Steadview Capital

The secular opportunity in India for long/short equity investing

Originally published in the May 2012 issue

A recent survey from Imperial College’s Centre for Hedge Fund Research showed that emerging market hedge fund strategies enjoyed the best annualised returns over nearly two decades, but also experienced the most volatility. This is true in spades for India in recent years. That poses challenges for long/short equity managers focused on India. One asset manager with a strong track record extending nearly three years is Steadview Capital Management. Steadview has produced annualised performance of 26% net of fees, versus 3% for the Indian market since launch in July 2009.

Steadview is headed by Ravi Mehta, who cut his teeth as an Asia analyst for ex-Tiger Cub Lee Ainslie’s Maverick Capital. The decision to leave Maverick at the end of 2008, aged just 27, wasn’t the safest thing for Mehta to do, but the young manager was hungry to prove himself and develop a track record. With a three year performance record in sight, Steadview now has over $30 million in assets, a fourfold gain since the beginning of 2011. This has come despite investors moving away from many emerging market and India-specific funds.

Several things stand out in the Steadview strategy. One is its high concentration. The fund will generally have about 15 positions on the long side and anywhere from zero to seven positions on the short side. This contrasts with the 30-80 positions most equity long/short funds run.

In addition, while Steadview has outperformed in up-markets, it has also been down much less than its peers in market corrections. Since January 2011, the Indian market is -28% in dollar terms, while Steadview has gained 3%. The fund has a defensive investment approach whereby it avoids leverage at the fund level, it does not invest in highly indebted companies, and it only invests in management teams that it feels have the highest standards of corporate governance.

Matching China
“India is an extremely out of favour market right now,” says Mehta. “But over the last decade (See Fig.1) it has returned nearly as much as China – so over 10 years both markets have gone up approximately four times, in dollar terms. Like China, the majority of this market return is a result of corporate earnings growth, rather than multiple expansion. What has driven the return in both countries is high economic growth. In India’s case, the GDP growth is a bit lower, but the return on equity from companies is a bit higher – that accounts for the similar 10 year return.”

Unlike China, India can continue to expand rapidly because it is primarily a domestically driven economy and not dependent on net exports to drive growth. It also is fortunate to have favourable demographics. Over the next 10 years economists estimate that India will add 136 million people to the workforce or about six times as many as China will add. China has attracted the envy of the world with an annual growth rate regularly surpassing 10% over the past decade. Ten years ago India lagged its Asian neighbour’s grow rate with a 5% rate of expansion. But half way through the decade annual growth expanded to 7%. China’s growth is now slowing down and moving closer to India’s growth rate, while other emerging markets such as Brazil are seeing GDP growth at half that rate.

“Structurally the growth rate keeps increasing as the economy moves towards a more free-market structure,” says Mehta.” India has opened up many sectors to foreign investment and private competition in the last 10 years. The fiscal deficit leads to $8-12 billion of divestments each year of government owned companies, which improve the economy’s productivity and capital efficiency over time.” He notes that there is low hanging fruit from a reform standpoint that the Indian government is likely to pursue in the next two years, such as the Goods and Services Tax and deregulating diesel prices, and he believes the government is focused on bringing back the introduction of foreign direct investment in multi-brand retail, perhaps within 12 months.

Valuations attractive
“What is exciting about mid-cap stock valuations in India, is that looking back over four years the mid-cap index is flat while earnings have grown 50%,” says Mehta. “Thus the mid-cap market PE has compressed from over 20 times to only 10 times. As a fund manager, I feel that we are in the classic stage in a business cycle whereby sentiment is low, valuations have compressed, and competitive intensity has reduced. That usually sets the stage for strong returns in coming years.”

If investors are cautious, it is because 2011 was a wipe out year for India, almost as bad as 2008. Stocks fell 37% in dollar terms with 25% of that the fall in the Nifty and the rest coming from rupee depreciation versus the dollar. Moreover, small cap stocks underperformed even more, plunging 60% in dollar terms. Against that backdrop, Steadview’s 5% drawdown in rupee (20% in dollars) deserves recognition, particularly in light of the rebound in early 2012 which has put the fund’s NAV above its 1 January 2011 level.

Domestic demand focus
The fund aims to capture burgeoning domestic market demand. As a result, over half the portfolio is in stocks sensitive to consumer demand, including consumer goods, apparel and food and beverages (see Fig.2). One winning trade for Steadview has been TTK Prestige, a consumer company focused on kitchen products such as pressure cookers, cookware, and appliances. In early 2012, it was still a top position in the portfolio, having tripled from the initial share purchase in the third quarter of 2010. Even so, TTK trades at a multiple of 16 with earnings per share growth expected to be around 35%. The company used to source many of its products from China, but is now finding manufacturing cheaper in India given the fall in the rupee relative to the RMB, and the rapid increase in labour costs in China.

steadview2aAnother winner has been Jubilant Foodworks, the master franchisee of Domino’s Pizza in India. Pizza is the most popular form of fast-food in India, a sector that is still in the early stages of evolution in the country. Jubilant is also the master franchisee of Dunkin Donuts and will open its first Dunkin Donuts store next quarter.

Calibrating exposure
Clients coming to Steadview are looking to tap India’s structural growth story. Consequently, the fund has a high net exposure and a commensurate level of volatility. Generally, the fund will have net long exposure of 80-90%. However, at times it will trim this exposure. In adjusting net exposure, the fund incorporates a forward P/E calculation, and also takes account of other variables, including macro balances, policy factors and inflation. Mehta says: “We try to think in terms of a greed and fear thermometer. When multiples are high in India and expectations are running ahead of reality, we get cautious and reduce net exposure.”

The investment case for Steadview is the prospect of long term returns from India’s emergence as economic leader and its transition towards a more market-based economy. The corollary is that investors need to make a long term commitment. The client base that this most likely fits includes family offices, endowments and foundations, and ultra-high net worth individuals.

“We are very fortunate to have a sophisticated group of family office clients who have a long-term view on India, and a deep understanding of how we approach investing,” says Mehta. “This enables us to be long-term in our thinking and stock selection, and not be overly bothered by short-term swings in the market.”

The volatility of the fund is not in doubt. In 2011, Steadview was down 20% versus the market’s 37% drop, but has rebounded strongly. It is up 28% so far in 2012 while the market is up 15%.

“Some Investors make the mistake of confusing volatility with risk,” says Mehta. “Risk in our view relates to the prospect of permanent capital loss. As an investor, if you aren’t using leverage, and are picking good companies and ethical management teams, in a market that is growing at 15% per year in nominal GDP terms, the risk of permanent capital loss is very low. I would consider our fund to be a volatile, low risk, high return product.”

Early stage opportunity
The India hedge fund opportunity is in its early stages. The country’s weighting in the MSCI Asia is only 7% despite it having around 30% of Asia’s population. Compared with China, the market is at a much earlier stage of evolution, as India’s daily trading volumes are a tenth of what they are in China. Moreover, the limited presence of hedge funds is a big plus for tapping the potential alpha in the equities market and limiting downside shocks from crowded trades being suddenly unwound.

“A key constraint to developing India as a hedge fund market is that it doesn’t have a very deep shorting market,” says Mehta. “Shorting is restricted to the futures market. But the cash shorting market should develop over time. The regulator is likely to soon allow leverage at the fund level as well. These two factors should lead to more rapid growth of the Indian hedge fund space. More capital in the space will translate into better valuations and capital access for India’s companies, which will be a positive for the country.”