. On a high level this is not very different from what other countries do.
In the US, for example, the President presents the budget to the Congress and asks for spending money (appropriations). Sometimes the Congress approves the budget and sometimes it doesn't, which leads to government shutdowns (2013 and 2018).
Of course, the nitty-gritty details of the Indian budget are unique. For instance, the Indian states levy no income or corporate taxes. Yet they are responsible for large amounts of spending on items like healthcare, education, police, etc. Every year the central government sends a percentage of what it collects, and reports that number in the budget - approximately 20% for FY 2019-20. There are many such idiosyncrasies, large and small.
For the last seven years we have chosen to ignore this annual ritual; our simple test being whether the budget would have any impact on how we invest. It doesn't.
We felt differently this year. India has slowed down considerably in the last 6-7 quarters and this government has shown a knack for big, audacious policy announcements. Cases in point: a new tax system, a new bankruptcy code, a new real estate bill, last quarter's corporate tax cut, and this quarter's privatization announcements. So quite naturally we were looking forward to some long due reforms in this budget. Unfortunately, there were none. Though fortunately, there were no adverse announcements either.
The Indian economy is entirely capable of getting itself out of this cyclical malaise. It’ll just take some time. Our go to source for tracking India’s macroeconomic health is the earnings data coming out of companies we track. Its early days but autos, consumer goods, and durables are ticking up. The recent hiring and manufacturing PMI data is also encouraging. None of this is a trend yet but things are moving in the right direction. The equity markets seem to agree.
As we mentioned in our Q3 letter, India is in a far superior place than it was 10, 20, or 40 years ago. In all those years:
The Indian market has only once lost money over a 10-year period (31 rolling periods). And it has never lost money over a 15-year period (26 rolling periods). All this is in US Dollar terms, which is striking given the amount of currency depreciation that has happened over time.
Our plan is to simply stay ahead of this lucrative market. And we know only one way to do so: buy good companies below their intrinsic value.
Lately, this style of investing has not performed as expected. What was expensive at the start of 2019 is even more expensive now. And what was cheap has stayed cheap. This disparity is even starker when it comes to large vs. small companies. After underperforming the large-caps by 12% in 2018, the Indian mid-caps once again underperformed by 17% in 2019. The MSCI India midcap index lost almost 10% last year.
We carry substantial mid and small cap exposure in our portfolio, so we are okay with our performance. However, we are keenly aware that we are betting against a trend with a powerful supporting narrative: buy quality companies regardless of price.
The root of this narrative is the hypergrowth of large platform companies the west. The prevailing thought being that businesses like social media, cloud, online retail, or search will eventually be dominated by just a handful of companies. Not only that, these platforms will eat into the profits of old-line businesses like staples, autos, and retail. As the dominant players like Facebook, Google, or Amazon get more users they become harder to dislodge and grow faster. This is borne out in the data. These companies, without using much capital, are doubling their already mammoth revenues every 3-4 years. It makes sense for these companies to trade at premium multiples.
However, we don’t see how this story applies to Indian companies. Here's a list of the 10 largest Indian companies with a P/E multiple over 50. Why 50? Because at those valuations there’s no guessing as to what’s priced in. These stocks are pricing super-natural growth rates over extended periods.
There are exactly zero new-age platform companies in there. No doubt, these are all good companies. But they sell paint, noodles, shampoo, insurance policies, and credit cards. Some of these categories are already highly penetrated. Some face immense competition. Some will likely get destroyed by platform companies! And yet, these companies are either pricing in 30-40% sales growth over the next few years or double digit sales growth into perpetuity. There's no margin for error. On the other hand, businesses in sectors like autos, healthcare, and real estate trade at historic low multiples. The market is saying that these businesses will stay weak forever. We disagree.
India is adding millions of households to its middle class every year. In 2005 there were around 15M households with income over $10K. In 2018 that number was 65M. In another 10 years it will be more than 150M. All these people will consume all sorts of stuff – medicines, homes, cars, steel, sugar, underwear, and much else. Companies that provide the right products at the right price stand to make tons of money. Great companies exist in all kinds of sectors. We need to find these companies and pay less for them than they are worth. That’s the only game that makes sense to us and our portfolio reflects this view. As usual, brief write ups on our major positions are presented at the end of this letter.
Notes & Letters
A collection of our thoughts, views, and excerpts from our investor letters.