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First State Stewart - India Equities

India Update

March 2015

This is the second semi-annual update on Indian no set formula when it comes to succession planning. Of the equities. Our aim is to provide a general update on companies that we have owned in the last 10 to 20 years, we some of our current thoughts and views, insights have seen families adopting different ways of passing the baton to the next generation. about existing holdings and changes over the period. We would appreciate your feedback. For example, the 118-year old Godrej Group is currently in the middle of a calibrated succession process, with the 4th th Change is in the air generation gradually handing the baton to the 5 generation of family members. Under the keen and watchful eye of the Since our last update in August 2014, we have met over 60 current Chairman, Adi Godrej, whom we have long admired, we companies across eight cities in the Indian subcontinent. have witnessed his daughters quietly assert themselves at Godrej The message from the ground in India is that businesses are Consumer Products. Nisa Godrej has been instrumental in the keenly awaiting investment-led growth to kick-off, while being success of the company’s international businesses (which now broadly supportive of the new government’s policy moves. account for 50% of sales) while Tanya has set about transforming While much has been written about the exciting prospects and the company’s culture and marketing strategy. However, it is equally daunting challenges facing the new governments in important to note that neither of the family members is the CEO the Indian subcontinent (with Sri Lanka recently becoming the – Vivek Gambhir, a professional, leads the business while family latest entrant to the region’s ‘regime-change’ club), we wish to members support him. However, at Godrej Properties where Mr. highlight another kind of change that has a direct, and far- Godrej’s son, Pirojsha, is laying the foundation of a big real estate reaching, impact on our portfolio - generational change. In this business – he has been appointed CEO. So, even within a group, section we speak mainly about our own portfolios, although this the succession model differs. trend holds true for much of corporate India. The Burman family, the entrepreneurs behind Dabur, took Our investment process places heavy emphasis on the long- a decision early on (in the 90’s) to let professionals run the term stewardship of quality franchises. In this regard we have business. However, their first attempt with professional observed that our interests are best aligned to businesses that managers was not particularly successful. Nonetheless, after are family-owned and professionally managed. Substantial family Mr Sunil Duggal was appointed as CEO in 2002 (he has worked ownership, subject to high standards of corporate governance, at Dabur since 1995, after stints with PepsiCo and Wimco) the tends to foster genuine long-term thinking that benefits organisation has not looked back, growing from US$265m in like-minded investors. Additionally, families that have truly sales then to US$1.2b today. As he approaches retirement, we empowered professionals (where the company is not run like a are increasingly scrutinising the bench behind him. fiefdom) have been able to attract and retain top quality talent. The Wadia family, stewards of Britannia, has had a similar policy Passing the baton with regards to letting professionals run the business. In contrast, they had a harder time finding a settled senior management There is an old adage in India about business families – “the first team since buying into what was then a joint venture with generation builds it, the second generation grows it and the Danone in 1993. Tussles with partners (Rajan Pillai, Danone) and third generation destroys it”. Hence, when investing in these even their professional CEO have led to four CEOs over the past companies, it is quite important to pay attention to changes at 12 years (including an interim one). The business went through the top and what they do to the overall strategic direction of a an period of inconsistent morale, culture and performance that business, its culture and the morale of the various stakeholders. is only stabilising now. The current CEO, Varun Berry (ex-head of Therefore, coming to a view on the stewardship displayed by PepsiCo Foods in India), who joined in 2013, has implemented families and key individuals occupies most of our time, rather many changes (strengthened distribution, rationalised SKUs and than trying to figure out government policy, interest rates or the increased in-house manufacturing) which are yielding results monsoons. What makes things more interesting is that there is (EBITDA margin has increased form 6% in 2012 to 10% now).

