Rock Solid
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A flood of money from overseas investors has entered the Indian market in a very short while. There are some imminent worries that this inflow could reverse. DSIJ analyses the issues at hand, concluding that the situation isn’t really bad.
“Markets are irrational”, “Exuberance is bad”, “Caution is the word”, “You can never time the market” – these are some of the most common admonitions you hear when the equity markets begin moving up. Should you ignore them and go out to invest so that you can ride the up-move from end-to-end? Or should you lend your ear to them and be careful so as to not burn a hole in your pockets and repent later? This dilemma is something that investors would be least inclined to pay heed to, particularly when the markets seem to be offering an opportunity to make profits. One way to get over this dilemma is to pay attention to the advice of the well-researched, and we would certainly not be out of line in taking credit for being one among them.
It was we who told you very early on that the Indian markets are beginning to gather steam for their next leg up. Since June, we at DSIJ have been the only ones to take a positive call on the market. No one, including the best market commentators and experts, was willing to take a firm stand on the future course of the market when we first wrote about an impending bull run. What has happened since early September 2012 is for all to see. We have been bang on target, and the market has been consistently rising since then. The Sensex has gone up by a good 12 per cent, coming reasonably close to breaking the proverbial glass ceiling and going past its previous peak.
While the good times are more than welcome, it does pay to look carefully for any signs of potential disruption, and this is what we seek to do here.
The government springing into action on the reforms front coupled with policy action in the US (read QE3) and Europe (the bond buying spree) are factors that have completely weighed the scales in favour of the bulls. The markets started moving up, and have not looked back since. While we expect the markets to scale newer heights going forward, as we mentioned earlier, it would be good to look out for any upsets in the onward and upward journey of the markets. All we are trying to do is to take lessons from history so that our readers can make informed investment decisions.
In our analysis, we have looked at two major factors that could, if at all, put brakes on the markets’ onward journey. The first and most important factor is with regard to the big FII investments that are coming in, which have the ability to keep the markets where they are and probably take them higher. The question is, will FIIs continue to invest in India? Are there any factors that may trigger their pullout from here? Are Indian institutions ready to take on the might of FIIs in case there is a need to do so? Secondly, is corporate India well on its course to improving its fundamentals?
Here is our take.
FIIs: Here To Stay
Remember the May of 2000, or even four years from then (17th May, 2004 to be precise). Does October 2008 ring any bells, or January 2009 for that matter? These were times when panic suddenly gripped the markets following events that weren't really expected to happen. Whether it was the unearthing of Ketan Parekh’s wrongdoings or UPA’s unexpected statements, the fall of the Lehman brothers or the undoing of the Raju’s (Satyam), these events have rocked the markets. Typically, one fallout of events like these is the massive pullout of foreign funds (FII investments) that primarily drive the Indian markets.
The markets’ rise can largely be attributed to the flood of FII money that has come in over the past couple of months. This stands true because retail participation in the markets has not been anything worth talking about.
Thus, there are worries about what could happen in case these funds are withdrawn at the same speed at which they have come in? Will this really happen? What could trigger such a pullout? Most importantly, if they do, is there a viable alternative to FIIs in the Indian context?
The impact of FII flows and the returns given by the Indian equity market is more like a chicken and egg conundrum. It is very difficult to interpret whether FII inflows push the markets up or whether FIIs come in to take the advantage of rising markets. However, various research papers have confirmed that it is the better performance of the Indian (or local) equity markets which plays the most important role in attracting FII money, and not the other way round.
However, if some tail risks emerge once in a while it may lead to a huge outflow of FII money, thereby impacting the equity markets. For example, in October 2008, the Lehman Brothers crisis led to a net outflow of Rs 15347 crore in the same month. This stands to be the highest withdrawal of money by FIIs in any single month till date. The impact of such a huge outflow was reflected in the performance of the Sensex, which saw a sharp drop of 25 per cent, once again the worst monthly fall seen since 1997.
Are we currently faced by any such events? Well, we do not believe so, and hence feel that a sudden exit of FIIs looks unlikely. Year-till-date, FIIs have invested more than USD 18 billion in the Indian equity market. The sheer quantum of this amount is at the heart of the fear of any negative event impacting the equity market and triggering a massive outflow of funds. Some of the risks in the offing which could trigger such an outflow include an early union election, a sudden deterioration of the situation in Europe or the US going down the ‘fiscal cliff ’, as is being perceived (See our Special Report on fiscal cliff).
