Investing in India: Fidelity

You’re sitting in an office in Mumbai, is that correct?

That’s right, I work from Fidelity’s Mumbai office.

Okay, and so you work on the Fidelity India Fund hence being based in Mumbai.  Can you tell me how long has that fund been up and running and is the rest of the team based in Mumbai with you as well?

That’s right, so we have eight analysts based out of the Mumbai office, so the entire India research is more or less based out of Mumbai plus we have 13 sector specialists or assistant analysts who help build models, collect data, etcetera, out of Delhi which helps us in the research process so pretty strong presence in Mumbai.  This one has been there in existence since mid-2005.

How big is the fund, what’s the size of funds under management that you’re operating?

The overall size of the funds which I advise or which are India focussed for Fidelity would be close to about $2 billion USD or thereabouts and the overall Australia fund is about $180 million AUD.

What are the fees on the Australian side of the fund?

On top of my head about 1.2% management fee.

Sure, and is there a performance fee as well associated with the fund?  I couldn’t see one on the PDF so I presume not.

There’s no performance fee but just a flat structure.

Excellent.  How long have you personally been working with the fund, Sandeep?

I have been in the equity markets for about 25 years, I started my career in 1993.  I worked on the sell side for nine years and joined Fidelity in 2002 in the Hong Kong office.  I was a regional analyst to start with and since 2005 I have been managing India money.

Excellent.  Investing in India, and I recall when I used to go to a lot of international fund manager briefings and what not, and the question would generally always come up to ask whoever the fund manager was, almost no matter what presentation it was at, people would ask about the opportunities of investing in India and the growth opportunities investing there.  Can you give us a bit of a lay of the land right now in India and how the economy is looking and how the market is looking?

What I would do is divide this question into two parts.  One is just looking at the long term what the opportunity is, what the history has been – what kind of returns sort of the market has given and then sort of more short term as to where we are in the business cycle and where the election cycle, etcetera, is.  If you look at India GDP growth has been about 7% real GDP growth and it’s a $2,000 per capita economy.  It’s exactly where China was in 2004 so it’s about 15 years behind China, 1.2 billion people, democracy, all those facts.  Just stop me when you think I am sort of going too much into depth.

That’s fine, continue on. 

The base is that it’s an economy which is a developing country at $2,000 per capita.  The opportunity set is that if this $2,000 gets to $4,000 or $5,000 there is a huge sort of consumption gain potential possible structurally over a period of time.  Being $2,000 lots of low hanging fruits, lots of productivity gains possible and over the years if you see those opportunities have played out.  Just take the example of air conditioners, as power has come, as incomes have gone up and you have seen the last five to seven years air conditioner market take off so you could take...and there are lots of these S curves in consumption where at a particular dollar level you start seeing those consumptions happen and you have seen a lot of that play out over the years in India.  It’s never a straight line, it’s an emerging market so there is always volatility.  There are elections every five years which creates its own dynamics and I’ll just come to that in a minute.

If you come to the Indian markets and think about what returns have been there over the long term, so if you daw a 20 year chart, a 10 year chart, a 5 year chart, Indian markets have given a compounded 9% to 10% USD returns over very long periods of time and not difficult to sort of think about the nominal GDP historically has been 14% to 15% and the rupee depreciates 3% to 4% per annum given the inflation differential and that’s been the return of the market more or less.  Of course, it’s not been a straight line, there’s always volatility, it is an emerging market and being a democracy there is always a lot of noise, a couple of good policies, one or two steps back and that’s been the journey but over long periods you have got 9% to 10% USD compounding from this market historically.

Going forward you actually mentioned something about the low hanging fruit and then talked about air conditioning companies, etcetera.  What else would you consider to be the low hanging fruit?

Across the consumption space whether you look at the consumption is very basic at $2,000 per capita and the way to think about this economy is that there are sort of 20 to 30 million people who are really rich at the high end and then there is a middle class of about 200 million, and then there is 40% of the population is close to or below poverty line.  There is a lot of people below $1,000 per capita, people within the $1,000 to $2,000, and a small cohort of people which is way above the $2,000 that would be equivalent to any developed sort of economy.  For the majority of the population, consumption is basic so as the incomes grow, as the GDP compounds at 7% and as the incomes grow you hit the consumption curve.  If you get the incomes, you buy a house, you want to install an air conditioner, you want to buy a two-wheeler, you want to upgrade your house, you want to put an air conditioner in the house, you want to just go to a multiplex or you want to buy a shoe which is more premium than what you had been wearing which has been very basic.

