INDIA CAPITAL FUND

MONTHLY NEWSLETTER Management Comments KERALA LAND OF TREASURE Neighbours of the Sree Padmanabhaswamy temple in Thiruvananthapuram, Kerala were no doubt surprised when an inventory of the temple cellars revealed gold and jewels worth an estimated $22 Billion. The temple was patronized in centuries past by the Maharajas of nearby Travancore and the treasure is a reminder of Keralas historically prominent position as an Indian Ocean trading centre, bartering spices and other commodities with merchants hailing from ports on the Mediterranean, the Red Sea and as far away as Indonesia. Keralas cosmopolitan heritage has found expression in modern times in continued growth of trading businesses and also in a contemporary movement of talented people along the erstwhile spice trading routes, as more than three million Keralites are employed in the Persian Gulf. These expats remit almost $9 Billion every year to their home state, boosting state GDP by more than 20% and stimulating local investment. Kerala does not have as high a business profile as Mumbai, Indias commercial metropolis or Bangalore (now Bengaluru), the countrys established centre of high technology. However, it has INDIA CAPITAL MANAGEMENT
NAV A2 SHARES
(Open Series)

June 2011

www.indiacapitalfund.com

Performance Data 30th June 2011

NAV A SHARES
(Closed Series)

FUND SIZE

US$54.43
Since May 2001 Relaunch

US$83.87
India Capital Fund (ICF)

US$362Mn
Bombay Stock Exchange ($BSE 30)

Number of Months: Number of Positive Months: % of Positive Months: Cumulative Return Since Relaunch:

121 75 62% 531%

121 72 60% 447%

Performance of ICF vs. $BSE 30

84 80 76 72 68 64 60 56 52 48 44 40 36 32 28 24 20 16 12 8 4
2001 2002

ICF NAV Per Share $BSE 30 (rebased)

US$

May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May

2003

2004

2005

2006

2007

2008

2009

2010

2011

Key Details & Fund Overview

Management Co: Launch Date: Structure: Domicile: Base Currency: Open for Subscription: Redemption Notice: Management Fee: Performance Fee: Minimum Investment: Custodians: Auditor: Administrators: ISIN: MU0160S00269 India Capital Management (ICM) Sept 1994; Relaunched May 2001 per note (2) below Open-ended, unlisted investment company Mauritius USD Month-end 60 Days / Monthly 1.25% per annum 20% of gains over 5% hurdle $250K non-US indiv, $1M Instit/$5M US Persons HSBC / Deutsche Bank KPMG Goldman Sachs Bank / International Financial Services Ltd

SEDOL: 6670377

Bloomberg: INDSMLI MP

Sree Padmanabhaswamy Temple, Kerala

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The ICF is an absolute return fund. The investment advisor, ICM, is one of the longest serving India-only advisors. The fund invests in a long-term concentrated research driven portfolio of stocks.

Monthly Total Returns Since Relaunch (net of all fees)

2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 Jan (15.6) (5.0) (4.0) (18.6) 1.6 12.7 (4.9) (8.7) (2.0) 7.8 Feb 0.8 (0.8) (8.7) (2.5) (6.5) (0.4) 4.9 (2.2) 1.4 8.5 Mar 6.9 10.6 8.0 (16.3) (2.1) 17.3 (2.5) 0.7 (10.2) 2.9 Apr 2.0 2.7 17.8 10.4 14.1 15.5 (5.1) 1.9 6.6 9.5 May (4.7) (7.3) 44.8 (9.7) 10.1 (17.5) 6.0 (18.4) 15.8 (4.3) 16.8 Jun (0.3) 1.7 (5.5) (20.2) 5.4 (8.7) 6.3 (1.6) 12.9 3.9 (4.5) Jul 7.0 7.1 2.8 8.2 (3.9) 4.8 5.4 9.5 (4.2) (10.7) Aug 4.0 0.5 (3.4) (2.7) 10.3 4.0 3.9 7.6 0.4 (4.2) Sep 14.1 12.0 (18.7) 13.8 8.7 13.1 6.8 5.3 (8.4) (6.7) Oct 3.1 (3.2) (27.4) 6.2 9.9 (12.4) (0.9) 12.2 2.5 3.2 Nov (8.1) 8.4 (12.8) 3.2 5.8 9.2 13.4 8.3 0.6 15.3 Dec 1.8 2.0 15.5 9.9 2.1 7.3 14.2 13.7 6.2 (5.2) ICF/YTD (11.8) 23.6 96.7 (68.8) 77.8 57.0 31.8 10.6 113.2 26.5 (14.0)

