Monthly markets podcast India August 2021

Narayan Shroff (NS): Hello & welcome everyone to our monthly podcast for Barclays Private Clients India. I am Narayan Shroff, part of the India Investments team and I will be your host for this podcast.

In the next few minutes, I will share with you our broad economic and market outlook and our investment strategy, followed by a short interview with our guest, Rehan Yar Khan, an entrepreneur since last 30 years and one of the top names in the venture capital space in India. Rehan will share with us his views and insights on the buzzing Indian technology and digital space.

As the first major economy to be affected by the Delta variant, India is also the first to emerge from its impact on economic growth. We see more signs of a tepid recovery taking hold, though whether a sustained pickup in activity is still to be confirmed.

Given that much of India’s inflation is imported, and the exchange rate effect on prices has been limited, there seems little that domestic monetary policy can do to address the issue. Also, the output gap remains negative, pricing power appears relatively weak and fiscal revenues constrained.

The key risk in the short term is an uptick in medium-term inflation expectations, which could create a policy dilemma for the RBI.

While rate hikes may be unlikely soon, the RBI is taking small steps to cut the liquidity provided during the pandemic. We expect the RBI to keep channelling liquidity into the system, especially at the grass roots level.

The RBI governor is committed to maintain the central bank’s growth supporting bias, even at the expense of temporarily higher inflation, in our view.

According to RBI published data, Indian deposit growth has consistently outpaced credit growth. The excess liquidity is being parked with the central bank under the reverse-repo window, earning just above 3%, close to the savings deposit rate for banks.

Bank credit growth remains subdued, probably due to risk aversion. The recent additional measures taken by the government to mitigate pandemic-related stresses in the economy are expected to improve credit flows.

In the Indian bond markets, while G-Sec supply remains high, with the RBI managing the absorption through G-SAP, primary issuances of corporate bonds in domestic market is very low. Overall, local primary corporate bonds issuance in the first quarter of the fiscal year was around 70% lower than last year. This is likely due to volatile markets.

However, we need to factor in the changing sources of funding, especially for stronger Indian corporates, with record international bond issuance this year, growing REITs and InvITs market as well as booming IPO and private equity markets.

Keeping core portfolios invested in high-grade corporate bonds of up to 5-year maturities seems preferable, ideally through a mix of roll-down strategies and actively managed portfolios in this segment.

The credit migration ratio (i.e. upgrades-over-downgrades) in India has seen steady improvement over the last year, improving to 2.08 times for the quarter ending June 2021, compared to 0.36 times for same quarter last year, according to the Prime Acuite Credit Rating Migrations database.

In a “core/satellite” strategy, it may be worth building a satellite fixed income portfolio across mid-yields, high-yields and structured credits at this stage of the broader economic recovery. Although, prudent selection, diversification and monitoring remains key in these strategies.

With the recovery in Indian equities this year, it may be time to review asset allocation and to consider rebalancing portfolios. It might also be worth weighting more to Indian equities using a core/satellite approach, with the satellite portion representing higher risk strategies.

While inflationary pressures persist and have helped topline growth in many sectors, margin compression does not look a significant threat in the near term. Having said that, operating margins seem to be peaking and further earnings growth will probably be driven more by continued sales growth. Superior-quality businesses with a resilience bias, pricing power and ability to acquire market share are well positioned in this respect.

Valuations of Indian equity indexes do not appear to be at exuberant levels. But neither do they seem cheap. Much of the expected earnings revival in stocks due to pent-up demand has likely been priced into valuations. That said, with the lack of alternatives available to investors, as well as supportive liquidity conditions, any market corrections will probably be short and shallow and may offer good buying opportunities.

