Reflections on investing in Indian equities over the past 20 years

Vinay Agarwal is a Director of FSSA Investment Managers, part of First Sentier Investors. He has more than 20 years of investment experience and joined the FSSA team in 2011. Vinay is the lead manager of the FSSA Indian Subcontinent strategy, the FSSA Asia Focus strategy and the Scottish Oriental Smaller Companies Trust. 
 

I started my career in the investments industry more than 20 years ago, in the mid-2000s. At that point, the Indian stock market was melting up (alongside global markets), and infrastructure and real estate companies were the darlings of the market. It seemed certain that these businesses would become multi-billion-dollar enterprises over the next five to ten years. 

As a young fund manager watching these stocks surge, I fretted over missing out on such outsized gains. When the markets began to wobble, I sensed an opportunity. Share prices fell quite substantially from their peaks and having ‘missed’ them in the initial frenzy I rushed in to buy – only to watch them fall into an abyss when the Global Financial Crisis hit.

Fortunately, my early mistakes did not prove to be fatal. Painful lessons like these keep us humble and make better investors out of those of us who manage to make it to the other side. I have been through a few more cycles since then and have learned many more lessons along the way.

After joining FSSA in 2011, our team has had to navigate the PIIGS¹ Euro-crisis, the Fed taper tantrum, the Reserve Bank of India’s Asset Quality Review, the election of Mr Modi’s Bharatiya Janata Party government, demonetisation, the Goods & Service Tax, the Non-Bank Finance Companies blow-up, nationwide lockdowns in response to Covid-19 and a spectacular melt-up in asset prices during 2020 and 2021 (220 new listings in 2 years!)

Against this backdrop, a patient investor in the FSSA Indian Subcontinent strategy would have received an annualised return of 13.5% over the last 10 years (in US dollar terms, gross of fees, as at 30 September 2024), despite the near-30% depreciation in the Indian rupee over this period. This compares to a return of 10.0% for the strategy’s benchmark, the MSCI India index.

Fundamentally, our performance is the result of the careful and consistent application of our principles, process and philosophy. These have been honed over years of experience of investing in India and across Asia and emerging markets more broadly.

Today, when we invest in a company, I consider our team to be long-term owners of the business, rather than stock traders in the pursuit of short-term gains. Therefore, we want to back owners and managers with whom we feel strongly aligned and have track records of treating all stakeholders fairly, in both good and bad times. They are ambitious in growing their business, but also risk-aware in their pursuit of growth.

As conservative investors, we obsess about the hidden risks in our portfolios. The bedrock of our investment philosophy is to protect our clients’ capital, and staying disciplined to our process means making decisions where we err on the side of caution. If our assessment of a company’s owners and managers is not up to the mark, we simply will not invest, regardless of the valuation or seeming strength of the franchise.

We have spent decades building relationships with high-quality owners and managers in India and have identified, in my view, some of the best compounding growth opportunities in the world. Here are some of my reflections from investing in Indian equities for more than 20 years.
 

Over the past 20 years, nearly a thousand companies have listed their shares in India; and with them several sectors of the economy – hitherto inaccessible to public market participants – have opened up. Examples include Insurance, Telecom, Modern Retail, Fast Food, Diagnostics, E-commerce, Food Delivery, and several more which did not exist in the Indian stock market 20 years ago.

Today there are around 6,000 companies in India for investors to choose from. But in our view, it is rare to be able to identify companies that have both a quality management team and a franchise that compounds free cash flows (or book value per share – BVPS) at attractive rates for long periods of time. Where we have managed to invest in such companies, we have found that the most important thing to do is to hold on, sometimes through periods of stress and disappointment.

Of the top 10 contributors to performance over the past decade, seven are companies we have owned throughout the period (save for a brief hiatus in one case). HDFC Bank, currently the largest position in the portfolio, is a case in point – over the past decade, BVPS has compounded at 16.6% compound annual growth rate (CAGR), driving an impressive 11.7% CAGR total return to shareholders. Other notable long-term holdings include Infosys (a 15.3% CAGR return to shareholders over 10 years), Kotak Mahindra Bank (10.7% CAGR) and Kansai Nerolac Paints (8.5% CAGR).
 

Eicher Motors is another top contributor to our 10-year performance. In 2012-13, when we first bought the company for the India strategy, we had been fortunate to have already known the Lal family for over a decade. The main reason for our interest was that there had been a generational change in leadership. We believed that third-generation founder-CEO Siddhartha Lal was looking to build a truly world-class franchise in motorcycles and trucks.

In the mid-2000s, under Siddartha’s leadership, the neglected Royal Enfield motorcycle business began to turn around. This started delivering results from around 2012 onwards.  The culture of the company also changed significantly for the better – I remember a meeting with him when he said the phrase “long-term” more than anything else! The construction of the Volvo partnership and the way he had thought about it also provided comfort on how other stakeholders in his company would be treated.

Eicher’s profit went up four-fold from 2013 to 2017, whilst the share price went up nearly ten-fold. When an erstwhile sleepy or poorly run management is replaced or shaken up by a new high-quality team, it is often the key ingredient to deliver outsized shareholder returns.

