Will FIIs pour more money?

N Mahalakshmi

Foreign institutional investors are a formidable force in the Indian equity markets, and their role has only become more important in recent times.

Retail investors are hardly present in today's market, as they never are when markets lie low. The largest domestic institution the Unit Trust of India has lost its clout with its corpus shrinking substantially.

Domestic mutual funds with an equity corpus of less than Rs 20,000 crore (Rs 200 billion) are yet to gain in size to make any significant impact in the market.

To be sure, FIIs inflows can't really flare up the market. If that had been the case, the stock market would have rallied last year when FIIs poured money in excess of Rs 12,900 crore (Rs 129 billion).

Their role, however, cannot be undermined when it comes to lending stability to the market. In the absence of their support, the stock market see-sawed for a large part of 2002.

For the full of 2002, they made net purchases of Rs 3,500 crore (Rs 35 billion). Will next year be any different? May be yes.

If only the 490 odd foreign institutional investors lift their eye lids and see the merits in Indian equities, the stock markets could attract more inflows than ever before.

Optimists vow that India is among the best investments destination among the emerging economies for six rock solid reasons.

1. Fastest growing economy: For the last five years India has been the fastest growing economies in the world.

Even this year's GDP forecast is around 5.5 per cent. That's just a notch below China. Few other emerging economies have displayed this kind of growth.

2. Strong forex reserves: The forex situation has never been as good ever before. With about $68 billion in reserves, the perception of currency and country risk is significantly reduced.

Says Chetan Sehgal, vice president, Templeton Emerging Markets Group: "For a global investor the dollar reserve situation is a key criteria to evaluate a market and the healthy reserves is a big plus for India."

Indeed, the strength of the local currency is of utmost concern as it can eat into there returns significantly.

For instance, even as the Morgan Stanley Capital International equity index for Venezuela gave a 49 per cent return, in dollar terms it translated into 18 percent appreciation as the local currency depreciated on the back of acute external debt burden.

For the first time in India, the rupee appreciated for a one full year. Chances are that with dollar revenues from the technology sector will only improve the situation even more.

3. Reforms in motion: Even though the pace of reforms has been a suspect, there is consensus among political parties that reform must go on.

The decision on divestments of HP, BP and Nalco have come as a relief to the market. Besides, the Securitisation Law passed by the government will enable the banking sector saddled with non-performing assets to come clean.

4. Corporate restructuring: In spite of touch times in the past few years, corporates have been able to restructure themselves effectively. "In many industries, and that including some manufacturing set-ups too, Indian companies are becoming world class," says Gul Tekchandani, chief investment officer, Sun F&C Asset Management.

For instance, Tata Steel is the lowest cost producer of steel in the world. Similarly, Nalco is the lowest cost producer of aluminium. Top hotels companies are positioning themselves to make acquisitions abroad.

Again, Tata Engineering's recent success in signing the car export deal with Rover proves that Indian companies are slowly getting there.

Many sectors that investors has had almost written off such as textiles, are making a come back. Concurs U R Bhat, head of broking, JP Morgan: "If some of these Indian corporates have been able to grow despite the challenging environment, they can do even better when the infrastructure bottlenecks get eliminated."

5. Equity valuations look attractive: Looking at markets top-down, valuations do look attractive. Currently, the Sensex is trading is trading at a trailing 12 month PE of 13, which translates into a earnings yield of 7.69 per cent, higher than the yield on risk-free government paper.

Five-year government paper trades at an yield of 5.99 per cent and 10-year paper at 6.24 per cent. This clearly means that the market is cheap and it makes imminent sense to invest in equities.

"Even if this is not the rock-bottom, from here on chances of making money in stocks are far more than the downside risk" says Tekchandani.

6. Technology story is intact: Despite the India software sector going through a rough patch on account of the recession in US, they will be back on track when business picks up.

It makes imminent sense for US corporates to outsource services from India for the cost advantage it offers. As per Nasscom estimates, the Indian information technology sector will grow at the rate of 22-25 per cent this year.

IT enabled services and business process outsourcing is expected to growth at a much higher rate of 70-80 per cent.

All this sounds really flattering. But India has a fair share of haunting issues as well. For instance, the state of the fisc is a cause for concern. "Macro economic stability and state of the fisc are basic hygiene factors to attract foreign investors," says Templeton's Sehgal.

The cost of rescuing government-owned financial institutions such as the Unit Trust of India will without doubt impact the fiscal situation.

That global rating agency Standard & Poor downgraded India's local currency rating to junk grade from investment grade is definitely worrying global investors, though local fund managers are more bothered about ground realities such as corporate profitability and growth prospects.

