This is not an offer to buy or sell securities. The India Capital Fund maintains positions in sectors and stocks discussed in this note.
Corporate India has historically been characterized by extreme fragmentation across sectors. But increasingly, some companies are pulling away from the rest in market share and especially in earnings. This change will have profound implications for investors.
How It’s Always Been
Many sectors in India include an unusually large number of credible participants by any global standard. There are more than three dozen banks, forty cement companies and one hundred ninety auto components manufacturers in the publicly traded universe alone, and a far longer tail of smaller players. Most other economies, even major ones like Germany and Japan, don’t come close to those numbers.
The historical reasons for such widely distributed market share are mainly due to inadequate logistics and high transportation costs that placed a premium on proximity to local markets. Every state had its own tangle of regulations and its own tax code that frequently differed from those of its neighbors. These factors made it difficult for businesses to build national scale and gave rise to regional and sub-regional players that made up for what they lacked in size and efficiency with local knowledge and a certain ability to get things done. That often included minimizing or sidestepping entirely their tax and pension obligations and passing some of those savings along to customers, making them price competitive vs. larger players that were more efficient but faced the added cost of paying their taxes.
Investors in smaller companies, India Capital among them, benefited from these conditions. While there are some genuine hidden gems and future champions in the making among smaller enterprises, there have also been a great many subscale companies with suboptimal businesses that nonetheless survived and profited in the absence of formidable national competitors.
Things Change
That has begun to change: now large companies are increasingly gaining market share. In many sectors, the top few participants now account for the majority of the total industry growth, and in some cases all of it.
How are they doing so? India’s watershed economic reforms, along with the increasing importance of technology, are allowing the best managed and most efficient companies to achieve productivity and scale that their smaller, less efficient competitors can no longer match.
The Goods and Services Tax, or GST, introduced in 2017, is one such reform. Before the GST, there were more than 100 state and local taxes; idiosyncratic, ambiguous and often duplicative. Moving goods across state borders and even municipal boundaries involved long waits, checkpoints and special taxes that effectively amounted to customs duties.
The GST subsumed all of these legacy state and local taxes into a single national value added tax. Out went the checkpoints and customs duties and in came a national common market with uniform tax rules. Large national companies have been able to cut shipping times and streamline logistics, trimming their costs and working capital requirements, while growing their presence in many state markets in which they had earlier found it difficult to compete.
Similarly, technology is disrupting the way business is done. Upwards of two thirds of banking transactions are now wholly digital and never touch a branch, diminishing the importance of having a physical location just down the street and radically increasing the value of a technology stack that provides a smooth customer experience. The banks that invested earliest and most energetically in building a digital channel, which includes some of the country’s largest institutions, have built a substantial technology lead over the rest. And with the capacity to continue to invest at scale, they are leaving many of their competitors -especially the smaller ones- further and further behind.
Why Investors Should Care
In financial terms, leading companies are now sharply more productive and capital efficient than their peers (Figure 1), as economic reform and technology have brought to the fore their scale advantages and frequently superior management. Likewise, businesses that have built truly national brands are able to command premium pricing, even in what appear to be commodity industries. For example, the distinctive yellow logo of the cement manufacturer Ultratech, can be found on billboards, bus stops and cricket jerseys throughout the country (Figure 2). As a known and trusted name, Ultratech commands pricing of about Rs. 160 per ton more than its competitors. That small 3% pricing advantage translates into a not so small advantage in profitability, about 15% on average, which has allowed Ultratech to grow market share even as it’s paid down debt.
That is becoming a common story, as a modest edge in revenue growth becomes a much larger advantage in earnings. The best run businesses are cornering an even larger share of profits than of revenues, giving them much greater room to further reinvest and outgrow their peers in a virtuously reinforcing cycle.
Superior growth and earnings can drive vastly superior shareholder returns. The top five banks, cement companies and telecom carriers have dramatically outperformed their competitors in share price terms (Figure 3). The gains, however, are not uniform. The analysis below is backward looking and therefore has considerable survivorship bias. Some major companies in each of these sectors have sharply underperformed peers and a few have gone out of business entirely. There are extreme differences between leading companies, even those that are superficially similar. Choosing a leading company in certain situations is very helpful but choosing the right one is essential.
What The Future May Hold
For those right leading companies, these are still early days on their road to the benefits of truly commanding positions. For example, while India’s top three banks have accounted for almost 60% of industry loan growth so far in 2022, together they still represent less than 40% of total sector assets. That leaves them a very long way to run.
All the more so because many of these industries are themselves so nascent. The same three Indian banks have cumulative assets equivalent to 36% of Indian GDP. While that sounds like a lot, assets of the top three Chinese banks amount to 83% of GDP. For Japan, the figure is 155%, and for France 211%.
And Indian GDP itself is poised for a great deal of growth ahead. As the barriers in India fall away to the kind of consolidation that has taken hold in so many other countries, it is increasingly the leading companies -those that bring to bear the benefits of scale efficiency, technology investment and brand strength- that will drive and benefit from the largest part of that growth.