As the broader economic recovery solidifies, an exciting set of opportunities for satellite strategies in portfolios can be found in the wider equity market. This seems to be especially the case in the small and mid-cap space and in sectors and themes underrepresented in blue-chip indices, like the Nifty50 or Sensex. Some of such sectors and themes include:

• Engineering and capital goods
• Housing sector
• Industrial metals
• Manufacturing in general, but specifically chemicals, textiles, sugar and paper look well positioned
• Financialisation and formalisation theme based plays in the small and mid-cap segment
• Late recovery in sectors such as travel and tourism may also deliver value

Unlisted opportunities continue to attract attention and significant flows, especially in the late-stage venture capital, private equity and the pre-listing market. The acceleration in the progress made by domestic technology and technology-driven businesses during the pandemic is expected to keep the primary markets abuzz for years to come.

To discuss more on this, we have our guest, Rehan Yar Khan with us. After becoming an entrepreneur straight out college almost 30 years back and founding 3 companies, Rehan founded the Mumbai Chapter of Indian Angel Network and co-founded Harvard Angels India. He is a TiE charter member and sits on the Executive Council of Indian Venture Capital Association.

In his 12+ years of start-ups and VC investing experience, Rehan has invested in more than 30 companies and counting on 3 unicorns already. Rehan is the Managing Partner at Orios Venture Partners, investing across early to late stage VC opportunities in India.

Rehan, I remember we first spoke sometime I guess in 2014! This was on some of the then 5-10 year mega trends like Digital Platforms, Direct to Consumer disruptions; Internet Products…these are now ruling the markets and taking over mainstream investing…

So, I’ll start with a repeat of the same question…What are the mega growth trends you see Rehan and which of those is India best positioned to capture in the next 5-10 years?

Rehan Yar Khan (RYK): When we spoke in early 2014, it was yet early days in India's new technology renaissance. We had only had 5 Unicorns. These were in spaces that addressed the top end of the market, because it was the “better-heeled” that were the early adopters of digital in India. Since then and especially in the last 2 years, things have changed substantially:

1. Internet penetration owing to the low cost of data and affordable devices increased and went to the mass of the population;
2. The launch of 4G and the spread of Wi-Fi allowed fast connectivity to the Cloud;
3. Adhaar and Jan Dhan bank accounts helped facilitate KYC for the majority of the population;
4. "Tech" as a definition, went beyond digital access to include areas like EVs, IoT and Robotics.

These factors have swelled the TAM (Total Addressable Market) from around 30M people to 450M; and the fast 4G connectivity has driven applications to the Cloud, allowing for thin clients.

These two factors have caused a surge in the number of unicorns in India to 44 by the end of 2020 and another 18 have already been added this year. From vernacular media to agritech to e-rickshaws to assisted commerce to e-pharmacies and beyond, all kinds of exciting sectors have opened up.

Thus, the major trends we see for the next decade are;

1. Segments lower down the income pyramid will become the largest markets
2. Small businesses will become adopters of technology
3. Hardware start-ups will emerge, not just software
4. Rising GDP will push the upper-end consumers towards more convenience and better for your products.

NS: Everyone’s talking of this huge push that COVID has provided to all things digital and that this being the new normal…how much of it do you think is already getting built into the valuations? What do you think the investors are ignoring?

RYK: Yes, COVID accelerated digital adoption and we are today where we expected to be in 2023. That's a big leap. Almost all large digital businesses are showing 2x sales from a year back, when previously these were growing at 25% to 30% a year.

It's not just consumers, it's businesses as well. To share an interesting example, last year due to lockdown, the Pushkar mela, which is the largest cattle trading fair in the world, was cancelled. Farmers who needed to buy and sell, could not. However, instead of sitting idle, they found apps, where they could list their animals and others could look them up and buy them.

I happened to meet one such farmer in Deogarh, which is a small village in Rajasthan. He was pleased with the apps that allowed him to trade, because otherwise, he would have to go 100 kms. away once a year to Pushkar or pay middlemen 40% cut. Would he go back to Pushkar? He said he was unlikely to, as it was a lot of time spent and now he could trade easily on the app.

As it's been a year since we have seen these kind of deeper adoptions, the VC community has brought them into the TAM calculations, leading to them being priced into valuations.

