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April 21, 2019

India: Tourists See One of Seven Wonders, Investors See the Eighth

“The world is split into two parts, those that have seen the Taj Mahal, and those that have not.”
 - Mark Twain

Compound Interest is the eighth wonder of the world.”
- Albert Einstein

As you may know, Lauren Templeton serves on the Board of Directors of Fairfax Financial Holdings, a large Property and Casualty Insurer holding company based in Toronto, Canada. Fairfax is known for its similar business model and financial performance to the U.S. based conglomerate Berkshire Hathaway. More specifically Fairfax is highly regarded for the role of its investment portfolio returns as a key factor supporting its 17.1% annualized share price return over the past 33 years[1]. Fairfax’s returns are attributable to the investment acumen of its CEO, Prem Watsa and his equally skilled team of experienced colleagues.

In December of 2014, Prem and his team spotted an intriguing long-term investment opportunity in India, precipitated by the election of free-market reformist Prime Minister Narendra Modi. Prime Minister Modi was elected based on the promise of higher economic growth and less government corruption, evidenced by his successful 14-year run as Chief Minister of the Indian state Gujarat. Fairfax’s venture, called Fairfax India, is a holding company listed on the Toronto exchange established to make controlling or substantial investments in the Indian growth story. Over this time period India has (somewhat quietly) become home to the world’s top performing stock market over the past five years (per FactSet data), measured in USD. We believe Prem and his Fairfax India team are uniquely positioned to generate attractive long-term investment returns through a combination of investment skill and local knowledge, underpinned by Fairfax’s existing close relationships with business leaders and policymakers across India. Fairfax India is led by Prem’s longtime (several decades) colleague Chandran Ratnaswami. Coincidentally, within the past twelve months, Lauren also joined the Board of Directors of Fairfax India. So, when the opportunity arose to travel to India alongside 40 other institutional investors visiting and meeting with Fairfax India’s investee companies this past January, we jumped at the chance.

The trip spanned nearly 10 days and Prem’s promise of “the trip of a lifetime” held true. Thankfully the trip was organized and led by one of Fairfax Financial’s holdings, Thomas Cook India, as it quickly became clear that local knowledge is needed in all areas concerning India, whether investing or traveling. The trip included visits to New Delhi, Agra, Jaipur, Bengaluru (formerly Bangalore), and finally Mumbai (formerly Bombay). Beginning with dinner at the home of the Canadian High Commissioner (Ambassador) to India, Nadir Patel, it also became readily clear that the Indian business community recognizes the critical role of outside capital in sustaining India's world-leading growth rate in GDP. Indian hospitality was infectious: warm welcomes, feelings of optimism, and pride in Indian culture permeated the trip.

India’s welcoming atmosphere stood in obvious contrast to the continued media reports of the West's fraying and increasingly contentious relationship with China, punctuated by the CFO of Huawei's arrest and surrounding accusations of spying by the Chinese telecom giant. The contrasts do not necessarily end there, as India's foreign diplomacy, and relations convey a non-threatening objective towards assimilating among the world’s superpowers versus replacing them. Former Indian Foreign Secretary (2004-2006) Shyam Saran who played a significant role in the negotiation of the country’s U.S.-India Civil Nuclear Agreement is quoted as saying, “India is not looking itself at the center of the universe, but at the margin, aspiring to get to the center.” This contrasts China reference to itself as “The Middle Kingdom” or in other words placing itself at the center of the universe[2]. Mr. Saran pulls philosophically from the ancient Indian text on statecraft named Arthashastra (that draws parallels to influential writings from Machiavelli and Sun Tzu[3]), and for that matter, the Arthashastra has maintained a heavy influence among Indian diplomats, politicians, and scholars. Based on this reasoning, India’s foreign policy of non-aggression, including political autonomy and non-alignment that has been in place since its independence, seems institutionalized and likely to persist. In sum, we believe India’s foreign policy objectives foster a constructive backdrop for relations with the West. Conversely, the West's range of perception surrounding China's foreign policy objectives spans from murky to negative. The negative view seems to be driving U.S. policy for the moment. In sum, India looks like a more natural partner with U.S. leadership (present and future) for commercial and diplomatic interests.