However, past experience shows that there is a disproportionate reaction of FIIs to good situations as well as bad ones. When the economy is doing well, FIIs intensify their buying, as we saw in the calendar years 2009 and 2010. The year after the financial crisis of 2008 saw the economy picking up from a low GDP growth of 5.8 per cent in the second quarter of 2009 to 9.4 per cent at the end of the second quarter of 2010. When this happened, FIIs pumped in close to USD 17 billion and USD 29 billion in the years 2009 and 2010 respectively, which was a sort of a record inflow. However, the situation deteriorated over the next couple of years, with the economic growth rate dropping to 5.3 per cent in the second quarter of CY12. Despite this, we did not witness any massive outflow of FII funds from the Indian markets. Although FIIs did exit from the Indian market, the outflow was a mere Rs 2714 crore. Against this background, we believe that FIIs will be not in a hurry to exit the Indian equity market en masse even if the situation worsens from here on for any reason.
Stocks Where FIIs Have Increased Their Stake
In the quarter ended September 2012, FII holdings have gone up in four out of every five Nifty stocks, going down in just three stocks and remaining unchanged for the rest. This speaks of an overall positive mood of FIIs for India Inc. at large.
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| % Shareholding At The End Of | Change |
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| Company Name | Sep 11 | Jun 12 | Sep 12 | QoQ | YoY |
| SKS Micro. | 19 | 8.3 | 31.8 | 23.5 | 12.8 |
| Tech Mahindra | 4.4 | 5.9 | 15.1 | 9.2 | 10.7 |
| Cairn India | 6.6 | 8.5 | 16.2 | 7.7 | 9.5 |
| IRB Infra. | 13.3 | 15.7 | 22.7 | 7 | 9.3 |
| Axis Bank | 42.6 | 35.7 | 41.7 | 6 | -0.9 |
| Educomp Sol. | 29.2 | 26.2 | 31.4 | 5.1 | 2.2 |
| YES Bank | 50 | 42.9 | 47.5 | 4.6 | -2.5 |
| NIIT Tech. | 23.7 | 22.6 | 27.1 | 4.5 | 3.4 |
| Shri.City Union | 15.3 | 15 | 19.5 | 4.5 | 4.2 |
Now, let us check the stocks or sectors in which FIIs have shown maximum interest and how those stocks have performed (See Table). One sector in which FIIs have increased their stake most is cement stocks. All the Nifty cement stocks have witnessed increased FII shareholding, for example, ACC, Ambuja Cements and UltraTech. Even BFSI has witnessed considerable interest from FIIs. SKS Microfinance saw the FIIs’ shareholding going up from 8.3 per cent at the end of June 2012 to 31.8 per cent at the end of the September quarter. Various other banks like Axis Bank, ICICI Bank, Dena Bank, etc. also saw the FIIs raising their stakes.
A word of caution we would like to add here is that there is no one-to-one relation between FII investments and a rise in share prices. For example, IRB Infra and Educomp Solution both saw FIIs increasing their stakes both on a yearly basis and a quarterly basis. Despite this, these stocks have yielded negative returns year-till-date. Therefore, investment by FIIs does not necessarily predicate the stock performance, and one should look into other factors too before buying the stock.
Good Tidings For FII Inflows In December
Moreover, we find comfort from the historical flows of FIIs in the month of December, as seen over the years. In the last 19 years (since 1993), there are only three instances when FIIs have taken money out of the Indian equity markets in the month of December (See Table: FII Activity In December Since 1993), 2011 being one of them. In the same period, on an average, FIIs have put in Rs 2280 crore during the last month of the calendar year. Even last year (2011), when they were net sellers for the entire year in the Indian equity market, FIIs remained positive in the month of December.
This addresses any immediate concerns about what they are likely to do over the next couple of months.
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Are We Strong Enough On Our Own?
In the event that something terrible happens and FIIs do sell, are our own institutional investors (read Mutual Funds) strong enough to act as a viable option and support the markets?One major factor that needs to be looked at in this context is whether these institutional investors have enough cash to support the kind of buying that will be needed in such a situation.
Our research suggests that there is no uniformity in the cash holdings by fund houses. Fund house like HDFC are sitting on lesser cash as compared to others like ICICI Prudential and IDFC. If we look the overall cash holding of Domestic Institutional Investors (DII), we believe that they do not have the same money power as FIIs in case of a sudden, substantial outflow of FII money. But all the same, it is worth noting that the government has time and again pressed institutions like the LIC to support the markets in times of a crisis.
Will this happen again? We don’t know. But one thing that we are quite sure about is that there is a very low probability of FIIs pressing the panic button. Moreover, with so much liquidity available globally and shrinking investment opportunities, India remains one of the prime destinations for FIIs. This fact is substantiated by the analysis of FII holdings at the end of September 2012 (Refer to: Stocks Where FIIs Have Increased Their Stake).
Now here is our take on the second most important factor that is likely to spook the markets – valuations and corporate performance in the next quarter (December 2012).
