Quarterly Newsletter11 min read

December 2019 / Q3 FY20

Light At The End Of The Tunnel: Reading The Cycle Through Howard Marks

“History provides a crucial insight regarding market crises: they are inevitable, painful and ultimately surmountable.”

Shelby M. C. Davis

Dear Investors,

The early weeks of 2020 are starting to feel different from the two years that preceded them. After a long stretch in which the market polarised into a narrow band of "safe haven" stocks while the broader universe was left for dead, the mean-reversion we have written about for the last several quarters is finally playing out. Credit is flowing again at the margin, the government is signalling resolve on tax and capital-gains policy, and our portfolio has begun to reflect the underlying business quality we have always believed it carried.

Below we share three things: a read of the early-2020 sentiment shift; what we expect from Budget 2020; and Howard Marks's market-cycle checklist applied to India today. We close with on-the-ground anecdotes from banking, autos, small-caps, and GST.

Our Performance

	YTD as of 27-Jan-2020
Equitree Capital	~12%
NSE Small Cap	~8%
Nifty	-0.41%

Year-to-date returns as on 27th January 2020. The Equitree portfolio has far exceeded the NSE Small Cap index over the same window.
Source: Equitree Capital internal performance records; NSE; Bloomberg[1].

01Is It Light At The End Of The Tunnel? Or So It Seems!

The early-2020 setup is one of the most interesting we have seen in two years. The portfolio is up roughly 12% year-to-date as of 27 January 2020, well ahead of the NSE Small Cap index at about 8%, and against a Nifty that is fractionally negative at -0.41%. That outperformance is not a function of a single sector trade — it is the reflection of a broader-market thaw after twenty-four months of frozen valuations.

The shift is showing up in soft signals before it shows up in earnings:

• The Prime Minister, at a global platform, signalled that India's capital-gains tax regime would be brought in line with global markets, and called on wealth creators to shrug off fears.

• The Home Minister stated that 90% of the political agenda has been delivered; the PM is actively inviting public budget comments and meeting corporate chieftains and regulators.

• The market regulator is softening on derivatives margin requirements and broker funding for clients from proprietary funds.

• Leading industrialists at the recently concluded global economic forum agreed that the worst seems behind us.

• The mean-reversion theme between "safe havens" and the oversold broader market is finally playing out — exactly as we wrote about in our last several quarterly updates, including the September 2019 edition.

In Focus

A note of caution. Q3 corporate earnings are unlikely to show meaningful growth, and the hard macro is still weak. The thaw is in sentiment first, fundamentals second.

02Budget 2020 — Will The FM Bite The Bullet?

The FM is walking a trapeze: a tax-collection shortfall on one side, fiscal-deficit discipline on the other. Both can't hold simultaneously, and the budget is where the trade-off becomes explicit.

What we expect the FM to attempt:

• Lower personal income-tax rates via slab rationalisation or a higher exemption limit.

• Long-Term Capital Gains relief to align with the PM's Davos signalling.

• Sector-specific import-duty tweaks to push domestic manufacturing.

• Policies for agriculture and infrastructure to revive rural demand and the capex cycle.

2AThe True Fiscal Deficit Could Be 5.5% — Not 3.3%

The headline budgeted fiscal deficit for FY20 is 3.3% of GDP. Strip out off-budget liabilities and the picture changes materially. Including off-budget liabilities, the true number is closer to 5.5%[2] — bank recapitalisation bonds excluded. The total FY20 revenue shortfall is estimated at roughly ₹1.6 trillion.

Government's True Fiscal Deficit Could Be As High As 5.5% In FY20

Reported deficit vs ex- and including off-budget liabilities, FY02–FY20.

Reported

Ex off-budget

Incl. off-budget

Union government fiscal deficit, % of GDP, FY02 (2001–02) to FY20 (2019–20). Pre-FY20 values are approximated from public RBI / CGA fiscal-deficit history; the three FY20 endpoints (3.3% reported, 4.2% ex off-budget, 5.5% incl. off-budget) are from the source chart. Off-budget liabilities for FY02–FY09 include oil, fertilizer and FCI bonds; from FY17 they include NSSF loans and government-serviced bonds; bank-recapitalisation bonds are excluded.
Source: Mint Graphiti; Union Budget documents; CGA; ICICI Securities Primary Dealership[2].

2BTax Collection: 45% Of Target By November — Lowest In Five Years

Tax revenue collected as a share of the full-year budget estimate, as of November, sits at 45.5% in 2019-20 — the lowest in five years. Non-tax revenue at 74.3% has held up better, but the tax-revenue line is the one that matters for the deficit math.