Source: ICM

$BSE30 (7.8) 22.2 89.4 (61.5) 65.2 49.3 37.3 18.7 83.0 4.2 (20.8)

Past Performance is No Assurance of Future Results. Investing in ICF involves a risk of loss. The returns above are net of all fees and expenses borne by ICF with dividends re-invested. (1) ICF has generally offered three different classes of shares: (a) A Shares from launch in September 1994 until May 2001, (b) A1 Shares from May 2001 to April 2003, and (c) thereafter A2 Shares. This newsletter shows for each period the performance of the share currently offered. A Shares and A1 Shares pay lower fees than A2 Shares, so the performance shown for periods prior to 2004 is greater than if the fees paid by A2 Shares applied to all periods. A Shares pay a 1.5% annual mgt fee and no performance fee, and A1 Shares pay a 1% annual mgt fee and a 20% over 10% performance fee. (2) ICF launched in September 1994 as the Indian Smaller Companies Fund Ltd. with a focus on small cap Indian companies. In May 2001 as part of its relaunch it changed its name to India Capital Fund Ltd. and changed to an all cap strategy.

India Capital Management Ltd, IFS Court, 28 Cybercity, Ebene, Mauritius. Tel: +230 467 3000; Fax: +230 467 4000; Email: info@indiacapitalfund.com or scott@indiacapmgt.com

Management Comments (contd) quietly excelled in a range of key indicators: Indias highest literacy rate most equitably balanced gender ratio, lowest infant mortality rate, and longest life expectancy. Together with an entrepreneurial culture, along with a robust flow of foreign remittances and the investments they stimulate, we consider Kerala one of Indias more attractive if lesser known investment destinations and your fund has a number of investments in the state. 10 YEARS AFTER THE UTI FIASCO It has been ten years since UTIs US-64 mutual fund, then Indias largest, abruptly suspended shareholder redemptions. It emerged that US-64s NAV had been overstated for years, instantly diminishing the savings of the funds 20 million investors, who had long viewed UTI as a symbol of trust. The scandal shook retail investors confidence in the mutual fund industry, of which UTI then controlled more than 55%, and in the equity markets themselves. Painful as the events were, they forced a radical modernization of Indias financial markets. All mutual funds were required to increase transparency by striking NAVs daily, disclosing portfolio information and submitting to the oversight of Indias securities regulator, as well as facing the discipline of greater competition from newly licensed entrants. Share trading itself became more liquid and transparent, as electronic trading was introduced for most stocks, direct market access was implemented and settlement times were cut from T+5 to T+2. These changes coincided with the beginning of a period of extraordinary growth of the Indian economy and Indian companies, such that the market capitalization of the large cap index is now 10x larger than at the time of the UTI scandal. Much of the benefit during this period has accrued to institutional investors, such as your Fund, as Indias retail investors continue to be lightly invested in equities ten years after the UTI fiasco (Figure 1), even compared to their peers in other emerging markets.

page 2

This may now change as the mutual fund industry has grown and diversified, with no fund house today accounting for more than 14% of the market (Figure 2). Bringing retail shareholding up to the level of China would result in inflows of approximately $50B. By comparison, net foreign institutional inflows in the great bull market of 2003-2007 were $53 Billion. This will not happen overnight, but it is likely to be an important component of the next phase of Indias financial development.