India Inc: On A Strong Footing
Valuations always play an integral part in the equity markets. They make markets look good or bad. Naturally, nobody would be interested in buying anything which is overvalued. Indian markets are no exception to this rule of thumb. Valuations and corporate performance go hand in hand and to get a sense of where the markets are headed going forward it is important to gauge the financial performance of India Inc. The September quarter is behind us and what will drive the markets going forward are the results of India Inc in the December quarter. But before we do that here is that has happened. (Our next issue will give you a detailed analysis of the performance of India Inc in the September quarter. This is a just a brief idea of what has happened).
September Quarter – Rock Solid Performance
1800 companies have announced their results till date. Here is what we had stated about what can be expected in the September quarter when we had analysed the results for the June 2012 quarter. We had categorically stated that “With inflation declining a bit, some improvement can be expected in the September 2012 quarter. The rupee has stabilised and the government is taking some positive steps on the reforms front. If the government continues with these moves, some betterment on economic front is expected. In terms of financial performance, we are at a trough and can only expect to go up from here. Commodity prices are expected to witness a decline and provide some relief. Considering all these factors, we feel that India Inc. is heading towards better September 2012 quarter results”. And we have been proved right. For the quarter ended September 2012 India Inc has posted strong results where the top-line on a Y-o-Y basis has increased by 12.50 per cent. The bottom-line after adjusting for the extra ordinary income has gone up by 17.41 per cent. On a sequential basis too, the performance has been good with a top-line growth of 1.31 per cent and a bottom-line growth of 11.76 per cent. The results have been better than expectations.
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The best part about the results has been an improvement in some worrisome areas. Operating margins that were under pressure for quite a long period have improved significantly to 18.31 per cent from just 17.52 per cent in September 2011 and 16.93 per cent in June 2012. This is on account of a decline in raw material prices. Raw material cost as a percentage of sales has declined to 46.86 per cent from earlier levels of 47.13 per cent in September 2011 and 47.19 per cent in June 2012. Another factor is the improvement on the interest cost front. The interest cost as portion of sales stood at 2.39 per cent as compared to 2.31 per cent in September 2011 and 2.67 per cent in June 2012. Though on Y-o-Y basis it is still higher, on a sequential basis the improvement has been quite significant.
December Quarter – Expectations
While the September 2012 quarter results are indicating towards early signs of betterment of the domestic economic scenario, the moot question is, is it sustainable? We are of the opinion that December 2012 quarter results will have many positive things in store. Here is what will probably happen.
Margins Set to Improve
Pressure on operating margins was one of the major factors worrying India Inc. Consistently increasing commodity prices and crude oil prices meant that margins remained under severe pressures. Further the depreciating rupee against the dollar only made the scenario more difficult. However going ahead, we are of the opinion that India Inc. is expected to witness an improvement in margins. Rather, as we had mentioned in the past, on sequential basis improvement is clearly being witnessed. June quarter was better than March and September is much better than the June quarter.
Another advantage is the relative recovery of the Indian Rupee (2.03 per cent Since October 2012) against the USD. We have stated earlier too that, a depreciating rupee may or may not help Indian exporters, however, an appreciating rupee will surely help importers. Along with this Brent Crude prices have declined from USD 117 to USD 107 per gallon decline of around 9 per cent) in past two months. So a combination of both these factors; fall in commodity prices, crude oil and appreciating rupee would definitely help India Inc on the margins front.
Interest Cost Expected To Decline
Some betterment on the interest cost was visible in the September quarter. For the December quarter the scenario is expected to improve further, as in October too the RBI has provided additional liquidity (CRR cut by 25 basis points bringing it to 4.25 per cent). This has again resulted in additional liquidity of Rs 17500 crore. Considering all these factors, we would not be surprised if the interest cost in December 2012 would come down below 2.30-2.25 per cent. Apart from this, as inflation starts contracting RBI may cut rates in the first quarter of 2013. Rather the RBI has faintly indicated towards the same. In the anticipation of the same, one can expect the lending rates to decline in near future.
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Volume Growth & Low Base Effect
All said and done, the most important factor that will result in better performance of India Inc. in the December quarter is the low base effect of December 2011. In December 2011, while the topline witnessed an increase of 20 per cent the bottomline declined significantly by 7 per cent. Hence along with low base and improved margins, the YoY effect is naturally expected to be better.
For the December 2012 quarter, we expect volume growth to continue. A very simple reason for this is, that the festive season for 2012 has been much more cheerful than that in 2011. Unlike last year when the overall scenario was quite grim and had impacted the festive season volumes, the scenario is quite cheerful this time. We are of the opinion that a combination of these factors will ensure that volume growth is sustained. Even the engineering and capital goods companies are expecting the capex cycle to continue and increase in order inflow of L&T (Up by 30 per cent on a Y-o-Y basis for September 2012 quarter) indicate towards better days ahead. Even the index of Industrial Production (IIP) figures have started to improve and after two months of negative figures they stood at 2.70 per cent in September 2012. With a revival in the Capex cycle we expect the December quarter figures for IIP to be good. On the bottomline front, apart from margin improvement there is another factor which is expected to help India Inc. In December 2011 many companies had witnessed mark-to-market losses on account of a sudden and sharp depreciation of the Rupee against the Dollar. With the Rupee showing some stability and appreciation, the bottomline too is slated to improve.
