INDIA’S CHANGING MINDSET

Investment Team Travelogue

2 | Investment Team Travelogue: India

Tectonic Shifts in a Digital World

India is full of economic and social contrasts. Cows still wander in chaotic urban traffic even as auto sales surge and domestic airplane travel takes off. Poverty remains a persistent challenge, but Indians are getting biometric IDs and tens of millions are moving into the middle class every year as unprecedented financial and digital-era reforms dovetail and take root.

Things are undoubtedly changing in the world’s largest democracy. While debate swirls in the short term about the spotty execution of crucial tax and currency reforms, the overar-ching goals of transparency, efficiency, and financial inclusion are not just feel-good phras-es. As citizens gain access to the financial system and education, and digitization expands commerce, new ventures are sprouting and greater opportunities for existing businesses are growing.

Disciplined, long-term investors should take note of the tectonic shifts. Thornburg Equity Research Analyst Sachin Kashyap recently traveled from Punjab to Jaisalmer for a family wedding and to Mumbai and Delhi for business meetings. He was reminded that decisions about money are still very local, and community matters when it comes to business mod-els. He brought back with him observations that help Thornburg’s team think deeper about the broad trends and hone in on themes, sectors, and stocks, as the timing suits.

Kashyap sees Indian equity opportunities in three main buckets: financial institutions, telecom, and information technology services. Here are excerpts from a conversation after his travels through the desert, discussions at family meals, and meetings with clients.

Sachin Kashyap, Equity Research Analyst

Q&A with Sachin Kashyap | 3

Q: How healthy is India’s economy?

Sachin Kashyap: India’s underlying economy has meaningfully improved over the last five years. Real gross domestic product (GDP) growth hit 7.1% in 2017. The country is running incrementally lower budget and current account deficits, and the current account gap is far more than covered by capex inflows. Moreover, the country’s total non-financial debt load amounts to 125% of GDP, less than half of China’s 257%, and well below the 192% and 277% that emerging markets and advanced economies, respectively, are carrying. And inflation has cooled to 3.3% from more than 10% in 2013.

Foreign investor confidence in the rupee increased sharply as a result of inflation- taming initiatives by former central bank Gov. Raguram Rajan. It was shaken in late 2016, when Prime Minister Naren-dra Modi ordered the replacement—without warning—of older, high-denom-ination currency notes with newly minted ones. The intent was to eliminate untaxed, unaccounted-for “black money” from the system, which had fueled shadow banking, tax evasion, and an illicit economy accounting for anywhere from 20% to 40% of GDP. There were a lot of howls, but the collateral damage wasn’t as severe as critics expected.

It was disruptive, though. On the positive side, bank deposits increased 4.4% during the exchange period. Still, as 99% of the high-denomination bank notes in circulation were turned in to banks and exchanged, it suggests unscrupulous individuals in illicit businesses found ways to move their wealth elsewhere. It’s nonetheless commendable that Modi undertook the “demonetization,” as it’s called.

That initiative was part of a broader program that involves major financial inclusion initiatives, all happening simultaneously. India’s Aadhaar, a unique ID system that is tied into three biomet-ric data points, has provided a first step for previously untracked individuals to access government benefits and open bank accounts. Then there’s the Goods and Services Tax (GST), which is creating a self-reinforcing mechanism,

encouraging merchants to do business with documented taxpayers. And perhaps most importantly, previously disadvan-taged groups, including Indian women, are opening individual bank accounts, which are accessible via mobile connec-tivity. For the first time, many directly receive welfare and other types of payments, and even credit, and have a degree of financial security.

Q: How has Universal ID provided access to previously underserved groups?