A more recent example of such a narrative playing out is at ICICI Bank. Since the controversial exit of the previous CEO under a cloud of allegations in 2019, the Bank’s board underwent wholesale changes, resulting in a new CEO being appointed. Sandeep Bakhshi has been instrumental in replacing the hitherto aggressive growth-at-any-cost culture with a long-term oriented, conservative and risk-aware mindset. The results are evident in the Bank’s performance, as it now boasts industry-leading asset quality and growth metrics.
 

The healthcare sector has not been kind to us, given that three of the portfolio’s top five detractors over the past decade are from this industry. HealthCare Global Enterprises, an oncology-focused hospital chain, and Lupin, a generic pharmaceutical manufacturer, are two companies where we have been wrong in the past. In most of these instances, our conviction in the people and business model has tended to be low. 

We are not the kind of investors who build complex spreadsheets and pore over monthly or quarterly data about research and development (R&D) pipelines, drug approvals, USFDA³ inspections, price erosion etc., and in both of these instances, we gave the owners/managers too much credit with respect to their capital allocation strategy and plans to improve ROCE, both of which had been decidedly poor.

But the biggest detractor from our 10-year performance came from a more recent purchase – Solara Active Pharma. We were enthused by the arrival of Mr Aditya Puri, the founding CEO of HDFC Bank (whom we hold in high regard), on to Solara’s board. The track record of the founder, Arun Kumar, in smartly allocating capital and creating shareholder wealth was encouraging as well. The business itself was reporting decent ROCE and had a long runway of growth in the Active Pharmaceutical Ingredients (API) industry. 

What we failed to gauge was the industry dynamics. We mistook cyclicality for structural change – a classic error! The management, under pressure due to a combination of factors, had resorted to stuffing the distribution channel. The wheels finally came off the business at the start of 2022 as the company was forced to take drastic action, which included firing the senior management team. 

Typically, we would have sold our position, accepting that we had misjudged the quality of the management and the franchise. However, we appreciate the efforts undertaken by the board and the owner to reach out to investors during this time of distress. Such things make a huge difference to investment outcomes over the long term. The company’s fortunes may or may not improve, but for the time being we offer them the benefit of doubt.

All said, it is worth noting that the sum total of the drag to performance from our top five detractors over the past decade was less than the positive contribution of any one of the top five contributors. This outcome is important, because it shows our investment philosophy at work, which emphasises capital preservation and utilising constructive debate within the team to weed out investment risks. In the past decade (i.e., 120 months to 30 September 2024), there have been 47 months where markets have fallen. The strategy has performed better than its benchmark in 37 of those instances (i.e., nearly 80%). 
 

The other silent detractors from performance were cash and taxes. Cash positions are entirely a residual of our bottom-up stock-picking approach. In recent years as valuations have risen to record highs, particularly for quality companies that we have long favoured, we found ourselves running much higher cash positions than ever before.

The situation was exacerbated during the Covid-19 induced lockdowns (no one could have been prepared for a time when the entire country was completely shut down for months), when our conservative mind-set aimed at preserving capital meant that we minimised exposure to companies where risk was the highest (including banks, which are, at the end of the day, the most leveraged businesses across all industries).

A side-effect of having a large cash balance, which I hadn’t realised, was that it subconsciously made me overly pessimistic. So, at a time when vaccines were looking feasible and it seemed like the immediate danger had passed (it hadn’t, as the second wave proved), we were conservatively positioned.

In hindsight, this was a mistake. When the stock market went from richly valued to red hot during late-2020 and 2021 (driven by record money printing globally), the portfolio’s cash position resulted in a sharp deficit in relative performance. We have since seen the froth (and valuations) come off significantly and are now what we consider to be fully invested (the latest cash position was around 4.4%).

Another aspect of prudence and its cost to performance comes in the form of the accrued taxes that we account for in our calculation of the portfolio’s net asset value (NAV). This is the single biggest detractor to recent performance given the incidence of capital gains taxes in India (we account for them conservatively, assuming we sell the entire portfolio tomorrow and therefore incur the higher short-term levy on all our stocks). 
 

We believe that growth among India’s top corporates will accelerate over the long term and our portfolio companies are well poised to capture this trend. The higher concentration among the top 20 holdings and the lower number of total holdings in the portfolio reflects our increased conviction. The weighted average ROCE of the portfolio is healthy, at more than 43%.

Given the quality of our holdings, the likelihood of earnings momentum to accelerate and the reasonable valuations, we are quietly confident about the portfolio delivering attractive returns to investors over the long term.

*Return on Equity (ROE) for GICS Financial companies, and Pre-tax ROCE (i.e. earnings before interest and taxation (EBIT)/Capital Employed) for other portfolio companies. ** Based on Bloomberg consensus estimates

As we look forward to the next decade (and beyond), I am especially pleased with our team and the investment process that we have in place. Over the past decade, we have added a number of team members, some of whom spend most of their time analysing Indian companies. 

As a result, our watch-list of quality companies in India has expanded significantly over this period, from around 75 back then to over 180 today. We regularly meet more than 250 Indian companies each year and our knowledge of them has grown significantly over time. The relationships we have built with business owners and managers have only gotten stronger.

All this gives us confidence that the best is yet to come.
 

Company data retrieved from company annual reports or other such investor reports. Financial metrics and valuations are from FactSet and Bloomberg. As at 30 September 2024 or otherwise noted.

Footnotes

¹ Portugal, Italy, Ireland, Greece, Spain

² Return on capital employed

³ US Food and Drug Administration