I believe the community is ignoring what happens to the world when it goes back to normal. The belief is, these trends are here to stay and will not disappear with the lifting of lockdowns. There is a good reason for this. Already we are seeing a global push away from the 9-to-5 office; high street retailers have closed stores en masse; food delivery is becoming a mainstay income for restaurants and many other similar trends.

NS: How to value digital/Internet companies? It’s not easy to digest those loss making, top lines and market share chasing dreamers with hopes to turn profitable! In your investments, how do you manage and monitor these timelines?

Also, What’s the benefit of listing on an Indian exchange versus global exchanges?

What’s the valuation premium between a seed stage, early stage VC, late stage / pre-IPO stages of investing?

RYK: Admittedly venture capital valuations are a voodoo art. Early stage companies have limited revenues and not enough data on company stickiness. Even later stage companies don't have profits, nor are even EBITDA positive. In light of these, the common way of valuing businesses has been on the basis of triangulating market multiples i.e. look the current trading multiples of 10 to 15 companies that share similar characteristics across the world.

Indian companies will benefit significantly from listing on local exchanges. IPOs generate a lot of buzz and that translates into greater brand awareness, which is better for business. When Zomato listed recently, it generated much media attention and in all likelihood helped it win over many new customers.

This same effect plays back in reverse, when people are in touch with companies as customers, they develop a fondness for these companies as investors. This helps the company’s stock.

Thirdly, there is a massive dearth of listed tech stocks in India and that translates into latent demand, providing the stocks with good subscriptions at IPO and thereafter.

It’s hard to say what the valuation premiums are at various stages, but it is generally found that the more established the company becomes, the more premium there is. Usually, at early stages there is scepticism about the idea, so premiums remain on the lower side. However, in late-stage investments, pricing becomes a challenge. Historically many companies that IPO trade below their listing price within a year.

Thus, it is key that late-stage investors get pricing right and ensure there is sufficient margin of safety between them and the listing price.

NS: Rehan, there’s just so much money chasing opportunities across the “technology” spectrum! How do you, your partners and teams that you work with keep yourself grounded and focused on creating and delivering value?

RYK: I would actually say that the Indian tech space is underfunded at all stages. The VC ecosystem is barely 10 years old and the number of firms with operations in India are less than 20, across stages. We can see evidence of this from the all-round strong performance of VC funds at all stages and the massive growth in valuations post listing. In a well-funded market, top-quartile VCs produce stronger returns than the mean and post-IPOs don't produce the kind of pops we are seeing in India.

The perception that India is a well-funded ecosystem comes from the fact that 10 years ago there was almost zero funding available and now there is more, so it feels like there is a lot! However, for a country of India’s size and growth, VC funding to GDP ratio is poor.

That said, the focus is important. One of the decisions we took right at the start of Orios is that we would not do cross border SaaS. That required knowledge, network and experience of international markets. It was a complete space by itself. We also stayed away from doing non-tech consumer brands in India, which are traditional distribution led. Thus our focus is on technology businesses for India in sectors like fintech, heathtech, EVs, NewCommerce, etc.

NS: Finally, what will be your top suggestions to investors in this space on what to do and what not to do?

RYK: The first would be to consider increasing allocations to India Tech. 2021 is the year for IPOs when many unicorns are listing. This is completing the cycle from seed funding to returns for investors. Recent tech listings this year are going strong since their listing dates. With this cycle now having begun, investors have a degree of predictability of returns.

Another factor is that the market for tech in India which is currently at $60bn is expected to be at $180bn in 2024.

When compared to other major technology markets like the US and China, India is considered better priced, thus there is greater margin of safety and downside protection.

However, when investing, concentration in a single stage, such as early stage only or late stage only, are less desirable. It is best that they consider investing across the life cycle of tech companies, from early to late stages. Each stage provides its own benefit, with early stage providing high returns and late stage providing stability and early liquidity.

NS: Thank you again, Rehan, for joining us today.

RYK: Thank you, Narayan, and thanks to Barclays for having me on this podcast.

NS: With this we come to an end of our podcast. Thank you for listening to us. Stay safe and healthy and happy investing.