Q3 2020 Letter

Our pharma basket (ex-Biocon), which consists of eight companies making formulations and Active Pharmaceutical Ingredients (API), was the biggest contributor to our return. Within this basket, Aarti Drugs was up 2.5x, Hikal was up 56%, and Natco Pharma was up 54%. Much of this price rise was on the back of better pricing and margins in a tightening market. As the pandemic recedes, and the pharma supply chains come back to normal, some of this extraordinary profit will disappear. We like the long-term prospects of our pharma businesses and are OK bearing the intermediate price swings.


Bharti Infratel, down 19%, was the only negative contributor. We love the tower business, but the prospects of Indian telecom are not yet clear to us. Infratel remains a small position.


On the ground


India’s data look more and more encouraging. Every indicator - health, mobility, electricity consumption, auto registration, airline traffic, etc., points to a slow but steady recovery. Hard lockdowns are over. Daily new cases stand at 55,000, but recoveries are higher at 80,000. India’s fatality rate at 1.5% is half that of the US, one-fourth the UK’s, and one-sixth Italy’s.


Our friends and family in India also report life coming back to normal, even though the new normal looks quite a bit different. We hope it looks better. India has long had issues with communicable diseases, especially amongst the poorer sections . We believe that the knowhow gathered, the systems built, and the habits acquired to fight this pandemic will help India fight those other infectious diseases too.


Daily visits to a few key destinations (7-day rolling average)

Source: Google Mobility Data. Our World in Data.



Daily new active cases, defined as new cases minus recoveries

Source: Covid19India


Pandemic investing: same but different


Commerce too will eventually come back but to a noticeably different looking normal. Investors, us included, sometimes forget how fragile businesses are. Most businesses run on thin margins . Most are levered, whether through actual debt, leases, permanent employees, or other fixed costs. Businesses are cutthroat, especially when vying for the same set of limited customers.


The virus, and more specifically our response to it, is bound to render some businesses unviable. But it will also sprout new ones. The economy will be fine, but individual businesses will experience variety of different outcomes.


Our job is to deploy capital in individual businesses. Businesses that will compound our money over a long duration. We have a process for that, and we are sticking to it. We currently have a unique opportunity to own high quality businesses, within rapidly consolidating, beaten down sectors, at reasonable prices. To properly evaluate such businesses, we need to answer four key questions:


1. Whether the long-term demand for their product remains unquestionably intact?

2. Is COVID going to wreck the unit economics for their sub-par competitors?

3. Will the ensuing consolidation lead to a high and sustained ROIC for our business?

4. Do the valuations make sense?


We require four yes-es.


To put all this in context, let’s look at the Indian homebuilding sector.


The demand for housing is large and growing.


1. From India's independence until now its life expectancy has gone from 33 to 70. The trend is surprisingly consistent – we add about 2-3 years in lifespan every 5 years. And yet India’s average age keeps going lower, a testament to a young and growing population.

2. Every year the percentage of population living in the cities goes up by about 1%. And yet, India is only 35% urbanized. Compare this to the world average at 56%, Mexico at 81%, China at 61%, and Thailand at 51%. India still has a long way to go before it's adequately urbanized.

3. The urban household size keeps shrinking, from 5.4 per family in 1992, and 4.6 per family in 2005, to 4.3 per family now. This trend towards smaller families will not reverse in our lifetimes.


All these individuals, growing in number, moving to the cities, and living away from parents in smaller families, are going to need homes. The estimates for urban housing shortage, a hard to measure quantity, vary from 10Mn to 20Mn units. Regardless of its exact size, this is a large underserved market with zero change in long term demand prospects due to the pandemic.


Supply, after a seven-year downcycle, has been shrinking.


A protracted downcycle despite large and growing demand sounds surprising but it shouldn't be. Every country, young or old, rich or poor, growing or stagnant, has been through housing cycles. India is no different.