In light of the above, if India’s growth story falters or becomes sidelined, the factors seem likely to come from within its own borders. The country’s experience through colonization under Great Britain left complicated scars. Following its independence in 1947 India basically withdrew from global commerce, and Gandhi's handpicked successor Prime Minister Nehru chose an economic path of socialism as a measure to install a form of nationalist protectionism—Indian control over the economy. This seems likely owed to a public recognition that British colonization came under the commercial guise of trade with the East India Company. From the point of independence until the eventual bankruptcy of India’s closed-off socialist economy in 1991, the narrative of capitalists as exploitative held an audience. Thankfully, much of that has changed. Beginning with market reforms in 1991 and the burst of growth that followed, Indians have increasingly witnessed the effects of capitalism and economic growth as the antidote to poverty. Modi’s election in 2014 was based on the promise of accelerating economic progress and providing relief from the state’s often corrupt but consistently suffocating bureaucracy where seemingly every commercial activity required a permit or a bureaucrat’s approval. In the five years since progress has surfaced. The most recent evidence came through the World Bank’s “Doing Business 2019” report that revealed India has climbed 23 spots year-over-year to rank 77 out of 190 countries. Key improvements underpinning the higher ranking included easier processes for obtaining construction permits, paying taxes, and cross border trade. Moreover, amendments to the country’s insolvency and bankruptcy code provide better protections for secured creditors, which helps further grease the wheels of capitalism (and economic growth). In sum, the above-mentioned changes are helping propel India with the world’s fastest economic growth among large countries. For instance, India posted 7.0% real GDP growth in 2018, more than twice the 2.9% growth witnessed in the U.S. and above China’s estimated 6.5% growth. Based on these developments, Indians are experiencing the benefits of pro-growth policies and do not seem likely to vote for alternative policies (irrespective of the leader). Our general view is that Modi will be reelected, but with the loss of a legislative majority, and therefore a coalition government. We can never rule out surprises in politics, much less Indian politics, and with that in mind share price volatility surrounding the election (positive or negative) is always possible.

While the high growth rate and improving business conditions that support it are obvious points for discussion, we believe the real story lies in the factors driving this growth, as they have no real precedent in the development of an emerging economy.

The real story in our mind is the role of technology in developing both the public and private sectors of the economy. In simple terms, the information technology industry contributes 7.7% of India’s GDP, while the U.S. compares at 5.5% of GDP. Put differently, India is the first developing nation whose economic backbone is primarily technology driven. This model contrasts with the more familiar industrial models of Japan and China whose economic growth was initiated on the manufacturing basis of low-cost labor and the export of cheap goods to the developed world. That growth model can work well for a few decades, but labor costs are eventually arbitraged across the developing world thus presenting a challenge to the industrial export model of China and Japan to maintain their previously high levels of economic growth. India’s weaker manufacturing base (and therefore exports) can easily be traced back to its aforementioned brand of socialism that placed caps on the size of manufacturers, and also kept trade mostly closed during the late 20th century, while Japan and China feverishly constructed the supply chain to the Western consumer. So, while India will either have to import and/or further develop its industrial base to support its growth, its primary economic engine of technology is shockingly dynamic, evolving, and deeply competitive. Our reference to the role of technology in rapidly evolving both the public and private sectors was based on firsthand observations of this transformative insurgence.