FIGURE 2 Mutual Funds AUM Growth (2001 to 2011)

00
$166 B

00

$22 B

0 Jun 2010 Jun 2011

Source: Association of Mutual Funds in India

STAFF PROFILE: SONIA LALWANI Sonia Lalwani is an Information Analyst at India Capital Research (ICR) in Mumbai and has over four years of experience in financial data analysis. Sonias family hails from Karachi, Sindh. Her grandparents had a successful cutlery company and were pillars of the local business community, but were forced to flee to Mumbai during the tumult of India-Pakistan partition in 1947. Sonia remembers her grandparents stories of living in refugee camps and working to restart their business and their lives in Mumbai from nothing. The city took them in with open arms. Even then resources and infrastructure were strained, but this is a city that believes theres always room for one more. Sonias grandparents persevered and rebuilt their business. I hear many stories like theirs, she says, and sometimes think one of the secrets of Indian companies success is a heritage of learning how to grow businesses with very little capital. Sonia studied at Mumbai University and traces her interest in research and data analysis to college days. Most schools in India focus on rote memorization, as had mine in earlier years. But at Mumbai University our curriculum focused intensively on research projects. It forced me to step outside my comfort zone to interview experts, conduct surveys and crunch numbers, but I realized over time that I was learning more and was having much more fun. For one such project, Sonia studied the reasons for the success of

FIGURE 1 Retail Investment in Equities & MFs

0
30-40%

22%

7%

0 India China Developed countries

Source: Reuters

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India Capital Management Ltd, IFS Court, 28 Cybercity, Ebene, Mauritius. Tel: +230 467 3000; Fax: +230 467 4000; Email: info@indiacapitalfund.com or scott@indiacapmgt.com

Management Comments (contd)

page 3

practitioners perspective on the various technologies and the supply-demand balance in each segment. Sonia joined India Capital Research in 2008. I knew right from the interview process, which was very demanding but a lot of fun, that it was the right place for me, she says. There is an intense focus here on gathering primary data, finding original ways to interpret it and understanding how it strengthens or refutes an investment thesis. The work is serious, but no one takes themselves too seriously. At ICR, Sonia supports the analysis of investment ideas, which includes working with proprietary data sets of several million discrete fields, as well as more qualitative projects. In one such project, Sonia interviewed teenagers in a number of midsize cities to test the commonly assumed good brand standing of a domestic apparel manufacturer. Her interviews and store visits undermined the market assumption and identified an increasing preference among affluent students for global brands. Outside of work, Sonia enjoys reading and on weekends she tutors a group of children who live on the streets of her neighborhood. It isnt easy since the students start with few academic skills and few good places to study, but its fulfilling to see their strong desire to learn and the progress they make. Sonia lives in Andheri, Mumbai. EUREKAHEDGE ASIAN HEDGE FUND AWARDS 2011 India Capital Fund won the Best India Hedge Fund of the Year at the EurekaHedge Asian Hedge Fund Awards, 2011. We are honoured to have the Funds performance recognized and are very grateful to all of our investors, staff and associates for making it possible. Mumbais dabbawalas. Dabbawalas, literally lunch-bringers, deliver more than 175,000 lunch boxes every day to working professionals from their home to their office. A lunch box changes hands several times as it is carried across the city via train, bicycle and hand-cart without computers and sometimes being sorted by dabbawalas who are not literate but it reaches its destination with six sigma accuracy and total punctuality. Sonia shadowed two dabbawalas for a week and came to understand how the systems success depends on clear allocation of responsibilities, well understood rules and precise communication. After graduating with a degree in management studies, Sonia joined Tata Strategic Management Group (TSMG), a consulting firm affiliated with the Tata Group, one of Indias most highly regarded conglomerates. As part of the infrastructure group, Sonia conducted independent research and handled large data sets for a variety of projects. In a project for a private equity firm, Sonia evaluated investment opportunities across the water cycle, starting from desalination of sea water to final treatment of used water. Sonia was not convinced that the data provided by outside vendors was complete, a frequent concern in India, so she cold called engineers working for the government and in the private sector to get

Jon Thorn at the awards ceremony in Singapore

India Capital Management Ltd, IFS Court, 28 Cybercity, Ebene, Mauritius. Tel: +230 467 3000; Fax: +230 467 4000; Email: info@indiacapitalfund.com or scott@indiacapmgt.com