The last Indian housing boom lasted until 2013. Barring a few blips, Indian home prices had continuously been increasing for years. The industry was largely unregulated, and small independent builders mushroomed in every city. Land was bought and "banked", often with borrowed money, even when construction was years away. As the banked land went up in value so did the borrowing capacity. Pre-sales brought some cash back into the business, but quite often that cash was diverted towards new projects. Rental yields dropped from 6% to 2% at the time when the mortgage rates were still in low teens. And yet people kept buying .


It had to end, and it did. The sector started slowing down in 2014-15 while the benchmark rates were still the highest they had been in more than a decade . And, it just kept getting worse from there.


In 2016, demonetization happened, which made cash transactions extremely difficult. Since a large percentage of property transactions happened in cash, this was the first major hit to the sector.


Then in 2017, the government passed the Real Estate Reforms Act. RERA was intended to make home purchasing a transparent and buyer friendly process. The act, amongst other things, required the builders to register properties and commit to construction timelines. It made them liable for delays. It also forced them to ring fence the proceeds from pre-sales for project specific use. All this made homebuilding extremely uneconomical for smaller builders.


In 2018 the IL&FS crisis broke out, which took down several non-banking finance companies, the primary source of capital for builders. Throughout the next year the situation kept getting worse - Dewan Housing, one of the largest mortgage finance companies defaulted multiple times in 2019.


In response to these painful times, the sector had slowly started consolidating in the recent years. New launches fell below new sales in 2017 and kept falling. Financing became extremely tight except for a few reputed builders. For example, until recently a typical unorganized homebuilder would have to pay 18% - 24% for short term debt. Godrej Properties - India’s largest residential developer, meanwhile raised multiple rounds of equity in 2018-19 and borrows at 8%.


The COVID impact


The lockdowns turned the slow and steady process into hunger games. Sales came to a dead stop, and so did construction (and construction linked payments). Except in cases where the builder had the wherewithal to provide for and keep their idle labor on-site, migrant labor moved back to native villages. Consumer loans, including mortgages are still under moratoriums. It is not yet clear what will happen to the accrued interest. A significant percentage of these loans will get restructured.


The gap between a branded, well financed homebuilder and the smaller, unorganized one is now insurmountable. We believe that:

1. As banks and NBFCs work through their mortgage moratoriums and restructurings, their inclination to fund smaller developers, or new ones without track records, will stay close to nil.

2. There will be a lot more consolidation. There are now half as many homebuilders in the top 14 cities as there were 5 years ago. And yet the market share of top 10 developers is sub 10%. We still have ways to go.

3. Customers will pay a premium for finished inventory and reliable developers. We are already witnessing this; Godrej sold more than 500 homes online in the middle of the lockdown, and Sunteck – a key holding for us, reported steady demand for its ready-to-move-in inventory.

4. Developers with access to financing will buy out existing unfinished projects on attractive terms from weak players.

5. Landowners looking to sell will find few takers apart from high quality developers, who are demanding joint venture partnerships, instead of outright sales. For example, Sunteck recently acquired 50 acres of land in a Mumbai suburb using INR 100mn in cash consideration, with remaining payments coming through revenue sharing. The potential inventory value of this land is INR 4.7bn. Such partnerships force landowners to put their skin in the game. And since, their success depends on the developer’s execution, track record and reputation become paramount.


For several years now we have held small positions in a few homebuilders we like. We recently added to our position in Sunteck, bringing our homebuilders basket close to 10%. We will likely increase our exposure to the sector over time through high quality homebuilders and ancillaries such as mortgage finance, tiles, sanitary ware, plywood, etc.


Portfolio updates


Apart from adding to Sunteck we made no substantial changes to our portfolio this quarter. Our updated portfolio weightages are as follows:


Sector Weight

Autos 13.7%

Commodities 8.8%

Consumer 10.1%

Credit Ratings 12.8%

Financials 10.1%

Homebuilder 9.8%

IT 4.1%

Others 1.0%

Pharma 26.2%

Telecom 3.4%

In closing, our goal remains the same – buy businesses with long term competitive advantages at reasonable prices. However, the world is moving fast, and along with it the subset of companies that fulfill our criteria is moving too. The next few months, though volatile, will also be full of opportunities. We are ready.


Sincerely,


Rahul Bhatia Aniket Khera