In regard to this transformation, a quick example comes to mind. One of Fairfax India’s holdings is a 54% stake in the Bangalore International Airport (BIAL), where we were fortunate enough to have a site visit and presentation from management. Bangalore, renamed Bengaluru (in 2014), is widely regarded as the technology hub of India, akin to Silicon Valley. BIAL is the second fastest growing airport in the world, and for its part was a clean, modern, and visually appealing site offering a looking glass into India’s future. We were impressed with Fairfax India’s prescience and skill to purchase the airport of a global technology hub for a P/E of 9.7x and a price to free cash flow multiple of 8.4x. When we returned to the airport the following morning to depart for Mumbai, more than 40 of us predictably went through the sometimes-awkward ritual search for our paper travel documents. During that moment, it was easy to recall BIAL management’s discussion from the previous day that it was only weeks away from installing facial recognition-based security for airport check-in alongside the three other major Indian airports. Do not worry though fellow traveler, a similar goal has been set for the top 20 U.S. airports…hopefully ready by 2021. India’s facial recognition airport check-in leverages its national biometric identification program named Aadhaar, which has already logged approximately 1.2 billion Indians in its government system. Originally designed to directly distribute government welfare transfers into the bank accounts of impoverished Indians (and eliminate “seepage”), the Aadhaar system is emblematic of India’s technology strength. As we will see later in the discussion, Aadhaar is initiating profound shifts in India’s economic progress that create leapfrog effects for its growth trajectory. We see Aadhaar as readily analogous to the U.S. constructing its railroads or the interstate highway system.

Aside from BIAL, we see broadening evidence of India’s growth story being supported by its advanced technology base. Take for instance that in 2014, Indian scientists sent a satellite named “Mangalyaan” into orbit around Mars for a cost of $74 million. While true that NASA did the same with its Maven Mars orbiter, its cost was approximately $672 million. For that matter, it cost the Indians less to send a satellite into orbit around Mars than it did for Hollywood to make a movie about Mars: The Martian starring Matt Damon carried a budget of $108 million.

Returning to the private sector, we observe similar cost efficiency and streamlining built on India’s tech foundation. In this case, the opportunities are being created through the country’s rapid adoption of internet and mobile phone use. For instance, the growth of internet users in the country has ascended from a reported 5.3 million in 2000 to an estimated 627 million in 2019. At the same time, the growth in internet use is keeping pace with the growth in mobile phone use. In this case, however, iPhones costing $999.00 are mostly absent as Indians prefer budget-friendly smartphones from Xiaomi and others that cost as little as $62.99, which helps drive a projected 829 million smartphones to be in use by 2022 (up from 20 million in 2000). Not surprisingly, India's top three e-commerce platforms have higher sales than India’s top ten offline retailers. For anyone following the constant war between Amazon and Walmart, India represents perhaps the highest stakes battleground, where Amazon is the largest retailer. However, Walmart entered the market aggressively with its $16 billion purchase of local e-commerce leader Flipkart in 2018. While Amazon remains the larger of the two measured in gross merchandise value ($7.5 billion versus $6.2 billion for Flipkart), it is also clearly getting a tough lesson in the complexity of doing business in India as its legal and professional fees are running nearly twice the rate of Flipkart’s (20% vs. 12.4% at Flipkart). Similarly, Amazon is investing an estimated $5 billion into Indian infrastructure in order to better facilitate deliveries, etc., where roads, warehouses, and Google map coverage are all less reliable in India’s rural landscape. In contrast, Flipkart is seeking permission from the Indian government to deliver by drone. Irrespective, it is estimated that the two firms control 80-85% of the online retail market in India. While both Amazon and Flipkart may both do well in India over time, our reference to Amazon’s challenges in navigating India is familiar to us as a common theme in emerging markets. From our perspective, it is helpful to partner with firms possessing a foundation of local knowledge complemented by strong market positioning. These positions have often been gained through a longstanding presence in the market; and can occur irrespective of the headquarters domicile.

Turning to India as it relates to our portfolios, the above-mentioned factors, including our preference for quality and growth at a bargain valuation, led us to add or in some cases increase our longstanding holding in HDFC Bank, Ltd. of India during the sell-off of 2018. For background, we have held HDFC Bank for the past eight years in our international strategy portfolio but had mostly resisted adding it to our remaining portfolios on the basis of its relatively high valuation. During the market sell-off of 2018, that variable changed though, and we added the position to remaining client accounts on the basis of its newly attractive valuation paired with what we believe is a quality firm, with already impressive, and yet improving, growth prospects.