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Given the history of management changes here, we assign a there are many other holdings that we have not mentioned and slightly higher risk premium to the Wadia group and Britannia scores of companies that we do not own (but keep meeting). We compared to some of the other families we back. use our time with the senior management and family members to form (and challenge) our views about the stewards, rather At Marico, it is only recently that 63-year old Harsh Mariwala than split hairs about near-term financial forecasts. While this stepped down after overseeing a remarkable transformation process takes time, once we are convinced, we then tend to stay during the past 15 years: from a US$70m commodity-type oil invested for a long time. business to a branded personal care and foods major with close to US$1b in sales. Saugata Gupta, a professional, who has recently In some instances, our meetings raise questions about the been appointed the CEO, has been working at Marico for over a culture, succession plans and prospects for the business. For decade and is set to take the company even further. example, we have seen India’s largest retail company introduce the next generation of family members to very important In the case of Eicher Motors, we have been fortunate to have roles at a particularly hard time for the business, which in our known the Lal family for over a decade. Vikram Lal ran the view, could be counter-productive. Similarly, we recently met company for 25 years until 1997, handing over to professional a pipe company in Ahmedabad where the 25-year old son of managers until Siddhartha Lal (Vikram’s son and from the 3rd the founder decided to hire a Bollywood actor as the brand generation of family members) was appointed CEO in 2006. ambassador – while the decision may be right, it raises doubts Through our meetings with the then 29-year old Siddhartha, we about the company’s culture in our minds. got the sense of the calibre of this new steward and his vision to build a truly world-class franchise in motorcycles and trucks. In summary, it is important to pay attention to instances of generational change in these kinds of businesses, coming as they In 2004, Siddhartha asked the board to give him two years to do only ever so often, for it is perhaps the single biggest defining turn around Royal Enfield, an ailing motorcycle maker that Eicher factor in their long-term success or failure. had bought in 1994. Not only did he manage to turn this division around, but today Royal Enfield motorcycles command a six- Leveling the playing field month waiting period with monthly sales volumes reaching over 30,000 motorcycles (from 2,000 when he took over). As a result, Another trend we picked up recently is the gradual breakdown the company, which had reported sales of close to US$450m of the previous norm of ‘well-connected’ corporate groups in 2004, today achieves sales of close to US$1.4b, with the benefiting from government policy. Companies we met across proportion of motorcycle sales rising from just 8% to nearly 35%. industries ranging from metals, telecom, auto and finance seem Their partnerships with global leaders such as Volvo and Polaris to agree that the era of crony capitalists generating super- have transformed the company’s franchise, giving them much- normal returns was coming to an end. There are three main needed technology expertise. reasons for this. Having witnessed this transformation from close quarters Firstly, the bruising corruption scandals that made headlines over for nearly a decade, we sensed that the market did not fully the past few years have elicited a sharp reaction from the public. appreciate the value the company offered in terms of growth The recent rout of the UPA in the 2014 general elections is an and quality and hence, between 2012-13, made Eicher Motors example. The fact that, Aam Aadmi Party, a fledgling political one of our top holdings. The stock has been one of our top party for the common man and born out of the widespread contributors to performance in 2014, rising as it did by ~200% frustration with corruption just a few years ago, was able to in US$ terms during the year. As is often the case, however, achieve a record win in the legislative elections for Delhi (winning the pendulum has swung too far in the other direction and a scarcely believable 67 of 70 seats against the considerable valuations are stretched even after taking a long-term view. might of the BJP and Congress parties) is another example of Sadly, we have had to significantly reduce this position (more on the population’s frustration. This means that politicians can no this later). longer ignore the damaging effect that corrupt dealings with corporates can have on their political careers. Some transitions have not been easy though. It was a group of seven IT professionals who came together to set up Infosys in Secondly, regulatory bodies such as the Reserve Bank of India 1981. As one of the pioneers of the Indian IT services industry, (RBI), Securities and Exchange Board of India (SEBI) and Telecom Infosys’ professional and meritocratic culture ensured that it Regulatory Authority of India (TRAI) have become much more was hugely admired and attracted the best talent. However, the independent (and powerful) than in the past. Additionally, founders behaved much like a traditional family-owned business watchdogs such as the Comptroller Accounts General (CAG) – a when it came to succession planning – instead of identifying key player in exposing the telecommunications 2G spectrum the most capable successors, the founders took turns becoming scandal, are now more assertive. The judiciary also plays a key CEOs. We believe this caused Infosys to lose its direction over the role in this process. past decade (12% sales CAGR over the past 5 years vs 17% for And finally, investors are becoming more aware of the risks in TCS). After a period of turmoil, the board appointed Vishal Sikka dealing with so-called “connected companies”, although there (ex-SAP) as the first non-founder CEO last year. Since then, all the are many who will still turn a blind eye to poor governance. founders have also stepped down from the company and the board. We continue to watch this keenly. This means that business groups that have benefitted in the past due to their political patronage are finding it increasingly difficult These are just a few of the examples from within our portfolios - to continue doing so. Certainly, investors in these types of

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companies have witnessed a distinct underperformance vis-à-vis As a rule, we avoid trading based on near-term valuations (a the higher quality peers – an index comprising about 75 Indian mug’s game) given that our holdings arrive within the portfolios companies that are regarded as being politically connected by only after having passed through several filters of quality Ambit Capital (a local brokerage) has consistently lagged the (management and franchise alike). We fully intend to hold BSE500 Index since 2011, suggesting that a series of corruption them for long periods of time (our average holding period has scandals coming to light at that time may have worked to the been over five years). But equally, we would consider ourselves disadvantage of such politically connected groups. negligent if we did not move decisively to protect our clients’ capital in the face of overwhelming evidence that shares were Of wonderful companies and fair prices simply unsustainably overvalued. We have been aggressively Since August, when we last outlined our Indian equity strategy, trimming some of our overvalued holdings over the past we have completely exited five holdings. Some of this was few months and as a result, our cash holdings are now at the driven by concerns that valuations had become unsustainable, maximum limit of 10% – the highest they have ever been. despite us taking a long-term view and factoring in a full-blown We are excited, however, that we continue to find new economic recovery in India. For example, Bosch India Limited, businesses that we wish to own for the long term, and would the Indian listed subsidiary of Robert Bosch Gmbh, is probably buy, if the valuations were more palatable. This is one reason the best auto-component manufacturer that one could invest why our Indian equity holdings, even though concentrated at in across emerging markets. Yet, even if we assume that its sales the top has now got a long tail of 19 holdings at less than 1% would double within the next three to four years (this sort of each. These are all businesses with attributes that measure up growth has occurred in the past) and that it would achieve its to our standards, but trading at valuations that make it difficult historical peak net margin on the enhanced sales, its current even for patient investors to make an acceptable return. It is this market cap is already trading at a rich 30x multiple of that future challenge that now occupies our minds and over the next few profit. Similar is the case with the other holdings that we have months we hope to consolidate our holdings significantly. sold, such as Blue Dart Express, Indian Hotels and even We prefer to be fully invested in our portfolios and feel Eicher Motors, in which we have reduced our holdings by half fortunate to have identified a wide range of businesses that we since our previous client note. want to own for the long term, as and when we get the right On the other hand, we have initiated positions in seven stocks. opportunity. Having reduced some of our holdings in Indian FMCG companies (notably Dabur and Britannia), we have initiated a small position in Hindustan Unilever, which sells a much larger portfolio of products, while trading at similar valuation multiples as some of its local peers. IDFC is another reasonably valued franchise that we have revisited in recent months. Majority of the other new positions are very much toe-holds – as we gradually build conviction (and valuations become more attractive), we will share more about these businesses.

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