"Because at the back of the mind, investors do know that deficits will get translated into higher taxes adversely affecting the bottomline," says Sehgal. "If we see some action on the fiscal responsibility bill, it will inspire confidence," adds Bhat.

Another problem is that FII fear unpleasant surprises. For instance, the furore on taxing companies registered in Mauritius really scared investors away.

In February this year, FIIs made net purchases of more than Rs 2,000 crore (Rs 20 billion). But after the Mauritius controvercy inflows stopped abruptly. Says Bhat "Investors are willing to take market risk, nothing more than that. This adds another dimension to the risk."

There are some micro level issues which plague Indian markets. The most basic argument for investing in markets outside the US is the negative correlation. For investors, it makes imminent sense to invest in markets which behave differently because even if one market underperforms, the other may provide a cushion.

"Since Indian markets now move more or less in tandem with the US, foreign investors may not find it worth the risk to indulge in these markets," says Bhat.

Some other fund managers disagree on the point. They say, the reasoning may not be valid because Nasdaq fell by 30 per centthis year, while the BSE IT index was up 5 per cent. Similarly, the Dow dipped 16 per cent this year, while the BSE Sensex was up 4 per cent.

The biggest problem is, however, that of market size itself. There are only a handful of stocks that have the kind of liquidity for foreign investors to take significant positions. In terms of turnover, Indian markets are concentrated in few stocks.

The share of top 10 most active index stocks in turnover is about 57 per cent, while it is in the range of 11 to 27 per cent for countries including China, Thailand, Taiwan and Korea. Also, promoters' holdings are high curtailing liquidity tremendously.

At the end of March 2002, average promoter holdings in all listed companies stood at 41 per cent.

Sample this: the aggregate market cap of all A group companies was Rs 5.25 lakh crore (Rs 5.25 trillion) as on December 20, 2002.

Of this, the free float or the non-promoter interest was only about Rs 2.93 lakh crore (Rs 2.93 trillion). If we look at the free float for the Sensex stocks alone, it is far lower at Rs 1.99 crore (Rs 199 million).

Even out of this, the combined FII holdings in A group stocks amounted to $12 billion, of which $10 billion was deployed in Sensex stocks alone.

Contrast this with the size of an average fund in the US which ranges anywhere $1 billion to $50 billion. Even if we get just 1 per cent of the global offshore fund corpus, it will bring in at least $10 billion straight away.

And our markets may just be short of stocks to absorb this kind of inflow. Says Bhat "In stocks which are worthwhile investing in, FIIs already have significant holdings."

It is a fact that the market-cap to GDP ratio in India is quite low at 32 per cent meaning that only a small fraction of the Indian business is really captured in the stocks markets.

The major businesses are not even available for investing. The developed countries it is 120 per cent. In the Asian region, countries like Honkong, China, Korea and Taiwan have a ratio upwards of 50 per cent.

For instance, the government-owned Indian Railways, post, state road transport corporations, with their size and business credentials can bring in a lot of investor interest.

Similarly, there are large private players which are closely held. Unless, all this comes into the stock market fold, opportunities will be limited.

Also, some fund managers are not so convinced about valuations. The Sensex commands only a third of the earnings multiple that the Dow enjoys.

Yet, some managers argue that they may be cheap for the right reasons. Companies such as Infosys, Wipro, Satyam, Dr Reddy's, Cipla and the like look fairly valued considering their growth rates.

"The ones which look cheap are cheap because of sluggish growth prospects or management issues" says Bhat.

There are concerns on the corporate governance standards as well. Despite the accounting juggleries in the US, global investors have more faith in the US regulatory system and corporate governance standards.

Unlike domestic fund managers who feel reasonably confident because of their regular interaction with the managements, foreign investors do feel quite insecure.

For a fund manager managing funds from his headquarters in the US, the quantum of investment in Indian companies may not really justify the costs of monitoring them on a regular basis.

Stocks trading a earnings multiple of say 2 or 3 in spite of their steady financial performance, does raise suspicion about the quality of management.

In fact, in this respect global investors look at emerging markets like Korea and Taiwan, much more favourably.

"One reason is that foreign investors understand these markets much better because of their export links" says Bhat. India, in that sense, is still less understood.

As per the global fund manager survey by Merrill Lynch, a net 67 per cent of the managers think the global business cycle will get stronger over the next 12 months. This will cheer up the US markets.

Global strategy reports also indicate that risk aversion to US equities will decline this year and overall fund flows will improve.

Having said that, whether global investors will take cognisance of the Indian opportunity and pour money into Indian equities cannot be said with any degree of certainty.

2002: The Year That Was

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