SK: Historically, government benefits—pensions, food subsidies, etc.—generally flowed to households, which are usually led by males. In many instances, mid-dle-men in local towns would disburse benefits, opening the door for potential abuse. Similarly, credit decisions were made based on lenders’ biases toward applicants, as opposed to objective data. By providing a means of proving identity, previously untracked individuals can open their own bank accounts, receive benefits directly, pay taxes, and build credit profiles over time. The Credit Information Bureau of India (CIBIL) has advocated for the use of Aadhaar in credit decisions. You can imagine how availability, access, and documentation enhance the opportunity for women, especially those most at risk.

There are many at-risk groups in India, and the country has a long way to go. If you google “Aadhaar,” you will find websites that claim that the country is invading women’s privacy. They provide patriarchal husbands ways to track their wives. Consider the absurdity of this view—it’s like saying the keys to unshackle your chains are a threat to your

freedom, because it might upset your jailor. As in many cases, the challenge is in the mindset. That will take time to change. But now the infrastructure is there for the change to take place.

Q: In what ways is this new ID system important for India’s financial institu-tions?

SK: One of the themes in emerging markets is the use of data to drive multi-generational leaps that can solve real problems. Credit availability is one such problem. Banks and non-bank financial institutions can use Aadhaar to collate data on an individual. An individ-ual Aadhaar number is linked to a CIBIL credit score, like a FICO score in the U.S. Most rural Indians may not have a CIBIL score, and so Aadhaar is simply a way of tracking them. Lenders are only willing to make small loans until you can prove timeliness and credibility of payment.

Coming back to your question, consider the core activities of a lending institu-tion—underwriting, monitoring, and collection. In the case of underwriting, knowing whom you are lending to is not possible without ID and is made easier if you can use standardized credit scoring for that individual; in the case of moni-toring, you now have additional data points from other lenders that can allow you to more efficiently assess risk in your loan portfolio; and, in the case of collection, you have a non-violent threat to enforce collection—the ability to record a past due or unpaid account in someone’s CIBIL score. We often hear stories from lenders about how much collection has changed. One bank

“One of the themes in emerging markets is the use of data to drive multi-generational leaps that can solve real problems. Credit availability is one such problem.”

4 | Investment Team Travelogue: India

mentioned that it used to send someone into the community in brightly dressed colors who would loudly call out the name of the past-due debtor, shaming him into paying the collector.

One of the largest financing events most people face is borrowing for a home purchase. While most skeptics view demonetization as a failure—again, as all the cash came back into the sys-tem—heightened fear of the tax man is now discouraging people from using black money in housing purchases. Previously, buyers and sellers would lie about the transaction price of a home to avoid a “stamp duty,” a tax of up to 10% on the selling price. Sellers would take more cash and less formalized payment— including mortgage-sourced funds, which are closely tracked and reported—to decrease the stamp duty. The effect is a housing market where much of the purchase price is paid in cash; this effectively locks out individ-uals who do not have a lot of money. But now that individuals are wary of a more stringent tax collector, people are more hesitant to lie about purchase prices for fear that they may be pros-ecuted. This means more formalized borrowers can enter the market with a lower effective down payment. Here again, and I can’t say it enough, the change in mindset is monumental.

Now what other opportunities open up to a family with a mortgage? The bank can see if it’s paying on time, can offer other lending products, or possibly insurance, wealth management services, or even non-financial products. Mortgage customers are very profitable for banks because the capital requirements to lend are low and the opportunity for addi-tional sell-through is high.

One company using novel tools to acquire customers is Bajaj Finance. It’s well known for consumer goods and “two-wheeler” motorbike loans. By using data and a tremendous amount of customer centricity, Bajaj has developed a platform with very low customer acquisition costs. So take a potential washing machine purchase: if Bajaj has relevant data, it can “text a loan” to a potential customer, and the customer

can accept the loan offer over the phone. The washing machine salesperson handles the rest. Bajaj is a very interest-ing business. It’s currently working toward entering the mortgage business. We don’t own Bajaj due to the lack of a strong deposit franchise, which we think needs to strengthen before we can safely deploy investor capital.

