Q1-2018

Welcome to the quarterly newsletter of SeaLink Capital Partners (SCP).
 

After the series of game-changing reforms in the Indian economy last year (demonetization, GST roll-out, bankruptcy law for faster resolutions, recapitalization plan for public sector banks), some of which caused temporary disruptions with liquidity shortages and production uncertainties, GDP growth is back on track and on a stronger foundation.  While the government’s steadfast focus on economic reforms and the relative political stability is reassuring for continued macroeconomic revival, tapering of liquidity in the equity markets and current high valuations lead us to be cautiously optimistic about their extended buoyancy.

Adaptability to changing market situations is a skill that we look for in management teams along with the resilience to remain focused in times of uncertainty.  There will be instances when a reprioritization of strategic initiatives will be on the anvil at portfolio companies.  However, before a shift in strategic direction, it is important that the right set of questions are asked and the groundwork for building conviction about the change is completed.  In the section below, we’ve shared our perspective and experience in this area. 

Indian economy and equity markets: Cautious optimism for the year ahead

GDP growth picked up to 6.3% during July-September 2017, ending five quarters of deceleration as manufacturing rebounded with businesses having adjusted to the new GST tax regime. Bank credit growth, which had been encumbered with the overhang of bad loans, has risen to 12% suggesting revival in economic activity. Advance estimates for the third and fourth quarters for FY 2018 show continued acceleration in GDP growth. However, due to the subdued growth in the first two quarters, the official estimate for the current fiscal year is at 6.5%, the lowest under the current government.

In the first upgrade of India’s rating in 14 years, Moody’s raised the sovereign rating from the lowest investment grade of Baa3 to Baa2, and revised the outlook from stable to positive. The upgrade was based on Moody’s assessment that recent reforms will enhance India’s structural credit strengths and improve global competitiveness. The external validation for India’s economic reforms continued with the country jumping 30 places in the World Bank’s Ease of Doing Business index, as a result of consistent efforts and significant improvements in the areas of insolvency resolution, payment of taxes, protection of minority interests and availability of credit. While India is currently at number 100 on the list, the government aims to continue its progress on reforms to break into the top 50.

There are, however, potential headwinds. With global oil prices rising, inflation is heading upwards and the likelihood of further interest rates cuts is low.  Fortunately, with all-time high foreign exchange reserves (over $400 billion) in the coffer, India is protected from sudden external shocks.  Fiscal deficit reached 112% of budget in November with four months of the year to go raising concerns of significant slippage against the government’s target of 3.2% of GDP and pushing bond yields up by 100 bps over the last couple of months. The government has pared down its additional borrowing requirement for the final quarter of the year to signal its intent of remaining fiscally prudent and contain the deficit within the range of the target, but that will have implications on public spending. As part of its reform agenda and fiscal deficit target, the government is expected to ramp up asset sales with nearly three dozen public-sector companies lined up for strategic divestments.         

2017 was a strong year for public equities in India despite disappointing corporate earnings and sluggish economy growth.  The S&P BSE Sensex rose 27%, the BSE 500 and MSCI India indices rose 35% and 29% respectively, while the S&P BSE Midcap index saw a 47% increase during 2017.  This rally was driven by record levels of investment into domestic mutual funds post demonetization, and supported by global flows. It was also an excellent year for capital raises.  36 IPOs across eighteen industries were listed in 2017, raising close to Rs. 670 billion (approx. $10 billion). In comparison, Rs. 265 billion (approx. $4 billion) were raised through 26 IPOs in 2016. The demand in the market was also demonstrated by oversubscription in excess of 10 times for 17 of the IPOs last year.  

The buoyancy of the public markets has made IPOs a preferable exit option for PE investments. Private Equity funds sold shares over $1.17 billion in the year across 20 IPOs (almost 25% higher than they did in 2016 and over four times the amount they sold through IPOs in 2015).

While the equity markets have continued their strong run in the first few weeks of 2018, there is an ongoing recalibration of expectations. Liquidity has been tightening – domestic mutual funds saw net outflows for the first time in December.  Corporate earnings are expected to show a revival in 2018 due to the low base effect and higher consumer spending in the last two quarters, and there is cautious optimism that it should provide some support to the current high valuations – the BSE-500 and MSCI India indices are trading at 25 and 24 times trailing PE multiples respectively. 

With recent wins in state elections in Gujarat and Himachal Pradesh, BJP and its allies control 19 of India’s 29 states.  Based on the latest population census, 67% of Indians live in one of those 19 states.  While that statistic suggests a rather favorable position for the Central BJP government nearly four years into its term, a much closer than anticipated contest with the Congress in the Gujarat elections have shown that the 2019 general assembly elections are still wide open.

The countdown to the General elections next year has begun and with that the importance of a sustained growth revival with reforms focused on inclusive development has intensified.  All eyes will be on the Budget presentation on February 1st, the last full budget prior to the elections where the government will be expected to balance fiscal stimulus with fiscal prudence.

Reprioritization of strategic initiatives, for the right reasons
 A reprioritization of strategic initiatives at a company can lead to a debate between entrepreneurs and investors. There may be instances where post-investment, management identifies additional areas of opportunity based on evolving market conditions.  How should an engaged investor ensure that the business is focusing on the right set of well-thought-out priorities for future growth? And how can investors make sure that entrepreneurs and management teams do not spread themselves too thinly across priorities?  Click here to read more

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