Half-year Report

INVESTMENT MANAGER'S REPORT

For the second half of calendar year 2019, Ashoka India Equity Investment Trust (the "Company") NAV total return generated 290 basis points (bps) of alpha versus the MSCI India IMI Index in sterling terms. The Company delivered -2.3% whereas the MSCI India IMI was down 5.2%. Since 31 July 2018 (the date post IPO when the Company was fully invested), the Company has delivered 985 bps of net cumulative alpha with a 7.0% absolute return compared to the benchmark return of -2.9%, both in sterling terms. 

2019 was a relatively weak year for the Indian equity market as it lagged the US as well as global emerging markets. Whilst the broader equity index was positive for the year, the distribution of returns remained polarized in a continuation of the divergence experienced in 2018. The S&P BSE large cap index was up 5.2% while the mid and small cap indices were down -5.1% and -13.9% respectively.

This was the second worst year for relative performance for Small and Mid (SMID cap) in the last fifteen years, coming on the back of 2018, which was the worst year in this period. As can be seen in the graph below, these two years have rapidly wiped out the cumulative valuation premium that SMID caps had reached at the start of 2018 following a sustained rerating that began in mid-2013 coinciding with Modi's nomination as the Prime Ministerial candidate for the BJP.

To be clear, the purpose of the above graph is not to suggest that SMID caps are ripe for a bounce back, but to show where we stand today relative to the past. At present, SMID caps are trading close to their longer-term average valuations, trading at a modest discount to the large cap segment of the markets. Through this tumultuous period, the Company has been predominantly invested in SMID caps, in contrast to the 20% weighting this segment has in the MSCI India IMI.

Generating alpha during such a time is analogous to swimming against a strong current and the magnitude of the Company's alpha over the benchmark should be viewed in this context. The benchmark itself has been a top quartile performer with most managers struggling to keep up with it. As a result, the Company is amongst the best performers relative to the peer group.

Key Contributors

HDFC Asset Management Company (HDFC AMC) is India's largest asset management company with close to a 15% market share of the assets held within mutual funds in India. India is one of the most underpenetrated markets for retail investment in mutual funds with the level of investment standing at 12.9% of GDP compared to the global average of 61%. This provides HDFC AMC a long runway for growth. It has been delivering industry leading revenue and profitability on a consistent basis. During the period under consideration it continued to gain significant market share particularly in the debt mutual fund category and delivered better than expected performance, despite a backdrop of regulatory headwinds.

Nestle India Limited, a subsidiary of Swiss Nestle S.A, is India's third largest Fast Moving Consumer Goods company. With marquee brands like Maggi, KitKat and Nescafe in its portfolio, it is a market leader in almost all the categories that it operates in. Under the leadership of Suresh Narayanan, Nestle has not only managed to emerge stronger from the Maggi fiasco three years ago, but also significantly increase focus on new product development and distribution. It has launched more than 40 products in various categories over the past two years following a cluster-based approach to enhance distribution. We expect Nestle to continue to deliver steady performance led by increasing penetration and new product introductions.

Dr. Lal Pathlabs Limited (DLPL) is the largest diagnostics chain in India. The industry is significantly underpenetrated and approximately 50% of the market is occupied by small companies who are gradually vacating the market due to scalability challenges and tightening regulations.  DLPL derives approximately 80% of its revenue from North India where it is three times the size of the next largest operator. It has focused on deepening penetration in its core market whilst gradually expanding into a pan-India presence. Amongst the peer group it has the highest contribution from its B2C business leading to better pricing power and customer loyalty. As a result, DLPL is the most efficient diagnostics chain in the industry with a negative working capital cycle and superior returns on capital. We expect DLPL to continue on its growth trajectory as it scales its reference labs and captures market share from smaller operators.

Key Detractors

L&T Technology Services (LTTS) is a leading engineering R&D services company globally and counts 51 of the top 100 R&D spenders as its customers. It has strong competencies across transportation, process engineering, industrial automation, telecoms and the hi-tech verticals. A multi-vertical strategy, global design centres, competencies across technologies, and deeper account mining are expected to drive strong business performance over the coming years. The stock price declined during the period as ramp downs in two specific client accounts impacted overall growth. However, we continue to like LTTS for its strong capabilities across its operating verticals as well as its focused and experienced management team.

Infosys is India's second largest IT services company with US$12bn in revenues. It has a strong global presence including in the key markets of North America and Europe along with a high-quality customer portfolio. Infosys operates across seven major verticals: (a) banking, financial services and insurance(BFSI), (b) retail & consumer packaged goods(CPG), (c) communications, (d) energy and utilities, (e) manufacturing, (f) hi-tech and (g) life sciences. BFSI is the largest vertical contributing approximately 31% of overall revenues. The company expects strong demand in retail banking, commercial banking, payments and wealth management segments to lead to robust growth in the vertical, with better win rates and a strong deal pipeline being the key lead indicators. Retail & CPG is the second biggest vertical contributing close to 15% of revenues and this vertical has seen large deal wins and new logo additions. The share price declined during the period as certain whistle-blower allegations surfaced in the media.