Q: The 2017 Goods and Services Tax (GST) has required a massive upheaval of existing record keeping for businesses to comply. What opportunities or challenges does this create?

SK: The GST is an important step forward for India. It consolidates certain taxes and is levied when something is sold. GST is applied through the supply chain and is creating the right incentives to drive compliance. For example, the calculation of GST owed by the retailer starts with the value of the goods sold to a customer, then deducts the GST paid by the wholesaler. This means the retailer will request appropriate GST documen-tation when purchasing goods from a wholesaler, otherwise the retailer will get stuck with a tax bill on the entire value of the goods sold, rather than the incremen-tal retailer profit. So now you have more tax compliance and an increase in tax collections and more formalization and less ability to work in the informal sector. Formalization makes it harder to have undocumented labor without benefits. Once again, a new system is a catalyst driving a change in mindset.

Q: Where does this create an investing opportunity?

SK: One is cigarettes. At Thornburg, we are moving away from sin categories like alcohol and cigarettes. But ITC, which is based in Kolkata, is India’s biggest cigarette manufacturer and most of its profits come from cigarettes. The company is vertically integrated, from leaf to wholesale. There are two alterna-tives to cigarettes: the bidi, a popular hand-rolled cigarette available on the street from small vendors, and it isn’t documented or taxed; and cigarettes that are illegally imported and sold by retailers. They aren’t taxed along the supply chain, and are cheaper than formally manufactured, taxed cigarettes. After the implementation of GST, the seller of illegally imported cigarettes will have to pay the full GST, because the retailer won’t get credit for the wholesal-ers GST. This drives up the prices of illegal cigarettes, reducing cigarette consumption. But it also moves market share back to formal economy cigarettes, which benefits ITC. And ITC is rein-vesting profits from its cigarette business into a household and consumer goods business, which is booming as India’s middle class expands.

Q: You call the expanding presence of banks in India’s daily life “financial-ization.” Explain the benefits.

SK: Financialization is a broad term, but it really means the inclusion of individu-als in the formal financial sector. It doesn’t necessarily mean they have bank accounts. But those who do are also gaining more access to services such as insurance and wealth management. As the cost of doing business goes down

“The Goods and Services Tax is an important step forward for India. It consolidates certain taxes and is levied when something is sold. GST is applied through the supply chain and is creating the right incentives to drive compliance.”

Q&A with Sachin Kashyap | 5

through scaled technology platforms, “financialization” is really driving access to reasonably priced risk management products, such as life insurance, or to wealth management products to help them save for the future.

Q: Where is the investing opportunity in the context of financial reforms?

SK: Well, a lot of small changes are together changing the broader financial sector. We talked about the universal ID, the GST, and demonetization. But there’s also the recapitalization of public sector banks, which are collectively called PSUs (public sector undertaking). India’s PSU’s have traditionally been used to implement public policy–lending to certain indus-tries, or classes of individuals. While many talented and honest individuals work at the PSU, the structure of these banks has allowed capital to be lent to borrowers who have no intention of repaying loans. Since taxpayers are the ones recapitalizing the PSUs, they’re effectively financing the unscrupulous borrowers. So two things needed to happen. First, the recognition of bad loans, which was hard since it would force collection, harm relationships, and crater their capital. But “extend and pretend” on bad loans only made the problem grow. So regulators forced the banks to identify and ring-fence these loans, and collect, sell, or write them off as needed. The second thing was the recapitalization of the PSUs so they could lend again. This helped the banks get back on their feet,

supporting the money multiplier. A 2016 bankruptcy law that expedites insolvency resolutions has also facilitated credit growth. These banks are now in better position to take on risk by lending to bona-fide, good-faith borrowers.

