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2022 Annual Letter

India has outperformed every major equity market over the last three years. After participating in the 2020-21 global rally for risk assets, it largely sidestepped the 2022 hangover, which pulled the S&P 500 down 19.5%, NASDAQ down 33%, and Emerging Markets down 22%[1]. Furthermore, it did so despite facing some of the harshest socio-economic conditions and the largest foreign outflows in decades.

It’s hard to pin down the exact reason for the outperformance but given India’s long-term track record it’s not particularly surprising. Let’s pick three different periods to illustrate this.

Since 1986 - the year BSE Sensex was first published.

That first index run included market data going back to 1979. From that starting point, 44 years ago, Sensex has returned 10.15% annually in US Dollars. It has done so despite a 90% drop in the Rupee over that timeframe.

Since 1991 - the year India opened its economy to foreign and private capital.

Since then, Sensex has returned 9% annually. S&P 500 returned 9.5% over the same period. UK’s FTSE returned 4.8%; and China close to zero.

Since 2001 - when Goldman coined BRICS.

Since then, China, Brazil, and South Africa[2] – the C, B, and S of the BRICS respectively, have all grown 5-6x in Dollar terms. Russia, the R, is close to zero. And India grew 13x – far outpacing even the US which grew 4x.

Of course, none of this guarantees future performance.

In fact, predictions of India’s impending doom are way more common than its eventual success. Pundits – financial journalists, economists, think-tanks, Davos types, all agree that it’s due to India’s inability to solve its structural issues. Strangely, no one seems to agree on what structural issues actually means. Inequality, corruption, failure of institutions, right wing central policies, left wing state policies, too much stimulus, too little stimulus; everyone has their favorite structural issue. And it keeps changing.

We agree that India will not be able to solve all its present problems in the near future, but does it have the track record of solving problems of its past?

Every year the IMF presents a report card of sorts on a few major countries. Their India report receives tons of media fanfare both within and outside India. Here’s how the IMF opened India’s report card ten years ago:

The unprecedented widening of India’s current account deficit in recent years is a symptom of underlying macroeconomic imbalances and structural weaknesses - high inflation, large fiscal deficit, and binding supply constraints.

It was a grim period – GDP growth had slowed down to sub 5%; the Indian market was down 5%, while the S&P was up 37%; and the CPI Inflation printed a high of 11.5%. Trade deficit was at an all-time low high around 7%. India’s problems appeared to be … structural.

Fast forward to now – India’s inflation is sub 6% while every other country is dealing with decadal highs. Trade deficit is less than half of what it was. Fiscal deficit remains under control despite record COVID related stimulus.

As for the structural supply constraints, India has made remarkable progress on that front too. It is now a power surplus nation. The pace of building highways is the highest it’s ever been. The government is looking to increase manufacturing to 25% of the GDP from 17% currently. It’s walking the talk by spending close to 20% of its budget (highest ever) on capital investments. Even these achievements pale in comparison to India's progress in digital infrastructure – world’s largest real-time digital payment system, lowest cost of mobile data, largest biometric identity program; all of this within a decade.

Are there still problems to be solved? Of course. Are they unsolvable? Of course not.

Our scorecard

We started Willow ten years ago with the assumptions that India will do well, and we will do better. Our goal was to meaningfully outperform the indices and other low-cost funds net of fees and expenses.

Since our inception, we have outperformed the biggest, most liquid India ETF by 4% (net of all fees and expenses). We have done so while sticking with the same principles we outlined in our very first letter to our partners. Here’s what we wrote ten years ago:

The basis of our operations is rooted in the Value Investing philosophy. Several versions of this philosophy exist in the investing world. Our version involves the following simple steps.

  1. Understand the economics of the underlying business. Avoid businesses that are too complex for us to grasp.

  2. Ascertain the business’ intrinsic value. Avoid businesses that cannot be valued.

  3. Buy if the market is pricing the business at a significant discount to its intrinsic value AND there’s a fair chance that the gap will close.

  4. Sell when the gap closes.

  5. Rinse and repeat.

So far this has worked well for us. Truth be told, we could have done better by simply sticking more rigidly to these principles. Every time we veered and overreached it turned out to be a mistake. Good news – there’s ample room for improvement, even better performance, and higher compounded returns.

Portfolio updates

Our portfolio composition was unchanged this quarter.

