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Q3 2021 Letter

India has outperformed every major equity market so far this year – in most cases handily so. Naturally the most common question we get asked now a days is, “Can this continue?”

We get it.

For five normal years before the pandemic, the Indian market cumulatively underperformed the global market by 26%. And in the last one year – the most wretched year in India’s recent history, it outperformed by 27%. So, it’s fair to wonder whether this one-year performance is merely a blip, or can it continue?

In an anything-can-happen sort of a way, of course it can. But that’s neither here nor there. So, perhaps a more relevant question is whether the earnings prospects for Indian organized businesses are now materially better than they were a few years ago? The answer is almost certainly a yes and here are some reasons why:

Indian corporates have worked hard to repair their balance sheets, and it shows

The debt/equity ratio for non-financial corporates is the lowest it’s been since 2015. Asset heavy sectors like Homebuilding, Mining, and Oil & Gas have been especially aggressive in reducing debt. Annual credit growth has halved over the last decade. This has reduced economic growth, but it has also put corporates in a position to now spend for the future.

Domestic Credit Growth Monthly YoY (%)

Source: CEIC

The banking system is finally on the mend too

Though it now seems like a different era, from 2007 to 2010 India’s non-performing loans (NPL) hovered around 2% of the total credit outstanding. Deposit growth was going gangbusters. Infrastructure projects got done on-time and under budget. Indian banks had dodged the GFC bullet. They had the money to lend, and India Inc. was ready to lever up.

NPL Ratio for Indian banks (%)

Source: RBI

Perhaps it was the exuberance or maybe the morass that came after - the NPLs started creeping up and slowly doubled over the next four years. Then Rajan started cracking the whip and the number doubled in just one year. From there on it kept going up until around 2018 when it peaked at around 12%.

For the last few years Indian banks have been working their way out of this stress – raising equity capital, cutting down infrastructure lending, selling non-performing assets. In 2019 the NPL ratio finally went below 10%. The pandemic almost certainly slowed the progress. As the loans under forbearances and moratoriums start getting paid back (or not), we’ll get a better picture. We’re closely watching. Thus far every bank and financial company we track is reporting solid numbers.

Reforms with upfronted pain and back-ended gains

Tax reform, Power sector reform, Agriculture reform, Labor reform – if there’s one constant, we expect from this government it’s the incessant announcements of reform. A government sponsored website counts 30 major ones announced over the last 5 years. It states,

“Pundits sometimes act as if “economic reforms” are a light switch that India’s central government can turn on and off. In reality, the process of reforming the economy is nuanced, involving a diverse set of issues and actors.”

We couldn’t agree more. Some of these reforms are more far along than others.

For example, GST (tax reform), after its initial teething issues, is now working well. Tax compliance is slowly inching up. Collections are at all time high. Similarly, the bankruptcy reform has managed to cut the resolution timelines by 70%. Labor reform bill is half-way there. And the latest round of power sector reforms hasn’t started yet.

These changes often slow things down at first. They also require additional corporate infrastructure – upgraded IT systems, compliance officers, registrations, attorneys, etc. Fixed costs and effort which shows up way before the gains do. In the end though, these reforms act like centrifuges; forever increasing the separation between large, well run businesses and the small, poorly run ones.

Every favorable long-term trend is still in place

India is still 1.4bn strong and growing. Its working and spending population is still larger than any country’s total population (except China). The country is still rapidly adopting digital payments, ecommerce, opening bank accounts, mobile internet – technologies that increase access to goods and services and decrease barriers to spending. This is the most business friendly government we’ve had in a while and remains so. The large tech savvy, English speaking pool of talent can now be accessed globally as remote working becomes more and more entrenched. We can keep going.

At Willow, our unit of analysis is an individual company, not the entire Indian economy. Even so, the businesses that really excite us are ones explicitly hitched to India’s unassailable demographic and income trends. A recent portfolio addition serves as case in point.

Betting the unassailable trend & KDDL (new investment)

Every so often, a large brokerage firm or a reputed consulting company publishes a post about the changing income dynamics of India. It’s hard work – data collated from disparate sources, presented beautifully and logically, trend lines drawn, extrapolations conducted. Here are some examples:

Inevitably, the conclusions drawn are: #1, large swaths of lower income folks will enter the middle class over the next decade and #2, any business looking to scale fast should leave all else aside and just focus on #1.