THE ASIAN WALL STREET JOURNAL

Monday April 30th, 2001

MARKET MADNESS

Breaking the Brokers

Pressure is on Indias securities watchdog to modernize the countrys exchanges and toughen up regulations.
BY JON THORN
February 28 should have been the start of the best post-budget stock market rally in Indian history, but it turned out to be the worst rout. Over the past two months, India has seen collapsing share prices, a liquidity meltdown, insolvent banks and brokers, arrests and firings, at least three suicides, and hundreds of millions of dollars of bank deposits and broker assets wiped out. Market liquidity has plunged 80%; some stocks have fallen by 40%, some of which were already down by 80% from the previous year. What exactly went so wrong, and where do we go from here? The answer to the first question lies in the business as usual practices on Indian stock markets. The answer to the second should become clear within the next two or three months. The Union Budget marked the first clear and sustainable evidence that the Indian government had finally become serious about the economy and the market. The budget included a 5% cut in personal income tax rates, a 3.5% reduction in corporate rates, a lower fiscal deficit target, power charges enforcement and privatization. The dividend tax was reduced to 10% from 20%. The Reserve Bank of India had cut interest rates twice by 50 basis points. In response to all this the market rose 4.4%. But the optimism turned to fear and panic, and despair for some, when on March 2 a group of broker-directors of the Bombay Stock Exchange joined forces to attack the investment positions of Ketan Parekh. Mr. Parekh was the markets biggest bull. His investing in India media, software and telecoms firms during the global rise in technology stocks earned him a fortune and the nickname Bombay Bull. Indeed, Mr. Parekh became so influential that many analysts enthusiastically tracked what became known as the K-10 Index his top 10 investments at any given time. The KP effect was when the price of such stocks moved up. The broker-owned BSE has a tradition of bull and bear speculators who attempt to manipulate stock prices by making hundreds of trades at successively higher or lower prices, then exiting with a profit. But much of this is done on borrowed money, a practice that inflates trading volumes and leaves the markets open to large and unexpected shifts. Under the nations badla system, speculators pay interest, or badla, rates of 20% or more to intermediaries to finance their trades. But only 10% a trades are settled within the oneweek settlement period. In practice, therefore, many speculators postpone settling their trades for as long as the badla intermediary permits. Brokers can make money financing their clients badla debt by borrowing from an intermediary and keeping the spread between the two rates, plus a sakes commission. This helped to fuel the stellar rise of Mr. Parekh during the technology boom. Mr. Parekhs problems began with the decline in technology shares and worsened after he and his clients faced huge margin calls on stocks that in some cases were down 90% from their previous highs. Every week demanded another check to cover the interest on those positions. By allegedly accessing privileged information through the BSEs surveillance department, a coalition of bears moved to squeeze Mr. Parekh in a bid to stem losses from what they believed would be a negative market reaction to the budget. Shockingly, one of the first of the bears to be around $150 million. Interestingly, while all this domestic pain was occurring in March, foreign investors were net buyers of $450.5 million worth of Indian stocks. The total net 2001 purchase by foreigners is now close to the total for the whole year of 2000. Domestic investors were net sellers of shares worth $62.8 million. There is likely to be other high-profile casualties in the BSE scandal, perhaps at the Unit Trust of India, the Indian equivalent of CalPERS and Fidelity combined, and even at SEBI. On April 3, Finance Minister Yashwant Sinha said he would pursue all wrongdoers, wherever they may be. As in the bribery debacle that engulfed the Ministry of Defense and ruling party, the political noise continues. And yet there are encouraging signs SEBI is finally acting like a regulator. On March 13, it suspended the board of BSE. The following day, it announced that beginning July 1 it would implement a rolling settlement system for 200 stocks, a number it has recently raised to 250, and it declared that the BSE would be wrested from the hands of the brokers and corporatized. These actions actually cap SEBIs running albeit unacknowledged dispute with many brokers over the badla system, which the brokers have fought one rearguard action after another to retain. In 1996, with the support of foreign and large domestic brokerages, SEBI targeted badla by moving from floor-based to screen-based trading. Next was the dematerialization of share certificates; almost all trades are now settled through electronic book entry. The most recent battle was over a rolling settlement period, by which share markets would follow a five-day trading cycle, with all trades during a cycle settled five days after at ends. SEBI officials rightly saw that a rolling settlement would make the badla system harder to operate, less profitable and, ultimately, unworkable, thus lowering the revenues of the brokers who rely on it. In October, SEBI introduced a trial rolling settlement for 15 stocks. But daily trading volumes dried up, in some cases from 200,000 to 2,000 shares a day. But it was the same brokers who depressed the trading volumes and then complained the new system wouldnt work. SEBI didnt listen, but neither did it take action to expand rolling settlement. As the criminal investigation into the scandal continues, SEBI is likely to take control of the market. Perhaps 25% of brokers will not be in business this time next year. As a result, it will be almost impossible to manipulate the market as in the past. That will be good for capital markets and investors. But the litmus test will be SEBIs ability to deliver on implementing a rolling settlement system in July.
Mr. Thorn is the managing director of The India Capital Fund PCC, formerly The Indian Smaller Companies Fund Ltd.