When we look across India’s banking sector, we focus on finding franchises that can compound capital over time. From balance sheet and risk management standpoints, they should be positioned to weather the inevitable economic storms. They should have strong deposit fran-chises, prudent underwriting, and management teams that are thinking three or four steps ahead in terms of the additional opportunities to provide services to their current and future customers. HDFC Bank has been one of our long-term holdings. While very well known as one of the highest-quality banks in India, bank profitability is

growing through less traditional avenues as well, such as HDFC’s credit card portfolio. We also own ICICI Bank, which has gone through a series of challenges as it cleaned up its balance sheet. The management team, underwrit-ing, and deposit franchise are actually quite strong, and we think the market underappreciates the ability for ICICI to compound capital over time.

Q: In India, many people who never had a land line now have a cellular phone. Data access is increasing and costs to consumers is low, yet there is still a need for investment. Where do you see the opportunity in telecom?

SK: People in India have really cheap access to data at 250 rupees ($3.85) per month for several gigabytes of data. The impact of cheap data is really compel-ling from an investment standpoint. To understand where the opportunities are appearing, it’s important to understand how we got here. India used to be served by eight major telecom companies and a number of smaller local players, and most underinvested and were subscale. Reliance Industries, which owns the Reliance Jio telecom network, decided to invest in excess of $30 billion to build out India’s 4G networks. With industry profitability crumbling under Jio’s aggressive pricing, India has seen a consolidation of its telecom networks into three players, and possibly going to two. The results are lower pricing for the average Indian and more rationally deployed spectrum, and the remaining operators for the most part have the balance sheets to invest in their networks.

“GST means more tax compliance and an increase in tax collections and more formalization and less ability to work in the informal sector. Formaliza-tion makes it harder to have undocumented labor, meaning workers below minimum wage. Once again, a new system is a catalyst driving a change in mindset.”

“When we look across India’s banking sector, we fo-cus on finding franchises that can compound capital over time. From balance sheet and risk management standpoints, they should be positioned to weather the inevitable economic storms. They should have strong deposit franchises, prudent underwriting, and management teams that are thinking three or four steps ahead.”

6 | Investment Team Travelogue: India

The market looks like it may become meaningfully more profitable once pric-ing returns to normal levels, which would be multiples of where prices are now.

Keep in mind that fixed-line networks are sparse in India. So with cellular data, Indians are gaining access to media content, which could previously be delivered only through expensive local cable operators. And critical services like banking can be digitized, and then there’s growing e-commerce. FlipKart, in which Walmart is buying a 77% stake, and Amazon are going head-to-head in India, thanks to mobile connectivity.

Q: Where does India stand relative to China in telecom?

SK: One of the most important assets in any wireless network is spectrum. In India, spectrum is owned by the govern-ment and auctioned to the telcos at nosebleed prices. In China, the govern-ment allocates spectrum without a bidding process. China’s three telecom operators—China Mobile, China Unicom, and China Telecom—have been investing heavily in 4G infrastructure since its introduction in 2010, whereas India’s data networks have only recently developed amid the sector’s consolida-tion. The opportunities are different. State-owned China Unicom, for exam-ple, has seen the country’s internet giants take stakes and board seats, incorporat-ing profitability incentives and more rational capital allocation. In India, prices are temporarily depressed due to competition, but we think prices will eventually rationalize to a level appropri-ate for profitability on the immense capital invested. This is part of the reason for our position in Reliance Industries.

Q: What surprised you during your trip?

SK: You can go anywhere you want in India by plane, and it is super-cheap. You jump on SpiceJet or IndiGo airlines, India’s equivalents of Southwest Airlines,

and they are quick and reliable. People who were taking trains or cars can fly. It is also much easier to own a car, and there are a lot of first-time car owners. For Maruti Suzuki India, the automobile manufacturer majority- owned by Japan’s Suzuki, a third or more of sales of certain models are first-time car owners. In Bombay and Delhi the pollution is already pretty bad from autos, motorcy-cles, and other sources. So one question obviously involves the opportunity for electric vehicles (EV) in India. It’s still very expensive to purchase an EV, and the recharging infrastructure doesn’t really exist. And most of India’s electric energy comes from coal. But people still have better transportation options than they ever have before.