The point is that at this level of income majority of the expenditure is food and the basic necessities and as incremental income grows you get that discretionary power and that is where the exciting opportunity over periods of time has been.  On the other hand, India is really under-developed from an infrastructure perspective, it has been growing slowly but there are opportunities just in home building or in infrastructure.  The trick has been that these opportunities are there, what you have to think about is which are the right management teams to sort of...with for capitalising on these opportunities.  The second aspect is what is in the price because sometimes some of these opportunities get well-recognised in the price and there is opportunity sort of elsewhere but there is a wide sector sort of to choose from in an Indian market perspective.  There are 5,000 listed companies and more listing are happening, for example, insurance is a new sector for India, it got listed just a couple of years back, general insurance and life insurance.

It’s truly an emerging market with the opportunities of growth being there, new listing happening and it is an emerging market so you’ve got to expect volatility in an emerging market whether it comes from macro where it’s a poor country so the government wants to spend money for social uplift, it’s a democracy and that leads to fiscal deficits, current account deficits and that creates its own cycle and sometimes it’s just the international sort of inflation going up, oil price has a major bearing.  Some of those macro factors have bearings on the market but the underlying is pretty solid with that 6.5% to 7% GDP growth.

Right, and so let’s maybe focus on now your individual stock selections.  What do you particularly look for when you’re looking for businesses to add to the portfolio?  Is it a bottom-up fundamental quality focussed approach?  

Absolutely, it is a very much fundamental quality focussed approach so our universe is 700 owned stocks, we have a strong research team, we have models on 250 to 300 companies.  The trick is really, or the focus is really, to understand how a company makes money and each company, each sector, has its own sort of nuances, what ROICs they would make, what kind of a cash flow conversion is there, what sort of a growth opportunity is there.  Based on those factors and the management’s ability to sort of grow these businesses what is the right value to pay for them and then sort of it is about buying them at the right value and then holding them for the long term to really sort of see the stocks play out.  We relyor I rely heavily on the research process, it’s really bottom up and you would notice that the turnover in the fund is not very high, somewhere between 20% to 25%.

When you try and understand the businesses, the cash flow generation capability, the management quality, the management capability and are they building the business for long term, are they creating capabilities and then try and ride it and let it play out over a period of time.

Can you maybe run us through an example of one of your current holdings and how that quality aspect has come into play in the stock selection process?

Sure.  Just a couple of examples.  Let’s think about a simple company which is sort of well-known, it’s Bata, which is a shoe retail company.  Bata is a very well-known brand globally, it is 72% owned by the Bata family.  It’s pretty much an Indian brand in the Indian minds, their average shoe price is about 800 rupees or close to 12 USD or about 11.5 USD.  They’ve got a huge retail network of about 1,500 odd stores.  Can they expand into this market, can they get consumption to go up and people start paying 2,000 rupees or $30 or thereabouts for shoes as the incomes grow?  It is a well-managed company, it has got the technology, the design from its international parentage, it’s got a good management team which was struggling three years back and that was more internal with a few management changes happening but over the last 12 months as things have stabilised.

You have really seen things sort of play out for the company, simple shoe retail business growing sort of at 15% to 18% with margin expansion and the premiumisation opportunity and that’s sort of something which is there in the portfolio.  The other examples are sort of a couple of examples to sort of emphasise the point is Havel’s we talked about air conditioners and this is a company which was selling electrical wires and switched gears in the domestic market.  Good business that generated a lot of cash flows, they got into manufacturing fans and selling fans, again became a great business, they could premiumisethat category.  Now they’ve gone into air conditioners, refrigerators, televisions and it’s a company which has grown from being a very small company to this stage and it’s not just about the product opportunities which they have been able to really capitalise on.

It is also at every stage the...family has been able to professionalise, create capabilities, hire the right kind of people so they think about the next 10 years or 15 years and try and build institutions.  It’s still a small company but the potential for this to multiply over a period of time is largely because the under-penetration and the key here is that it’s a simple business, a lot of people can enter it but they have been able to create a brand and distribution, and they are creating the management capability to build this institution and it’s been a great stock for the portfolio over a period of time. 

