Perspectives

Consequences of Putin’s war in Ukraine

Dear Partners:

In order that we can share our thinking on the current situation in Ukraine with all partners, we have put together a brief note that summarizes trends we see, their implications, and how we intend to act. I hope you find it useful.

A caveat. The situation is evolving and we typically see first order effects at present, but there will be second and third order effects which only become clearer with time. Hence, this note is “work in process”.

Investing during a crisis

It is now clear that a macro risk (Russia/Ukraine) has become a known event. Not surprisingly the markets are selling off as new information is factored into prices.

No one knows how this will end or its short term implications. If anyone tells you they do, it tells you more about them than their forecasting abilities.

INVESTMENT THESIS ON SOLARA ACTIVE PHARMA

Solara has a strong Pharma API ¹ and an emerging CRAMS ²business. It has recently announced a merger with Aurore, a privately owned company in the API/CRAMS space. Pharma API is a USD 180B industry globally of which India has ~ USD 4B share. The developed world has been outsourcing manufacturing and India now has the additional tail wind of the developed world wanting to de risk from China (USD 35B).

INVESTMENT THESIS ON AXIS BANK

We believe Axis is amongst the 4 private Banks in India that has the right to win long term. It offers opportunity for long term compounding but where entry valuations are significantly in favour in a richly valued market.

Partners are aware that we already own ICICI Bank, HDFC Bank and Kotak Bank as our core Banking positions.

Why add a 4^th Bank? Banking is not a winner takes all business. The RBI ban on issuing of additional credit cards (now lifted) and repeated technology outages at HDFC Bank is a reminder that one never knows where risk lurks. If there is opportunity for multiple players to do well, one should spread the risk.

The principal value of any Bank lies in its deposit franchise. A bank’s Cost of Funds (COF) determines its right to win long term because it can choose the risk it wants to underwrite. If COF is not in the top decile, you are doomed to a vicious cycle of pursuing higher risk segments which eliminates resilience during a crisis. And it takes time to build a superior COF position. Low valuations accompanied by high COF is a high probability value trap. As one can see from the chart below, Axis’s deposit franchise is amongst the best in the business, even as it has ceded some ground to its peers in the last few years.

Source: Spark Capital

Financial institutions are like icebergs as the true risks in their Balance sheets are not well disclosed. Hence, a conservative mindset in credit and credibility on reported NPAs is key. Under new leadership, Axis Bank is undergoing a transformation to a fundamental culture of conservativeness with a more prudent provisioning policy, more granular loan book being built and prioritizing credit discipline over growth. ¹

Why is the stock trading at close to 1 std deviation below mean valuations in a raging bull market?

Source: Bloomberg

Axis was seen as a superior franchise to ICICI Bank till a few years ago with much lower cost of funds but ICICI Bank has now pulled ahead with more granular lower cost deposits and higher NIMs.
Axis leadership does not seem as well settled as its peers. The top deck comprises people mostly hired from outside the bank with very low tenure at Axis vs peers. The average tenure within the group of the top leaders at Kotak, HDFC Bank and ICICI Bank is well over 20 years.
This has led Axis to miss growth opportunities such as the one created when HDFC Bank was stopped from growing in Credit cards by regulators. And hence Axis has reported far lower growth than other Banks in H1 of this year.
Moreover, there is also a credibility deficit that needs to be bridged. The CEO mentioned an 18% ROE target by 2022 (a CEO’s aspiration is Dalal street guidance) at the start of his tenure and the bank is far from that number at present.

Despite the above, we believe Axis Bank at present provides a compelling opportunity as this pessimism is being reflected in valuations (one std dev below mean) while growth is looking up. Hence, Axis offers a rare combination of both growth and valuation re rating.

While ICICI Bank is a superior franchise at present, (it is also our 2^nd largest position), we believe that 5 years from now Axis Bank can be a 15-17% ROE business while growing Book value per share at 15%+. The bank’s transformation journey is perhaps two years behind ICICI Bank, and it is well positioned to gain market share in the Banking system from weaker players.
We don’t worry about short term growth rates in credit, and these can be especially misleading in Banks when cautiousness may be prudent in an unpredictable environment. And a leadership team which is reorganizing itself after a period of credit losses will understandably be more cautious in underwriting risk. That is not a structural issue in our opinion and growth rates will inch up over time.
The management team is not in denial as can be seen from a recent interview of Amitabh here where he concisely lays out the work to be done for Axis to catch up with its peers.

In our optimistic scenario, we assume Axis valuations re rate over time to one standard deviation higher than mean. In this scenario, the returns could be closer to what one has seen in ICICI Bank over last 3 years. When sentiment changes, multiple expansion happens swiftly (see chart below). However, markets tend to wait for certainty. Therein lies the opportunity as you can get superior outcomes by ignoring the herd if you are willing to bear short term pain and not play momentum. It was only 3 years ago that ICICI Bank was derided for having a fundamentally flawed culture and now ICICI Bank seems to be the consensus pick for the Banking stock of the next decade.

Source: Bloomberg

In our pessimistic scenario, Axis Bank’s transformation remains incomplete, and its deposit franchise weakens. Or it is unable to gain market share on Assets. This could happen if the Axis senior leadership team is not stable. In this case while returns in Axis Bank will be poor, the beneficiaries of its challenges will be the other three private Banks (ICICI, HDFC, Kotak). Hence, as a portfolio play, we will do fine as we are also participating in the others quite meaningfully and they would then generate significantly better returns than our base case estimates.

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As on 30 Sep 2021, total restructured loans for the bank stood at just 0.7% of loans, whereas the BB and below exposures are further ~1% of loans. Restructured loans as % of respective loans across segments are 0.7% for corporate, 0.8% for retail and negligible for SME. Provision coverage on overall restructured book is 24% with 100% cover on all unsecured retail. ↩︎

The Fin Tech Valuation delusion

Technology buzzwords – “ML. AI. Blockchain. Platforms” are fueling investor delusions. We share 2 articles and also explain why we don’t own any “FinTech” as of now.

Technology buzzwords are fueling investor delusions

Signal vs noise – what game are we playing?

“In life, the challenge is not so much to figure out how best to play the game; the challenge is to figure out what game you’re playing.” (Kwame Anthony Appiah http://appiah.net/)

CLSA is a reputed broking house. It published a report 2 days ago recommending investors book profit in India.

We agree with CLSAs that valuations in India, on aggregate, are stretched. In our last letter we mentioned, we were “cautious, but not bearish” and that because we have borrowed returns from the future, we could be in for a period of muted returns.

INVESTMENT THESIS ON ITC

While our core approach to investing is to buy “disciplined compounding stories at a fair price”, it is equally true that “at the right price, all assets are AAA” (except where one suspects governance issues). We will buy companies in “Special Situations” when they trade at a meaningful discount to fair value. ITC meets our Special Situations criteria.

ITC has multiple business lines.