Q: There are still profound problems in India, especially for the poorest people. How do you address that as an investor?

SK: India is making leaps in progress. And this all comes back to mindset. Tax compliance is increasing rapidly as enforcement rises and more and more transactions take place in the formal economy. Indians are accessing the internet en masse and experiencing new ideas for the first time, shaping the cultural discourse. Aadhaar is creating a means to prove your identity and provid-ing a path for financial independence and access to financial products like loans and

insurance, and both trends are increasing risk taking and entrepreneurship.

To be sure, India remains a wild and amazing country full of rich history and optimistic people. There’s no way 1.3 billion people could coexist otherwise. It also has hundreds of millions who lack basic services. But as access increases, productivity will grow and the ingenuity among so many Indians will unleash ever more upward mobility, expanding the country’s middle class. Age-old norms will be increasingly challenged. This is why we are positive on India’s long-term structural prospects. Understanding the big picture while undertaking bottom-up research can help identify many great long-term investment opportunities. n

Sachin Kashyap is an equity research analyst for Thornburg Investment Management. He joined the firm in 2017. Sachin earned a bachelor’s degree in business administration from the University of Colorado Boulder and holds an MBA from the University of Chicago Booth School of Business. Before joining Thornburg, Sachin was part of the equity research team at Janus Capital Group, where he covered European Telecom & Media, US Autos, and Consumer Discretionary equities. Prior to that, Sachin was a manager in PwC’s Capital Markets practice, where he advised clients on due diligence, valuation, and SEC reporting matters.

“India has hundreds of millions who lack basic services. But as access increases, productivity will grow and the ingenuity among so many Indians will unleash ever more upward mobility, expanding the country’s middle class.”

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PORTFOLIO WEIGHT OF COMPANIES MENTIONED AS OF 3/31/18:

Amazon, Inc.: Thornburg Core Growth Fund, 3.27%; Thornburg Long/Short Equity Fund, 1.47%

China Mobile, LTD.: Thornburg Developing World Fund, 2.12%; Thornburg Investment Income Builder Fund, 3.55%; Thornburg Long/Short Equity Fund, 2.45%; Thornburg Value Fund, 2.55%

China Unicom Hong Kong, LTD.: Thornburg Developing World Fund, 2.13%; Thornburg International Value Fund, 2.91%

HDFC Bank LTD: Thornburg Developing World Fund, 2.84%; Thornburg Core Growth Fund, 2.09%

ICIC Bank, LTD.: Thornburg Better World International Fund, 1.79%; Thornburg Developing World Fund, 0.90%

ITC, LTD.: Thornburg International Growth Fund, 1.71%

Reliance Industries, LTD.: Thornburg Developing World Fund, 2.89%; Thornburg Global Opportunities Fund, 4.16%; Thornburg International Value Fund, 2.65%

Walmart, Inc.: Thornburg Core Growth Fund, 2.09%; Thornburg Long/Short Equity Fund, 2.50%; Thornburg Value Fund, 2.52%

Companies mentioned in the article but not listed above were not held in the Thornburg funds as of the 3/31/18.

8 | Investment Team Travelogue: India

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Goods and Services Tax (GST) — An indirect tax (or consumption tax) levied in India on the sale of goods and services. GST is levied at every step in the production process, but is refunded to all parties in the chain of production other than the final consumer.

Fair Isaac Corporation Score (FICO) – A type of credit score created by the Fair Isaac Corporation. Lenders use borrowers’ FICO scores, along with other details on borrowers’ credit reports, to assess credit risk and determine whether to extend credit.

Public Sector Undertaking (PSU) – A state-owned enterprise in India owned by the union government of India, or one of the many state or territorial governments, or both. The company stock needs to be majority-owned by the government to be a PSU.

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