implicated in the conspiracy was BSE President Anand Rathi, who resigned March 8. Shortly afterwards, four finance companies associated with him were ordered by the Securities and Exchange Board of India to suspend their operations. In the meantime, hot money fleeing the market pummeled Mr. Parekhs K-10 Index, and any stock suspected of an association. Market players who had ridden on Mr. Parekhs coattails were forced to sell almost anything to meet their ever-increasing interest payments to maintain their long positions. For his part, Mr. Parekh finally stopped paying on his widening margin calls and was arrested March 29 on charges of conspiracy, breach of trust and fraud. The Bank of India claimed it had lost about $30 million after checks issued on behalf of Mr. Parekh by a co-operative bank bounced. The cooperative bank, whose president is now under investigation, was expressly forbidden by law to lend cash to brokers or against securities trading. Mr. Parekh has so far revealed that he was involved in massive schemes in which capital was invested through his companies to buy stock in a creditor firm to support share prices. In another case, he purchased shares in two small media companies on behalf of a larger one, without revealing that the larger company was the beneficial owner. The total bill for his misdeeds will be

THE ASIAN WALL STREET JOURNAL

Thursday August 23rd, 2001

PARALLEL UNIVERSE

UTI Not Long for This World

Mounting investor losses and allegations of corruption have hastened the demise of the Indian governments mutual fund.
BY JON THORN
Imagine a world in which a governmentcontrolled investment company manages 60% of its nations mutual-fund assets, and where the fund isnt subject to the control of a national securities regulator or indeed to any regulation whatsoever. Imagine that the largest fund holds 16% of total national mutual assets, and that instead of sticking to a mandated asset allocation of 60% bonds and 40% equities, has reversed that proportion. Then imagine that although the fund provides a price-per-unit basis for its 10% dividend payout, and unit investment and redemption price, the price isnt based on the aggregate net asset value (NAV) of the funds holdings. Instead, it provides an administered price, which it states is the smoothed (and unaudited) NAV per share. Imagine no longer. Welcome to the Unit Trust of India, a living nightmare for the 20 million investors in its largest scheme, US-64. Globally, theres nothing comparable to UTI. In the United States, it would be like combining CalPERS, Fidelity and Vanguard all into one, and then the next top 10 mutual funds. Corporates and individuals see UTI as a branch of the Indian government and have always believed it to be the embodiment of state underwritten security and probity. Sadly, theyre now discovering this to be false, not the least since senior UTI personnel, including its former chairman, were detained for questioning or arrested on charges of fraud and corruption. Since the Indian budget was announced on February 28, the Ketan Parekh stock market scam has driven stock liquidity down by 80%. The major changes to market operation and management that the regulator, SEBI, has since put into place have changed for the better many assumptions about investing in India. The bright new dawn of this new stock market was July 2, when T+ 5 rolling settlement was introduced and the cash and futures market was finally separated. But that same day UTI announced its suspension of redemptions from US-64 for six months. If the whole of the Bombay Stock Exchange 30 Index had issued profit warnings, the effect on market confidence would have been less. The UTI US-64 had been suffering a wave of redemptions from mainly corporate investors for nearly six months before the announcement, and it was that wave of accelerating redemptions that forced it to bolt the door. It was common knowledge in the market that US-64 was using a unit price that had not moved down much for almost one year, although the stock market had fallen sharply. It was obvious therefore that the funds portfolio could not add up to the redemption price. Many investment professionals have difficulty understanding this specific point so important for understanding the parallel topsyturvy universe of Indian finance so it demands repetition: The unit price of US-64 was and is substantially higher than its actual NAV per share. The UTI had been on borrowed time since 1998, when problems first surfaced and the government bailed it out and set up a committee to make recommendations to fix what was clearly