I noticed both examples that you mention there had sounded like they had decent levels of insider ownership, is that something as well that you particularly do look for when looking at companies or was that just by chance with those two examples?

That’s the peculiar nature of the Indian market.  If you look at the overall ownership of the equity market about 60% or thereabouts is still owned by the founder families and the foreigners, the foreign institutional owners, own about 20% to 22% of the market and then the mutual funds, insurance companies, are a small portion but a growing portion, the domestic sort of institutional ownership is a small portion but growing portion and the rest is retail investor.  A large part of the market is owned by the founder families in India.  That’s been a good thing and a bad thing.  The bad thing in the history because as the markets evolved and the markets opened up in ’91 the founder families considered these businesses to be their sort of fiefdoms, they will put their sons, daughters – and that’s happened to a large number of businesses. 

Over the last 30 to 35 years since the Indian markets have opened up, you’re seeing a gradual transformation happening.  These founder families realise that market capitalisation or relationship with the market is extremely important, that brings down the cost of capital, you have access to equity markets and if you have the right sort of cost of funds you can grow better than your competition.  Corporate governance wise Indian companies,and a lot of my colleagues would agree, are one of the better companies in the region, Asian region.  The second thing is that the founder families now realise that they need the second generation to take over, they need the third generation to take over and will those sons and daughters be able to run the businesses right.  They are professionalising, they are getting the management capabilities in and slowly letting go of control because to let go of control is sort of difficult.

I think this aspect is one of the most exciting aspects about the Indian markets which is not very visible in the whole consumption low penetration story because to me this will really create value long term because these businesses can then sort of scale.  It’s the gradual transformation happening and again you’ve got to remember India is an emerging market.  You could roll back the dial 20 to 30 years back, I don’t know how – Australia is a very institutional market owned by the pension funds and your superannuation fund but that’s the direction over a period of time India will grow, and at this stage it’s really these are the aspects which make it an emerging market but very exciting from a long term perspective.

Excellent.  Can we just talk briefly about the portfolio guidelines?  I’m looking at the fund overview and it said it’s got a portfolio guideline of stocks plus to negative 5% from the benchmark and the industry positive to negative 10% from the benchmark.  Can you explain why these particular guidelines are in play in the portfolio?

10% ownership limit in an individual security is a guideline from the regulator as well for listed sort of funds, foreign institutional investors, and plus to minus 5% broadly is a guideline to give enough diversification for the fund.  The idea is to have a portfolio of about 50 stocks, anywhere between 45 to 60 names, 50 approximately has been the historical sort of ideal number in the portfolio.  Why 50?  Why not 30, why not 60?  50 is what I feel comfortable knowing the companies well enough and there are always some companies which are building a position and getting out of the position which is a tale and you just don’t want to clean it up because the price has moved against you.  There are a few names always from that perspective but 50 is an ideal number which gives enough diversification, enough control that one understands these companies extremely well, know the companies in the portfolio and keep looking for more ideas.  The market volatility is always there so it’s sort of a core long term fund with enough diversification to take advantage of long term plus the volatility – to protect against the volatility which could be there in an emerging market.

Excellent.  We’ll just finish up with one question.  I don’t know if you know much about the Australian market here but one thing that is very popular amongst investors because of the nature of the institutions and the superannuation funds,is income.  Dividends are very important to Australian investors.  I think that’s one thing that does stop a lot of Australians from going internationally.  Can you tell us what the dividends or income are like from the Indian market as a whole?

As I said India is an emerging market, it’s short of capital so you see the current account deficit being there because we import capital in.  It is a growth market where there is an opportunity to grow and businesses are sort of able to reinvest at very high ROEs.  The dividend yield is not very high unlike the Australian market, it is 2.5% to 3% sort of a yield and honestly speaking it is more a growth sort of – you’ve got to view India as a growth market where there is opportunity to reinvest the cash flow which you generate into pretty high ROEs and that adds value rather than thinking about India as an income or a dividend market because it’s not mature, it’s still growing at 6% to 7% and it’s short of capital so there is opportunity to deploy that capital so dividend is really not a very strong point of India at this stage of development.

Great, Sandeep, thank you very much for your time and I’ll let you get back to that portfolio.

Great, thank you very much.