Year	Non-tax revenue (%)	Tax revenue (%)
2014-15	60.4	42.3
2015-16	78.1	50.5
2016-17	54.2	58.9
2017-18	36.5	57.0
2018-19	56.6	49.4
2019-20	74.3	45.5

Collections as of November as % of full-year budget estimates.
Source: Mint Graphiti; Union Budget documents; CGA[2].

2CFCI Subsidy Carryover: Liabilities Are Compounding

Carryover liabilities of unpaid subsidy bills to FCI have become structurally larger over the cycle. The carryover line is approaching ₹2,00,000 crore in 2019-20; subsidy deferred during the year is around ₹1,50,000 crore[2].

FCI Subsidy Carryover Has Become Structurally Larger

Carryover liability to FCI vs subsidy deferred during the year, ₹ crore.

Carryover liability to FCI

Subsidy deferred during the year

Source: Mint Graphiti; Food Corporation of India; Mint calculations[2].

2DGST Compensation Cess: The Gap Will Widen

The gap between estimated GST compensation cess collections and the compensation needs of states is set to widen sharply over the next three years[2]. The compensation requirement assumes 5% growth in revenues.

Year	Estimated collection (₹ Cr)	Compensation requirement (₹ Cr)
2019-20	96,800	1,60,000
2020-21	1,01,640	2,28,400
2021-22	1,06,720	3,08,670

Estimated GST compensation cess collection vs compensation requirement, ₹ crore.
Source: Mint Graphiti; GST Council meeting note; Mint calculations[2].

03The Best Time To Invest Is When Everything Appears To Be Gloomy

Howard Marks's Mastering Market Cycles offers a side-by-side checklist of indicators that read "vibrant" at a market top and "sluggish" at a market bottom. The exercise is not to call a bottom — it is to ask honestly which side of the table the current evidence sits on.

Indicator	Vibrant	Sluggish
Economy	Vibrant	Sluggish
Outlook	Positive	Negative
Lenders	Eager	Reticent
Capital Markets	Loose	Tight
Capital	Plentiful	Scarce
Terms	Easy	Restrictive
Interest Rates	Low	High
Yield Spreads	Narrow	Wide
Investors	Optimistic	Pessimistic
	Sanguine	Distressed
	Eager to buy	Un-interested in buying
Asset Owners	Happy to hold	Running for exits
Sellers	Few	Many
Markets	Crowded	Starved for attention
Funds	Hard to gain entry	Open to everyone
	New ones daily	Only the best can raise money
Recent performance	Strong	Weak
Asset prices	High	Low
Prospective Returns	Low	High
Popular Qualities	Aggressiveness	Caution and discipline

Howard Marks's market-cycle checklist — vibrant (bull / expensive) vs sluggish (bear / cheap) signals.
Source: Howard Marks, Mastering Market Cycles, 2018[3].

3AWhere India Sits Today

Now overlay India's 2019 readings:

• GDP at an 11-year low. FY20 GDP is estimated at 5%[4]; the IMF projects an even lower 4.8%[4].

• Retail inflation at a five-year high of 7.35% in December 2019 — well above the RBI's upper band of 6%[5]. Food inflation hit 14.12% in the same month[5].

• Unemployment rose to 7.5% during September–December 2019 — the seventh wave of increase since the May–August 2017 trough of 3.8%[6].

• Broader market falling since January 2018; investor caution is at a multi-year peak; gold sits at all-time highs, the classic distress signal.

• 2019 IPO fundraising was the lowest since 2015, with credit and liquidity constraints throughout the year.

Takeaway

Most indicators sit on the right column of the Marks checklist. That, combined with our own bottom-up portfolio readings, is why we believe this is the best time to add equity exposure on a 3–4 year horizon — not because the bottom is in, but because the prospective-return math has rarely been more favourable.

04Anecdotal Evidence Suggests Things Picking Up On Ground

4ABanking — The Deposit-Credit Mismatch

Incremental deposit accretion in the Indian banking system was about ₹5.3 lakh crore higher than credit growth as of November 2019[7]. ICRA expects FY20 year-on-year deposit growth of 8.4–9% to outpace credit growth. That gap forces banks to lend — the cheapest way to fix a deposit-credit mismatch is to put money to work.

4BAuto — The Worst Is Behind Us

Passenger-vehicle inventory is back to normal levels post the festive-season discount push. Maruti and M&M reported slight growth. The BS-VI transition and the upcoming scrappage policy are the next demand triggers; market leaders are openly signalling that the worst is behind them.