a nonviable business. That committee was headed by Deepak S. Parekh, chairman of the Housing Development Finance Corporation, respectively, the most respected figure and most admired institution in Indian finance. The Parekh Committee made 19 recommendations of which 16 have been implemented. The three that have not conversion to NAV pricing, independent and legal regulation, and a return to the investment remit of investing allegation is that some senior managers, including P.S.Subramanyam, the former UTI chairman, recommended purchase of shares in a private placement by Cyberspace Infosys, a concept stock that seems to have lacked even a concept. This was contrary to a strong recommendation made by UTIs research department. There have been many and strongly worded government statements that UTIs small investors are protected and will get their money back. While voters should not be defrauded, the government has more to do than fill in UTIs asset hole. Since July 2, UTI reinstated redemptions for a maximum of 3,000 units (circa $638) per investor. It also announced that full redemptions will become available from May 2003 and that until then the redemption NAV will increase by 10 paise per month for the next 20 months, and that full NAV pricing will start in January 2002. The flip side of this disaster is that there are today few stock markets in the world where the government has both stated clearly that it will do all it can to underpin prices and has an obvious interest in pushing up prices, which is what it will need to do to get UTIs NAV closer to its unit price. The move back to debt from equities must also be completed without UTI dumping stocks in a market with few buyers. The government is trying to get other financial institutions to buy blocks of stock direct from UTI, and it hopes that they will do this at a premium for size-to-themarket price. (Full disclosure: The selling has started and we at India Capital Fund PCC have recently purchased stock from UTI, although not at a premium). Clearly this is a large overhang in the market, especially for some individual stocks; normal market service will not be resumed until the overhang has gone away. A lot of focus has been on the larger equity holdings in the US-64 portfolio, many of which are good companies, as the stock market meltdown has crushed the prices of all but the best and the luckiest. The debt portfolio however has not yet been closely scrutinized, and more horrors may lurk as some weak companies start to default. One of the reasons US-64 moved so heavily out of government debt and into equities was the search for yield, cash and earnings to meet its liabilities. The history of markets show its always a bad idea for a government to manage assets, whether on behalf of taxpayers or investors. How UTI and US-64 emerge from this mess is now a heated debate. Whatever the avenues pursued, a lot of investors will have lost a lot of money. Strangely enough, theres no sense in India that radical surgery is needed to amputate UTI from the government. But this may change over time. The future of the savings industry in the worlds second-most populous nation is definitely being debated, and its a safe bet that UTI eventually wont be Indias mutual fund manager of first choice or last resort. Mr Thorn is the managing director of the India Capital Fund PCC, formerly the Indian Smaller Companies Fund Ltd.

mainly in debt rather than equity are, of course, the hardest things to fix and exactly what created UTIs problems in the first place. UTI was handed a golden opportunity to clean up by the stock-market bubble that developed in India from 1999 to 2000. It is widely believed that this may have been the only time the past decade when UTIs published unit-price reflected the value of the underlying NAV. But it failed to act, assuming the markets would climb higher still. Although the origin of these problems is now of only academic interest, remaining investors who have in effect financed the over-NAV redemptions of the early redeemers especially deserve a good reason why more was not done to fix UTIs problems while they were more easily fixable. Some of UTIs senior managers were clearly remiss in dealing with fundamental and obvious problems. Neither did the government fulfill its duties. The Finance Ministry appears not to have pressured UTI strongly enough to implement the Parekh Committees recommendations. Far worse than incompetence, arrogance or dereliction of responsibility is the alleged fraud and corruption among some senior UTI staff currently being investigated by the police. The