We would like to use this newsletter to talk about the rupee in context of the IT sector.

In the run up to the elections for the Lok Sabha in May, 2014, there has been much speculation about the rupee dollar exchange rate, which could potentially prevail, if there is a strong and stable government at the Centre. The rupee, on its part, had depreciated significantly in August – September, 2013 to as much as Rs 68 to the dollar amid all the pessimism on India, especially the very high current account deficit that the country faces. At its current reading of Rs 59 to the dollar, the rupee has appreciated 13% since then, based on some good policy action from the RBI in terms of encouraging rupee inflows and recently with the prospect of a stable government at the Centre.

At this point, it is a good idea to step back and look at the fundamental factors driving the value of the rupee vis-a-vis the US dollar. India is heavily dependent on imports, especially oil and gold imports. India runs a current account deficit, i.e. the gap between exports and imports of goods and services of roughly $60-70 bn every year.

This gap needs to be filled by foreign inflows, whether in the form of FII flows into equity and debt or in the form of FDI.

Over the last few years, India has received on average $16 bn in the form of FII equity flows, $3.5bn in the form of FII debt flows and $22 bn in the form of FDI. This is not, on aggregate, sufficient to fill the gap of roughly $ 60-70 bn that the country needs to bridge its current account deficit. The gap gets filled by suppliers credit for imports and bank borrowings / ECBs. At the same time, given the precarious condition that India was facing in August, 2013 in terms of a very rapid depreciation of the rupee and questions being raised about longer term sustainability, the RBI would be tempted to build reserves to absorb any large inflows that may come in the future and also to keep the rupee from appreciating too much in order to sustain the export competitiveness over the long term, especially in an environment of competitive currency depreciation by most countries.

On the other side of the equation is the depreciation to be expected in the rupee because of the inflation differential that India has with the United States. With the US inflation running at 2%, and India’s inflation averaging 5-7% over the long term,economic theory suggests that the rupee should depreciate at 3-5% p.a. over long periods of time. From 1993, when the rupee was first let to float on a partial basis, the rupee, at its current price of Rs 59 to the dollar, has depreciated at 3% p.a. since then. This is well within the range of expectations and would suggest that the rupee is not significantly undervalued at this point to warrant a large appreciation, as some quarters have been expressing in recent times. Needless to say, these euphoric views are diametrically opposite to the views being expressed by pessimists in August, 2013.

The fear of an appreciating rupee seems to be the reason that the Indian IT services companies have underperformed in recent times. Given the fundamental weakness of the Indian current account situation, we believe the hopes of a much stronger rupee in the near term do not seem justified and the IT sector presents a good hunting ground for us to pick undervalued investment opportunities at present.

This month we would like to discuss another one of our high conviction investments – HDFC Ltd. HDFC is a housing finance company and is also the holding company for HDFC Bank, HDFC Life Insurance, HDFC Ergo General Insurance and HDFC Asset Management Company.

In the housing finance business, HDFC’s edge is its lending discipline. Its total write-offs on account of non-performing assets since inception are 4 basis points (0.04%) of its total disbursements to date. It is also among the most efficient housing finance companies with an operating cost to total assets at 0.3%. This gives it an edge, to cherry pick its customers and yet make a decent spread on its loans.

HDFC has grown its loan book at a rate of 25% over the last 15 years – growth over the last 7 years has been a tad slower at 22%. Earnings growth over the last 15 years has also been a steady 21% p.a. Our investment philosophy revolves around buying steady businesses with a competitive edge, which have weathered multiple economic cycles and sustained or grown their competitive edge along the way. HDFC fits the bill with its long term track record of delivering sustained growth and maintaining the credit discipline over the years.

An interesting feature of the Indian housing finance market is that the total mortgage debt to GDP in India is very low at 8% as against 30-40% for most countries in South East Asia and 70-80% for the developed world countries like US and UK. This implies low penetration of housing finance as also the conservative nature of Indian households who have preferred not to take on excessive loans on their balance sheet. This conservative nature of HDFC’s borrowers is also evidenced in the repayments (including pre-payments) as a percentage of total loan book which have averaged 20% for HDFC’s mortgage portfolio. Importantly, this number has not changed in any meaningful way over the last 15 years. This implies that although at the time of disbursal, the loan is for 15 or 20 years, the borrower has a healthy enough balance sheet and cash flow to continuously pre-pay his loan and pay off the loan in about 5 years on average.