We wholeheartedly agree with the former but very much doubt the later. Because, if you look closely, you’ll see that it’s actually not the middle class that’s growing the fastest, it’s the uppermost classes. This tiny group makes less than 0.1% of the population, maybe 5-6bps, and is rapidly growing form a small base. Depending on who you ask, this group has grown by 3x to 5x in the last 10 years. There’s little doubt that the next 10 years will be any different.

Folks in this group want the same things as their US or European counterparts. And most importantly, they have the means to pay the full price. The problem for this group is access. Very often, folks in this group can’t find what they’re looking for in India.

KDDL is a pathway into the wallets of this fast growing, extremely mobile, price inelastic class.

It’s a 30-year-old company started by Yashovardhan (Yasho) Saboo and now jointly managed by him and his son Pranav. It started out making movements for Titan, India’s largest watch company, and over time branched into making dials and hands for high-end Swiss watches. That manufacturing business generates 300M EBITDA on 1.8B sales. It's a stable 15% ROE business with 4-5% annual growth.

It’s a good business but it’s not the focus of our thesis.

Instead, the focus is their retail business called Ethos, a chain of 50 stores selling high end Swiss watches. Its local comps are private family run businesses with 1-5 stores and the global comps are the likes of Hengdeli, Watches of Switzerland , and Tourneau.

In a normal year (2020 and 2021 were obviously not normal for this kind of business) Ethos generates 4.5B in sales with 350M in EBITDA. The management believes that it can scale this business to 10B in sales with 10% EBITDA margin over the next 2-3 years. If they are right the company will earn 3x as much as it does now. We think they are. And, they have a long runway from there on.

Our thesis rests on answering the following basic questions:

  • Will a high-end Swiss watch be relevant 5, 10, 20 years from now?

  • Will it be relevant in India? Will the sales of these watches grow in value and volume?

  • Will people buy from Ethos as opposed to other venues?

  • Does the management know how to run and grow the business? Are they honest?

  • The company is investing heavily in creating digital experiences and a secondhand marketplace. Will that work?

  • Is the stock trading at a discount to intrinsic value?

It took us about two years of work - multiple meetings with the management, key employees and competitors, store visits, poring through financials, arguing over valuations etc. to conclude that the answer is ‘yes’ to all.

KDDL is a small company ($100M in market cap) and we are betting on a business that’s still not fully formed yet. The risks are akin to those of investing in an early-stage company. Promoter track record, a stable legacy business, and decent valuations all serve to mitigate these risks. But all the upside – the real promise of this business, lies in India’s unassailable trend of producing an ever-larger number of luxury buyers, willing to pay up for one-of-a-kind products, shopping seamlessly across digital and physical channels, just like their global counterparts. At the very core that’s what we’re really betting on.

Portfolio Updates

Our homebuilding companies were the biggest contributors to our return. Sunteck was up 61% and Godrej Properties was up 67% for the quarter. We wrote about our long-term homebuilding thesis in our Q3, 2020 letter. We are betting on organized, high quality, ethical developers taking inordinate amounts of marketshare away from the unorganized, unscrupulous ones while the housing sector itself grows leaps and bounds. Thus far our bet seems to be working. We believe that we have a long runway ahead.

There were no significant detractors this quarter. We currently hold 18 companies in our portfolio, down from 20 last quarter. As we explained in our previous letters, our approach towards our healthcare companies will be to build a basket rather than take concentrated single-stock positions. That basket now has 7 stocks, down from 9 last quarter.

Portfolio composition ex-cash

Looking ahead

In an otherwise uneventful quarter, the country briskly moved towards normalization – a trend that continues. The Indian industry, and specifically our portfolio companies, did rather well. India has now crossed the billion-shot mark. Majority of the population is now at least partially vaccinated. We are optimistic for the future though we won’t start jumping with joy just yet – the last time we did so we jinxed ourselves. International travel is starting to open up. Our bags are packed, we’re ready …

We wish you and your family a Happy Diwali and a prosperous year ahead.


Rahul Bhatia Aniket Khera


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