4CSmall / Mid Caps — The Reversal Begins

S. Naren and Prashant Jain — two of the most disciplined large-cap voices in the industry — are now publicly endorsing the small-cap thesis. The valuation mismatch between safe havens and the broader market has been amplified to the point that even traditionally cautious houses are calling it.

4DGST — A New All-Time High

Both November and December 2019 GST collections cleared ₹1 lakh crore. January 2020 collections are expected at ₹1.15 lakh crore against the prior all-time high of ₹1.13 lakh crore[8]. Compliance is improving and the formalisation curve is bending.

4EWhat We Are Watching

• Budget 2020 — the trapeze between tax shortfall and fiscal discipline.

• Coronavirus — early days, but a meaningful drag on global trade if it escalates.

• Brexit — the actual impact is finally about to be measurable as the end-January deadline passes.

• Middle East — Iran-related tensions remain a tail risk to oil and global risk appetite.

05In Closing

The macro backdrop is still difficult, and Q3 corporate earnings will not be the print that turns the tape. But the gap between price and value in the broader market has rarely been wider, the soft signals are inflecting, and the Marks checklist places India squarely in the column that has historically rewarded patience. We continue to deploy our usual discipline — staggered entries, business quality first, valuation second — and we thank you, as always, for the trust that allows us to do that.

As always, please feel free to reach out to us with your comments, suggestions, and queries.

Warm regards,

Team Equitree

Pawan Bharaddia

Co-Founder & CIO

Ssuneet Kabra

Co-Founder & CEO

Sources

Equitree Capital internal performance records, year-to-date as on 27th January 2020. NSE Small Cap and Nifty closes from NSE / Bloomberg. Individual portfolio performance may differ.

Mint Graphiti infographic, page 3 of the Q3 FY20 Equitree Quarterly Update. Underlying data: Union Budget documents; Controller General of Accounts (CGA); ICICI Securities Primary Dealership; GST Council meeting note; Food Corporation of India; Mint calculations. The fiscal deficit, tax-collection share, FCI carryover, and GST cess gap charts have been rebuilt natively from the data points transcribed from the source infographic.

Howard Marks, Mastering Market Cycles: Getting the Odds on Your Side, Houghton Mifflin Harcourt, 2018. The vibrant-vs-sluggish indicator checklist is reproduced verbatim from the book.

Ministry of Statistics and Programme Implementation (MOSPI) — First Advance Estimates of National Income, FY20: 5% GDP growth (11-year low). International Monetary Fund (IMF) — World Economic Outlook update, January 2020: 4.8% projection for India.

Central Statistics Office (CSO) — Consumer Price Index, December 2019. Headline retail inflation 7.35% (five-year high; above the RBI upper-band of 6%); food inflation 14.12%.

Centre for Monitoring Indian Economy (CMIE) — unemployment data for September–December 2019 at 7.5%, the seventh wave of increase since the May–August 2017 trough of 3.8%.

Reserve Bank of India (RBI) — banking-system deposit and credit data as of November 2019: incremental deposit accretion ₹5.3 lakh crore higher than credit growth. ICRA — FY20 deposit-growth forecast of 8.4–9%.

GST Network (GSTN) — monthly GST collections data: November and December 2019 both above ₹1 lakh crore; January 2020 expected at ₹1.15 lakh crore against the prior all-time high of ₹1.13 lakh crore.

Previous Issue

Special Edition - October 2019

The Wait Gets A Little Longer: Government Awakens, Greenshoots Appear

Next Issue

March 2020 / Q4 FY20

Businesses Not Stocks: A Longevity Stress Test Of The Portfolio

Disclaimer

This newsletter is prepared by Equitree Capital for informational purposes only and is directed at existing investors and prospective investors who have requested it. It does not constitute investment advice, an offer, or a solicitation to buy or sell any securities, and should not be construed as a recommendation of any security, sector, or strategy.

Past performance is not indicative of future results. Returns referenced are as of 27th January 2020 and may not be representative of any specific investor's portfolio. The macro and sectoral commentary reflects the views of Equitree Capital as of the date of writing and is subject to change without notice. Forward-looking statements are subject to risks and assumptions that may not materialise.

Investments in small- and micro-cap equities carry higher volatility, liquidity, and business-specific risks, including the possible loss of principal. References to third-party research (Howard Marks, Mint Graphiti, ICRA, IMF, CMIE, MOSPI, CSO, RBI, GSTN) are illustrative of macro context and are not endorsements of those providers. Recipients should consult their independent financial, legal, and tax advisors before making any investment decisions.

This document is private and confidential. It may not be reproduced, redistributed, or published, in whole or in part, without the prior written consent of Equitree Capital.