In many ways, we believe HDFC Bank's development during the past ten years is mirroring the technological progress witnessed in other sectors of the economy. For instance, in 2008, 43% of its customer transactions were initiated through its branches, with the remaining 40%, 14%, and 3% captured through ATMs, telephones, and finally internet and mobile respectively. In 2018, 85% of the bank’s transactions came from internet and mobile, with the remaining 6%, 1%, and 8% coming from ATMs, telephones, and branches, respectively. For comparison purposes, our study of banking surveys from PWC and Pew suggest that 51% of U.S. consumers bank primarily online. While online and mobile banking is also growing rapidly in the U.S., we do not expect it to catch up to India’s levels anytime soon as U.S. banking surveys also reveal that while U.S. consumers increasingly bank online, the majority want continued access to a branch. While the data is insightful, the services surrounding HDFC’s digital experience are more impressive. The bank was the first to launch a social media banking bot called OnChat that allows customers to transact through Facebook Messenger. Through OnChat HDFC’s customers can use a chat box to pay bills, check stock prices, and book cabs, hotels or even movie tickets. If OnChat is not a good fit, customers can simply ask their Google Assistant or Alexa to speak with HDFC Bank, or even check the interest rates available on various loans. Customers can also access “Insta Alerts” that keep them notified of any and all transactions in their account 24/7. Through these services, HDFC is also collecting valuable information regarding customers that increases its future service levels, as well as its ability to offer products (i.e., insight into creditworthiness). On this basis, HDFC has strengthened its market-leading position by eliminating paperwork and offering a "10 Second Loan" to pre-approved customers. Basically, these customers can request a loan and have it funded in real time, and the same service can be provided for credit cards through a virtual InstaCard that is instantly activated and ready for use. After cycling through the bank’s digital service offerings, it would be easy to forget we are discussing a bank. The more important takeaway though is that we are discussing a bank that is leveraging technology to create a pleasing customer experience, and in doing so, we believe is winning on multiple fronts. Compared to the average Indian’s daily experience with bureaucracy, processes, and paperwork, HDFC’s service innovations have found a steadily growing audience. For evidence, the firm’s market share of 0.8% in 2000 has steadily climbed to 6.4% as of 2016, placing it second highest in the market. Moreover, the firm's emphasis on digital service has lessened the traditional model's burden of opening ever-increasing numbers of branches in order to grow. On this last measure, loan growth has expanded with lesser capital outlays, which helps bolster an already impressive level of profitability measured through return on equity (ROE). For evidence, consider that HDFC Bank’s 2018 return on equity was 17.9%, which compares favorably with the U.S. median bank ROE of 11.6% for the same period. The bank’s growth and profitability have translated into annualized dividend growth of 22.6% during the past 10 years.

Despite its impressive growth and track record, we still believe the bank, much like India, is in its early innings of growth. As a simple illustration, India’s per capita GDP is currently $1,939 compared with $8,827 in China, and $59,532 in the U.S. In keeping with our discussion of technology and digitization in India, we see economic growth over the next 5-10 years being supported by the underlying growth in digital payments. Likewise, we believe this growth will also significantly benefit HDFC Bank, along with consumers, retailers, etc.

