June 2019 / Q1 FY20

01Is This The Darkest Hour Before The Dawn?

The setup for small & mid caps today rhymes with prior cyclical bottoms. A relief rally has come and gone, retail sentiment is fragile, and the broader market is still treating small caps as un-investible. Our read of the underlying earnings, balance sheets, and liquidity is the opposite — the foundations of a recovery are quietly being laid. The question is no longer whether the rebound comes, but how soon.

In the rest of this letter we walk through the seven reasons we believe the time correction is at its fag end, the fear is overblown, and patient capital deployed today should be rewarded over the next couple of quarters.

02Are Small & Mid Caps Oversold Or Is More Downside In The Waiting? We Believe It Is The Former

2ATime Correction Seems To Be Getting Over

The 2008 cycle saw a ~79% correction; the 2013 cycle saw a 54% correction. The longest persistent bear phase over the last fifteen years was ~21 months — the S&P BSE Small Cap index falling from 11,148 in September 2010 to a bottom of 5,101 in June 2013[2]. We are currently ~18 months into the present bear phase.

The NSE Small Cap index is correcting ~40% from its January 2018 peak, and the average company below the top 250 stocks is down ~47% over the last 18 months[3]. The time correction should be at the fag end now, with recovery expected over the next quarter or so.

2BDe-Rating Of Stocks Already Factors In Muted 1st & 2nd Quarter FY20 Earnings

Brokerages have already reduced projected earnings for FY20 across sectors after a dismal Q3 and Q4 FY19. The "growth" premium has tapered off. As an example, the S&P BSE Auto index has corrected ~15.8% in the past 6 months — from 20,132 on January 10 to 16,948 on July 10[3]. Our ground-up analysis reveals islands of opportunity across diverse sectors where the de-rating has run far ahead of the actual earnings impact.

2CPolitical Uncertainty Is Out Of The Window For The Next Five Years

The thumping BJP / NDA majority addresses national-election anxiety. After the NDA 1.0 cleanup — Demonetization, GST, IBC, NCLT — NDA 2.0 should push the growth agenda. A stable government should also attract foreign capital back into Indian markets.

2DNPA Cleanup And Corporate Governance Issues Are Largely Behind Us

A significant turnaround is visible in the Q4 PSU Bank Index numbers — 187% PAT growth year-on-year and 85% PAT growth for the full year FY19[4]. Private banks (ICICI, Axis, IndusInd) have stabilised after their NPA and governance issues. Banks have been recapitalised with ~₹140k crore over the past one year[4]. The ~47% market correction has factored in many of these issues. Corporate governance is an ongoing concern but does not make the whole market un-investible.

2EGlobal Macros And Trade War Do Not Impact India As Much As Feared

India is not a predominantly export-oriented economy, and the US-China feud actually presents an opportunity — Indian companies can gain global trade share. The Federation of India Export Organization notes that the US is looking to increase sourcing of toys, footwear, apparel, and engineering goods from India. The US Fed has turned soft on rates with expected cuts ahead, and cheap funds should flow back to emerging markets including India.

2FNBFC Liquidity Issues Likely To See Some Relief

Since the ILFS and DHFL defaults, general tightness in NBFC liquidity has led to a dramatic fall in lending. The numbers tell their own story.

The primary issue is asset-liability mismatch — not an absolute dearth of liquidity. Magma Fincorp raised ₹6,000 crore over the last one year, and Bank-NBFC tie-ups are emerging — ICICI Bank with Indostar; Bank of Baroda with SREI Finance.

Recent Budget measures to enhance NBFC liquidity:

A bank credit reality check: overall bank credit as of 24th May 2019 was up ~11% year-on-year[6].

2GBudget Lays Out A Vision Document To Drive Growth

The Budget articulates a vision to take India to a $5 trillion economy by 2025. Substantial capital outlays for Railways, Roads, and Water Supply have been laid out over the next five years. The privatisation plan signals that the government is willing to go down to 40% in PSUs, and for the first time the government plans to raise sovereign bonds from global markets. The caveat is that the efficacy of open-market borrowing is yet to be tested.

03Don’t Let Emotions Drive Your Decisions!

The biggest mistake investors make is investing in bull markets (Euphoria) and booking losses in bear markets (Fear). Businesses don’t stop functioning in a bear market, nor do they report their best numbers in a bull market. Business cycles and stock-market cycles must be seen separately to understand true value. The Indian stock market is currently in a bear market driven more by macro than micro factors. When fear kicks in, everything looks bad — especially smaller companies — and buying interest is at utmost lows.

Below is the journey of a typical investor through a full bull-and-bear phase — nineteen numbered moments along the curve, from the first thrill of catching a trend to the final capitulation and reluctant re-entry. Read it as a mirror, not a forecast.

04In Closing

As always, we remain committed to ensuring that we create wealth for our investors over the long run, and we will be happy to hear from you should you need any further information or clarification from our side.

Sources

01

Equitree Capital portfolio research, FY19 PAT growth and TTM PE for the Equitree Emerging Opportunities portfolio versus NSE Small Cap 100. NSE Small Cap 100 figure excludes loss-making and recently-profitable companies. Portfolio FY19 PAT growth 5.02% on aggregate; revenue growth ~9.42% for the year.

02

S&P BSE Small Cap index history — 11,148 in September 2010 falling to a low of 5,101 in June 2013, marking a ~21-month bear phase. Historical 2008 correction ~79%; 2013 correction 54%.

03

NSE Small Cap index correction of ~40% from the January 2018 peak; average company below the top 250 stocks down ~47% over the 18 months to June 2019. S&P BSE Auto index from 20,132 (10 January 2019) to 16,948 (10 July 2019), a 15.8% decline.

04

Q4 FY19 PSU Bank Index aggregate PAT growth of 187% year-on-year and 85% for the full year FY19. Banking sector recapitalisation of approximately ₹140,000 crore in the year preceding June 2019. Industry trade press; bank disclosures.

05

Finance Industry Development Council (FIDC) — quarterly NBFC loan disbursements split by Rural / Semi-Urban / Urban / Other across FY18 Q1 through FY19 Q4. Aggregate of ₹18,72,103.44 crore disbursed across the eight-quarter window. Data sourced from FIDC industry reports.

06

Reserve Bank of India weekly statistical supplement — gross bank credit, food credit, and non-food credit growth, comparing the year ending 24 May 2019 versus the year ending 29 March 2019. Gross bank credit growth +11.5% year-on-year as of 24 May 2019.