Lending against a house in India is also inherently safe because a house is also a family’s home and reneging against this loan is considered very disgraceful culturally. Moreover, in India there also happens to be a cash component to most real estate purchases, which gets financed by the borrower directly and therefore the actual home equity is higher than the stated number of 35% (for HDFC) at origination of the loan.

HDFC also owns 22.7% equity in HDFC Bank, 72% in HDFC Life Insurance, 74% in HDFC Ergo General Insurance, 60% in HDFC Mutual Fund and 59% in Gruh Finance. These are all valuable businesses that HDFC has spawned along the way and now contribute significantly to its total value. All in all, this is a great company and our valuation models suggest that the price that one is paying currently is very reasonable considering its growth prospects and stability of the business.

The 6 year old bear market in India showed the first signs of changing gears, with the Nifty trading at all time high levels, nearly 7% above the peak levels reached in Jan 2008. Markets were strong during the month, and the financial year ending Mar 31, 2014 also witnessed a strong closing, with the Nifty up 18% for the year. This has been the best performance for the Nifty in the last 4 years.

Since the bear market began in Jan 2008, equity as an asset class has been shunned by investors in India, in favour of debt, real estate and gold. During this period, it is the foreign investor who seems to have looked at Indian equities far more favourably than domestic investors. Over the last 6 years, domestic investors’ inflows into equities have been close to zero or negative, as indicated by net outflows from Mutual Funds and other Equity linked plans. Mind you, domestic investors do have substantial savings. Total incremental bank savings this year will be close to $ 180 billion, compared with an annual investment by FII’s at about $ 25 bn. Domestic investors have sufficient savings, but have just not gained comfort with equities during the bear market. The preference has been much rather to invest in debt, where returns on a post-tax basis, trails inflation. History suggests a bullish period would change this mind set. Investors tend to chase recent performance and the slowdown in appreciation in real estate and gold and the concomitant recent uptick in equities will likely push domestic investors to invest incrementally into equity.

With markets hitting highs, we have been asked the question as to whether it is a good time to invest in equities. It is our belief that the future direction of the equity market is dependent on 2 factors – growth and valuation.

An analysis of the Top 10 holdings in our portfolio (we would like to believe it is a biased sample) shows a median revenue growth of 18.3 % pa over the past 6 years. Profit growth is slower at 14.3% pa, though still very healthy. Growth continues to be strong for several companies in India. The strong demographic profile indicates the coming years should continue to be favourable for the right companies. On the profitability front, returns on invested equity of the Nifty are close to the low levels seen over the last 20 years and have scope for expansion from current levels. From a valuation perspective, the Nifty currently trades at close to 16.5x its FY2015 earnings, which is near the low end of its historical trading multiples.

The outlook for equities continues to be good, both from the perspective of growth and valuation. The coming years look very interesting for most of our portfolio companies and we believe they are well positioned to capitalize on the growth opportunities that the economy will throw up, as the economy gets back on track.