Portfolio composition ex-cash

Our financials book, led by Ujjivan Finance and Ujjivan Small Finance Bank (SFB), was the biggest contributor to our portfolio. We wrote about these companies in some detail in our Q3 letter. Here’s a quick summary:

Ujjivan was previously a non-deposit taking microfinance company which recently underwent a rather tedious process of converting itself into a regulated bank. As part of that process, it split itself into Ujjivan Finance (holdco) and Ujjivan SFB (opco). The holdco was trading at a significant discount to its intrinsic value considering its holding in the opco. We believed that eventually the companies would merge, and the discount would close. The opco, a deposit taking, regulated small bank, is itself is a great business run by a great management team. It happens to be trading below intrinsic as well.

Ujjivan Financial gained 32% for the quarter and Ujjivan SFB was up 30%. The bank reported its highest ever quarterly profit as it’s quickly getting it’s operating costs and credit losses under control. The management focus has now shifted from firefighting to growth – both in the branch network and digital capabilities. The holdco-opco merger was approved by both the boards and process has now moved to its next stage. So far this is going according to plan.

Our consumer companies, led by KDDL, were the second largest contributors to our return. We wrote about KDDL in our Q3 2021 letter. It started out as a contract manufacturer for watch makers and later branched into luxury Swiss watch retailing. That retail business, called Ethos, was carved out and taken public in mid-2022. For several quarters, it has progressively been posting better numbers and is now valued at INR 20B, which seems like a fair valuation for the business. Management had set a goal of 1B in EBITDA for themselves and they are within spitting distance of hitting it.

KDDL, the parent, owns 61% of Ethos, and itself trades at 13B, implying a 1B valuation for its core manufacturing business. This standalone business generates around 500M in pre-tax earnings at 30%+ ROE and 10% run-rate growth. We believe the parent company trades way below intrinsic. The management agrees and continuously buys stock in the open market. We’ve been in constant dialogue with the management and expect great things from them.

Sunteck Realty was the biggest detractor with the stock being down 21% for the quarter. Our homebuilding companies, Sunteck and Godrej, have also together been the biggest drags on our annual performance. The sector has ben hit with two simultaneous problems – input cost inflation for homebuilding materials, and higher mortgage rates. We don’t know how long these problems will last but we know that they disproportionately hurt weaker operators. It’s likely that Sunteck and Godrej eventually will end up benefiting from this stress.

Macro hiccups notwithstanding, the Indian homebuilding sector remains an attractive long term investment opportunity. We detailed our investment case back in our Q3 2020 letter.

To recap our thesis, the demand for housing is large and growing – India has a young population which is getting younger, it’s still massively under-urbanized, the average family size is consistently decreasing hence accelerating household formation.

There’s an urban housing shortage of 10M-20M homes and yet there is a glut of unfinished homes. In the last housing boom, which lasted until 2014-15, piles of unscrupulous characters entered the business, levered up, amassed land banks, siphoned off funds, and dug foundations that never got filled. In 2016 demonetization hit the cash-heavy sector hard. In 2017 the government passed real estate reforms to clean up the sector. The banking crisis of 2018-19 saw default of Dewan, one of India’s largest mortgage finance companies. The industry started consolidating with shady, over levered builders slowly exiting the industry. The pandemic proved to be the final nail.

We believe that over time the industry will consolidate in the hands of organized, branded, large developers that have track record of high quality product and on-time delivery. Sunteck and Godrej are both good examples of this. Despite the recent drops, these positions are ~1.5x our purchase price. We plan to hang on to these businesses through the full cycle.

The other big detractor to our annual performance was the Indian Rupee, which dropped 10% against the US Dollar. Some of you have asked us about hedging; our view on currency hedging is simple – most of the times it’s expensive and doesn’t make sense. For example, at the start of 2022 the 1-year USDINR forward was pricing a 4.5% drop in the Rupee. And, over the last 10 years the Rupee has annually depreciated almost exactly that much. Had 2022 been an average year, the cost of the hedge would have washed out the profit from it. Of course, in hindsight putting on the trade would have netted us at least 5% but as far as we know we have no edge in currency speculation – it’s very likely we have negative edge. We simply price in a 4-5% drop in the Rupee every year and move on.

We remain excited about the future of India in general and our businesses in particular. 2022 was the first full post pandemic year when India was fully open for business. All our portfolio companies have come fully back to normal and most of them are making record profits. At an index level too, after several years of struggles, the ROE has now returned to the mid-teen levels of 2014.

NIFTY 12 month trailing ROE

Source: Bloomberg

Of course, India’s problems will never end – new ones will keep showing up, but so will its solutions. The constant punditry generated din is best avoided. Speaking of which, 2024 is an election year, so for the next few quarters expect even more cacophony than usual. We’ll try our best to offer no comments.

We wish you and your loved ones a happy and prosperous 2022. If you have any questions regarding this letter or your portfolio, please do not hesitate to ask.

[1] MSCI Emerging Markets index [2] MSCI Index returns for each country denominated in USD


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