Intellect Design Arena Limited is a financial services software product company, regarded as a leading solution provider in transaction banking software which accounts for 45% of its revenue. Other product suites include payments, retail banking and digital banking software. It has invested substantially in product R&D over the last ten years and is now monetizing the enterprise software product suite. The stock price declined during the period due to the ongoing weakness in technology spending amongst North American & European banking customers. Sales cycles have elongated, consequently impacting deal closures and revenue momentum. However, we continue to like the business given its market leadership in global transaction banking software products and the strong growth trajectory expected from its broad product pipeline.

Investment Outlook

Calendar year 2019 felt like a more eventful one than years past. The Indian economy entered the year following a challenging 2018 which saw non-bank financial companies (NBFCs) besieged with liquidity problems. The situation has since improved, but challenges remain with weaker NBFCs in the system finding it difficult to raise capital and some facing solvency challenges.

Signs of moderation in demand emerged early in the year and subsequently economic growth has seen material deceleration. With the benefit of hindsight and the compulsion to rationalise, experts have attributed the current slowdown to a series of shocks to the economy over the past few years including the short term impact of demonetisation, implementation of a Goods and Services Tax (GST), real estate reforms, a clampdown on corruption, peaking corporate loan NPAs and the NBFC crisis. In our view the trend of ever-increasing tax rates in various forms over the last few years is one of the primary reasons for the deterioration in business sentiment and the resultant slowdown in job creation. Experts can pick their own poison, but the reality remains that the full year GDP growth in 2019 is expected to come in at 5% compared to 7% for the previous year. World Bank, estimates suggest growth in India is expected to recover to 5.8% in 2020.

The monetary easing cycle that began in late 2018 has continued throughout 2019 and the Central Bank has further room to be accommodative, although currently it is on a pause following a recent pick-up in inflation towards the end of the year. The benchmark repo rate currently stands at 5.15%, down 135bps since the beginning of 2020. Macro variables such as inflation and the current account deficit remain stable. Furthermore, India enjoyed one of the best monsoon rains in decades, which may benefit agricultural output and revive rural sentiment. 

The BJP led NDA government secured a strong majority in the central parliamentary elections held in May 2019. The current electoral maths indicates a potential majority in the upper house of Parliament as well as in the forthcoming elections in 2022. This should allow the Government to push through several long pending difficult reforms, if it chooses to. Whilst a stable government at the helm for the next five years remains a positive for business sentiment, its first budget in early July disappointed the market, primarily due to tax increases on the so called 'super-rich' as well as the introduction of a share buy-back tax. The latter is effectively an additional tax on the corporate sector while the former is an incremental personal tax. In the days and weeks following the budget, business sentiment, already suffering from a slowing economy, weakened further.

Recognizing the gravity of the situation, the government sought to take several corrective measures to revive sentiment. Among other things it announced divestment of several public sector units which has the potential to raise tens of billions of dollars of much needed fiscal resource.

On 20 September 2019, the Government announced the reduction of the headline corporate tax rates from approximately 35% to 25% and a further reduction for new manufacturing units to 17%. In our view this could mark an important turning point in the NDA Government's tenure of the last six years marking a U-turn in its previous trajectory of raising taxes. We believe this could be the first of a series of tax cuts which should improve the competitiveness of Indian industry, revive business sentiment, rekindle entrepreneurial risk-taking and create jobs. The Union Budget presented in February 2020 focused on fiscal prudence, infrastructure spending and incentives to encourage domestic manufacturing. In addition, the latest monetary policy declaration from The Reserve Bank of India focused on offering to support growth by aiding in the faster transmission of lower interest rates to the real economy and regulatory forbearance to stressed real estate developers to enable access to funding to complete projects.

We are closely monitoring the evolving coronavirus epidemic and evaluating any potential impact this may have on our investment companies. At the moment we do not believe there is significant effect, but if the situation deteriorates there could be supply chain disruption for some of our portfolio companies in industries such as manufacturing, speciality chemicals and pharmaceuticals. Looking further out, we anticipate that this disruption may result in some manufacturing and production moving from China to other parts of the world, including India. 

As much as one may want to talk about the macro economy, in our opinion the opportunity to continue to generate significant alpha through stock selection remains the most attractive aspect of the investment case for India. From this perspective, the outlook for India is as positive as in years past.

Acorn Asset Management Ltd

10 March 2020