Equity markets showed some strength during the month, making up for the weak performance in January. The Nifty closed up 3.1% for the month of February. Our portfolios have done quite well during the month. Strength in the markets was partly led by strength in global equity markets, and reduced concerns over the Fed tapering.
During the month, the portfolios benefited from a sharp movement in one of our older investments. ICRA, one of the top 3 Rating agencies in India, has been in our portfolio for over 2 years. Moody’s, one of the world leaders in the Ratings business, had a 28.5% holding in ICRA. Moody’s made an open offer to increase the stake in ICRA to 55%. The open offer is at a price of Rs 2000, nearly double the price at which it was trading at in June 2013. We like to see situations where the key promoter wants to raise their stake in a company. Key promoters are committed to the business for the long run, and the intention to increase the stake shows their confidence in the long term prospects of the business. Over the past few years, we have had a few other situations where promoters have increased stakes in companies that we held at that point in time – Crisil, Hindustan Unilever, Glaxo Consumer, Glaxo Pharma – to name a few – indicating promoter confidence in companies where we have chosen to invest. We hope that a few more of our investee company promoters join this trend.
The Rating business in India, from the point of view of investors, can best be described in one word – wonderful. The business requires very little fixed assets. Working capital requirement would normally be negligible, as customers pay in advance and inventory is nil. Due to regulatory requirements, any company with a bank loan requirement greater than Rs 10 cr needs to get rated. Industry penetration is low and the number of companies that are required to get rated keeps growing. Although there has been some slowdown in recent times, the business has been growing at over 20% over the last 6 years – since the current bear market started. We continue to be believers in the business and the promoter intent to raise their stake has just increased confidence in our belief.
Over the past 6 years, the Sensex has traded in at the current levels of 21,000 in Jan 2008, Nov 2010 and Feb 2014. During the same period, the valuations for the basket of Sensex companies, as measured by the Price/ Earnings ratio has been steadily coming down from 28x in 2008, to 24x in 2010 to the current levels of 17x. As Sensex levels remain the same, valuations have been steadily coming down. What was expensive in 2008, has started to become cheap. We believe this is an essential condition for markets to turn around.
Though there are several macroeconomic worries, stock prices get defined by valuations, and at present the market as a whole is trading near the lower end of its historical valuation range. We remain optimistic on equity investing in the coming years, more so with the quality of the companies that we hold in our portfolio.

This month we would like to discuss one of our high conviction investments – HDFC Bank. HDFC Bank’s key edge over competitors is its liability franchise, its ability to gather low cost, current and savings account (CASA) deposits which is among the highest in the industry, averaging 50% over the last decade. The low cost of its deposits is a great competitive advantage because it allows HDFC Bank to cherry pick high quality customers to lend to, and yet maintain a net interest margin which is among the highest in the industry. HDFC Bank is the most efficient player in the banking industry with among the lowest cost to income ratios. It has the best NPA record with gross NPAs (including standard restructured assets (SRA)) of about 1.5% and provisions for doubtful debts which exceed 200% of the gross NPAs. The rest of the industry has an estimated average gross NPA (including SRA) of 9.4% and provisions of an estimated 24%.
The Indian banking industry has grown at 17.5% over the last 50 years. The market continues to be underpenetrated as credit as a percentage of GDP is much lower than global standards. HDFC Bank is able to continuously gain market share over public sector banks (78% of the banking industry) because of certain inherent disadvantages of PSU banks. For one, PSU banks are always short of capital, because banks routinely need to raise capital to shore up their capital adequacy. The government does not have the money to keep funding the PSU banks adequately and has an ideological issue with letting its stake fall below 51%. Political interference is another disadvantage that the PSU banks face and we don’t think it is a coincidence that the gross NPAs of PSU banks are much higher than that of the private sector banks. As a result of these competitive advantages, HDFC Bank has grown its deposits base at 30% over the last 10 years as against 17% for the entire banking sector. Despite this trailblazing growth, its market share is only 4.4% as of now.
Over the last 5 years, when things have been rather rough for the Indian banking sector, with rising NPAs and a large restructuring of assets, HDFC Bank’s gross NPAs including restructured assets have averaged 1.5%. What we like further is that the bank has used these tough times to cut expenses sharply – cost to income ratio was at 42.7% in the latest quarter while it has averaged 48.5% over the last 5 years. It has achieved this while it continues to roll out into large hitherto unbanked areas. From 327 cities that it covered in 2008, it now covers 2,104 cities/towns.
What makes HDFC Bank interesting at this point of time is that there is a technical overhang in the stock. The RBI notified on 16th December 2013 that further FII and NRI buying in the stock is not permitted because the FII limit of 49% has been crossed. As a consequence, the MSCI Index has cut its weightage for HDFC Bank in its India Index from 7.05% to 5.34%. So, not only are FIIs, which are the largest factor on the margin in the Indian stock market, not permitted to buy the stock incrementally, there is a fair amount of forced selling because of the weightage change by MSCI. When a great company is available cheap because of technical factors, it often presents the perfect opportunity to get into the stock.