Incidentally, the country’s Aadhaar program has paved the way for a sharp acceleration in the pace of commerce across India thanks to the growth in digital payments. Much like in China, however, the growth in digital payments is being fueled by global tech giants, rather than traditional financial players. In the same quick breath, however, unlike in China, the global tech firms must partner with existing Indian financial institutions that have a strong digital presence, and as we discussed earlier, HDFC is key among them (in our view). This is owed to the role of the Indian government and innovative banks like HDFC joining to construct the payment infrastructure, allowing them to become quick incumbents. In this framework, digital payments are transacted through popular apps from Google (Google Tez) and Facebook (WhatsApp). The introduction of Google’s payment app in September 2017 drove an exponential increase (8x) across India’s digital payment system (UPI) in only four months’ time. Despite the immediate growth, we believe India’s digital payment system has the potential to develop for years to come given that cash share in Indian transactions is currently around 70% in value and 90% by volume. In terms of defining growth, industry analysts at Credit Suisse forecast the size of this market to reach $1 trillion over the next five years from its current level of $200 billion. Estimates are guided in part through the observation of digital payment growth in China, which is more developed compared to India in this regard, while also being facilitated through e-commerce and social media platforms (i.e., Alibaba’s Alipay, Tencent’s WeChat). The other big piece of the digital payments growth story, and for that matter, a big piece of India’s growth story, is its so-called “demographic dividend.” Based on the China experience, digital payment adoption accelerated on the basis of mobile phone adoption, as well as young people entering the workforce. While we have already covered mobile phone growth, over the next 15 years 375 million Indians will reach the 25+ age group and further populate the Indian workforce, based on UN data. In a simplified macroeconomic context, this also means that India will carry the distinction of having a working-age population larger than its non-working age population, providing contrast to developed world economy demographics in the decades to come, including some more extreme cases such as Japan where there is an expectation for 58 non-working people per 100 as soon as 2025. Nevertheless, we believe the growth in digital payments provides another significant growth opportunity to HDFC over the next 5-10 years. Our rationale is based on HDFC’s already leading market share of digital transaction payments in India with 28% market share in credit card spends, and 20% of mobile transactions. We believe the firm’s early adoption and large presence in the digital transaction space will help it gain the additional transaction volumes likely to come from Google (Google Tez), Facebook (WhatsApp) and Alibaba (Paytm), among others. The real benefit that we expect to accrue however is a rapid expansion in the gathering of valuable customer data, and the opportunity to offer products to these customers. Put differently, a vast number of Indians remain in the informal economy (i.e., 90% cash share mentioned earlier), whereas smartphones and digital payments will draw them into the banking system. Importantly, their identity and financial history are generally assured through previous Aadhaar registration. Given that the company already has deep experience in digital offerings and the ability to analyze new customer data through its existing cloud-based infrastructure, we believe it is well positioned to capitalize on the estimated loan growth from $588 billion to $1.6 trillion (3x) through 2023.

In closing, it is difficult to express the scope of the economic opportunity in India, particularly in a quarterly commentary. This sentiment applies even further to the general feeling of optimism that was readily detectable among Indians. India’s potential for socio-economic progress is nonlinear, and perhaps even harder to digest than its tap water. The key will rest primarily on the country’s continued embrace of leaders and policies that promote economic growth, which we believe has become more widely acknowledged among the populace.


Lauren C. Templeton               D. Scott Phillips, Jr.
Principal                                   Principal

P.S. For the sake of saving space in our letter, we share some trip photos and other interesting tidbits on the pages that follow.
[1] Past performance is not indicative of future results.
[2] Ayres, Alyssa. Our Time has Come. New York: Oxford University Press, 2018
[3] Ayres, Alyssa. Our Time has Come. New York: Oxford University Press, 2018
Bangalore International Airport (BIAL) Prior to Fairfax India’s Investment
BIAL Today (Following Fairfax India’s Investment into BIAL)
The View from BIAL’s Air Traffic Control (Fairfax’s investment includes the surrounding 460 acres planned to be developed with hotels, restaurants, parking, etc.)
Visit to the Taj Mahal
Meeting the World Famous Dabbawalas in Mumbai (The Dabbawalas are a 125-year-old bicycle and local train lunch delivery service delivering hot lunches from customer’s homes to their workplaces. Approximately 4,500-5,000 Dabbawalas deliver between 175,000-200,000 lunches per day with a reported error rate of 1 per 16,000,000. The Dabbawalas are the subject of a 2010 case study by the Harvard Business School.)
Past performance is not indicative of future results.  The actual characteristics with respect to any particular client account will vary based on a number of factors including but not limited to: (i) the size of the account; (ii) investment restrictions applicable to the account, if any; and (iii) market exigencies at the time of investment. Templeton & Phillips Capital Management, LLC (“TPCM”) reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. The information provided in this report should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account's portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed may not represent an account's entire portfolio and in the aggregate may represent only a small percentage of an account's portfolio holdings.  It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. Recommendations from the past 12 months are available upon request. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness.  All investments have the risk of loss. 
TPCM is a registered investment adviser.  Registration does not imply a certain level of skill or training.  More information about TPCM including its advisory services and fee schedule can be found in Form ADV Part 2 which is available upon request.   LTF-19-03
Copyright © 2019 Templeton and Phillips Capital Management, LLC, All rights reserved.

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