To sum up, we feel the financial performance of India Inc is expected to be better in December 2012. Rather the September quarter results are suggesting that there will be an upgrade of overall EPS estimates for FY13. In August the consensus FY13 EPS for the Sensex-based companies was downgraded to Rs 1213-1215. We now expect an upgrade of least 8-10 per cent in these estimates. This would provide an EPS of around Rs 1310-1312 resulting in a P/E of 14x on FY13E earnings. Further this provides an upgrade in terms of FY14 expectations. FY14E EPS stood at Rs 1380, and if an upgrade happens, it is estimated to come at around Rs 1490-1500. Valuations at 12.50x on one year forward earnings (FY14E) leave enough room for investors to park funds in markets. Even at 16.50x of FY13 earnings the Sensex can touch the levels of around 21650. After you have read all this, do you still feel there is a reason for you to worry about whether this market is on a sustainable growth path?
Relax and invest to enjoy the benefits.
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How do DIIs (read Mutual Funds) look at the scenario that is currently panning out in the markets? To get to know of this, we spoke to Lalit Nambiar, Fund Manager & Head – Research UTI AMC. Here is what his take is. It should help you understand how Indian institutional investors are perceiving the whole situation.
How do DIIs (read Mutual Funds) look at the scenario that is currently panning out in the markets?
To get to know of this, we spoke to Lalit Nambiar, Fund Manager & Head – Research, UTI AMC. Here is what his take is. It should help you understand how Indian institutional investors are perceiving the whole situation.
Year-till-date, FIIs have invested more than USD 18 billion in the Indian equity market.
What are the factors you would attribute this euphoria to?
As an observer, I would presume that from an FII perspective, India was relatively attractive, driven as it was by a strong domestic consumption engine even as most of the global economies were slowing down. But I would not call the trend euphoric in any way as the Indian market valuations are still around their long-term average.
How attractive do you find the Indian equity market as compared to other emerging markets in terms of valuations?
In terms of valuations, after the recent out-performance, perhaps some markets such as China are looking more attractive. So in the very immediate term perhaps till about January, Indian markets may take a breather. That said, however, we are setting ourselves up for a downward movement in the interest rate cycle which will eventually result in kick starting a virtuous cycle of growth. It is impossible to pick or time the bottom on this one. Suffice to say that looks like we are closer to the bottom of the investment cycle than we ever have been since 2007. Thus on a long term horizon, say five years out, Indian equities are well-placed to outperform. What is your take on the recent slew of reforms unleashed by the new Finance Minister? Are they helping to create a better investment climate?
We have had only policy announcements so far, I think much more has to happen in terms of policy action, and revival of investment cycle for which all eyes will be on parliamentary action later this month.
What is the sense you are getting now from long-only funds in terms of the direction of flow of FII money in the Indian equity market in 2013? What are the factors that will determine the direction?
I would think they would be looking at the interest rate cycle and also watching government actions especially on the fiscal front and in the area of speeding up decisions in the power sector.
In terms of sectors, do you see any particular trend in the emerging market money flows, especially for India?
Barring the interest rate cycle story, I think there is no sector theme which can be played and it still looks very specific to the fundamentals of individual stocks.
What will be the factors that will either encourage or discourage FII investment in the remaining part of this calendar year and in the next calendar year?
Based on past behavior, I suppose it is safe to presume that strong corrective actions on the fiscal front and government resolve on reform will embolden FIIs, while populist measures will not go down well with them.
Do you think any specific step needs to be taken by the government to improve the investment sentiment in India?
Starting with deregulating, raising SEB tariffs and diesel prices, cutting food and fertilizer subsidies, auctioning assets of defaulters, implementing GST, it is a long list. The issue is everybody knows what is wrong, but whether there is the political backbone to implement these steps, especially as we come closer to the date of the next Lok Sabha elections is debatable.
What impact would the rupee volatility have on the investments that are coming to India?
It will not matter to FDI players as they have longer time horizons but for portfolio or FIIs it will be a factor to keep in mind. That said, I do not think we are likely to see sharp swings as we did in the recent past.
What is the probability of the sudden outflow of FII investments from India (as was seen in the year 2008)? What, do you believe, are the triggers that may lead to such outflow?
Except in the case of a sovereign rating downgrade of India to speculative grade, there is a very low probability of a sudden exodus of FII money.