This regulation was enforced upon identifying that the mutual funds have been misrepresenting their products with the intention of gaining market share of the retail market. During the Indian bull market in 2017 where BSE Mid Cap Index posted a 50% performance, the mutual funds loaded their portfolio with the small and mid-cap stocks to "boost" their returns. The implementation of this regulation started the rotation of funds from the rest of the universe into the top 100 and some into the next 150 (mid-caps) as they scrambled to meet the hard deadline of June 2018, resulting in a massive underperformance of the mid-cap and small cap universe. This was followed by a margin increase in futures & options and then the financial crisis in the non-banking financial space triggered by payment default by IL&FS in October. These events further exacerbated the underperformance of the mid and small cap stocks as investors sought to flight to safety and herded into the performing top 100 stocks.

 

As of January 2018, the entire markets (across market caps) was trading at elevated valuation of close to 30x(TTM PEx). Today the median valuation of the top 100 stocks is close to 25x and the median valuation of the next 900 companies have fallen at an increasing rate as the market cap goes down. There is no correlation of the drawdown to the earnings growth.

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REFORMS AND CORPORATE CLEAN UP

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India has significant parallel economy (operating informally by escaping taxes( in almost all industries. In some industries it is as high as 70% of the industry. The government has over the last 5 years taken strong structural steps that has made and will make it extremly difficult to avoid taxes. 

 

Below are some updates on key implementations.

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• Over 1.3 Billion people have been digitally authenticated and over 305 Million new bank accounts have been opened under the 'Aadhar' (unique ID card) and 'Jan Dhan Yojana' (debit card) implemented by the government

• India is undergoing massive raids by the income tax authorities on businessmen who were notorious in avoiding taxes and who accumulated huge illegal wealth

• Along with digitization, demonetization and GST (Centralized and Online Goods & Services Taxes) are making the economy more formal and increasing the tax compliance

• Strict actions have been taken against the rating agencies and auditors to significantly improve quality/authenticity of the financial statements and debt risks

• Government along with RBI has implemented big reforms in the banking sector, especially the ones states owned

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Many founders in collaboration with the banks, ratings agencies and auditors gold-plated project costs that needed funding This enabled debt approved much higher than the actual project cost. The excess money was siphoned off through shell companies into the pockets of the above parties. The result was founders and other service providers enriching themselves and the shareholders ending up holding unviable projects that couldn't service the debt.

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With the abovementioned reforms and clean up, the modus operandi has been broken. It will be extremely difficult for such founders to succeed in the reformed system thereby providing the genuine entrepreneurs a level playing field. This is going to be a massive change that will reshape how India corporates work and succeed. We expect that many of the poor-quality companies will perish and the good quality mid and small cap companies will grow at super-normal rates to becoming large caps. These should be the companies investors be betting on.

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Government reforms are targeting reduction in cost of doing business in India. The result so far has seen stagnant (or lower) land prices in the last 6 years, low interest rates, availability of electricity at reasonable rates and faster approval of permits to start a business. As US and China Engage in trade war, customers worry about one country sourcing and plan to diversify their vendor base going forward. Chemical industry is already seeing huge momentum from such shift as many companies in that industry (all mid-small caps) growing at well above 20% earnings growth over the last 5 years. India is full of extremely smart and ambitious entrepreneurs and if a level playing field is made available to them, they can create globally competitive companies as already evident in the Chemical, Pharmaceutical and IT space.

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The Opportunity For Alpha