Be ready, FIIs are set to come in

A few years ago, it was fashionable for foreign institutional investors (FIIs) to be part of India’s growth story. Now, the situation has reversed, and it is probably more fashionable for them to remain outside India. Last year (in 2011), FIIs withdrew a net Rs 2714 crore from the Indian equity market. The reasons for such apathy of the FIIs towards India are both economical and political.

This indifference of the FIIs is evident from the latest fund manager (FM) survey by Bank of America-Merrill Lynch (BoA ML), which shows that just when it seems that investors cannot reduce their allocation to India any further, they actually do: 61 per cent of the emerging market (EM) fund managers polled were underweight on India, which is the highest percentage of FMs being underweight on the country since July 2008, when it was 75 per cent. January marks the 17th consecutive month of India being underweight on their list.

Before arriving at any conclusion, however, one should note that these surveys state their view for the next one month, and the scenario is likely to change in the course of the year, as and when new developments take place. However, before going into any discussion about the year ahead and about events that will shape the FII flows, let us understand if the Indian stock market is still a slave of FII flows or not.

Historically, there has been a strong correlation between FII flows and our stock market performance. So much so, that at one point of time, it was said that the Indian equity market dances to the tune of the FIIs. If we look at the data for the last ten years, we find that the direction of the broader market is the same as that of the FII flows. For example, in 2008 we saw FIIs taking out a net Rs 53000 crore from equities, and the Sensex tanked by 52.86 per cent during that period. In the following year, we received a net Rs 85405 crore from FIIs, and the Sensex went up by 75 per cent. 

Nevertheless, this bond has been weakening in the last couple of years. In 2010, we saw a record net FII inflow of Rs 133266 crore, whereas the Sensex moved up by just 17 per cent. Last year too, the 25 per cent fall in the Sensex cannot be explained by the less than a quarter million of USD outflows that we witnessed.


Some may argue that most of these funds might have found a place in non-indexed companies, and hence, are not being reflected in the broader market index. In order to dispel this doubt too, we studied individual companies and tried to gauge their impact on the stock prices. We do not find any direct correlation between a rise in FII holdings and the stock returns. Even after regressing data for individual companies, we do not find that an increase in FII holdings helps the stocks to perform well. For example, AIA Engineering saw the FII holdings increase by 4.25 per cent in the last one year, and yet, the stock declined by 33 per cent in the same period. On the contrary, Divi’s Labs saw the FII holdings decline by 6.05 per cent last year, but the stock went up by 18 per cent. However, the number of companies in which the FIIs have reduced their holding and whose stocks have gone up regardless of that are very few.

One of the arguments that is doing the rounds in media is that FIIs have shifted their weight on small cap and mid cap counters. Yes they have. Out of the 256 midcap companies they have increased their stake in 128 companies compared to having reduced their holding in 105 companies between December 2010 and September 2011. During the same period, the BSE Mid cap index is down by 34 per cent, which further authenticates the weakening bond between FIIs increasing their holding in companies and the movement of their share prices.


If we look at CY09, FIIs pumped in approximately three per cent of the total market cap of the BSE 500 companies (which in turn constitutes almost 95 per cent of the total market cap of India Inc), and the BSE 500 index was up by almost 89 per cent. In the following year (2010), they put in 2.3 per cent of the amount of market cap standing at the start of 2010, and the index moved up by just 16 per cent. Hence, there is no comprehensive and convincing relationship that emerges between FII investments and the market movement.

An analysis of the market cap of individual companies vis-a-vis a change in the FII holdings too does not show perfect correlation. Though the FIIs look like they are losing their importance as a potent force to drive the market, their absence definitely impacts the market psychologically. Hence, it becomes important to understand the course that the FII flows will take. Sunil Singhania, Head Equities, Reliance Capital AMC, says, “From the initial flow of the current year, it looks like the FIIs will remain positive for the year.” Let us understand the factors that will help India to attract these important constituents of the market, which help lift the sentiment in a major way.

Policy Paralysis: Cure In The Offing
One of the prime reasons why FIIs turned their back to the Indian equity market is the inability of the central government to bring in any major policy reforms. This fact is well captured in what Lord Meghnad Desai, Professor of Economics, London School of Economics & Political Science,  said at the recently held India Investment Conference – 2012. “I am awed to find no concern within the political system. There is an attitudinal problem in the political system and not even a single political party has shown any concern” said Desai.  Although the government did try to take some initiative on that front by opening up the country’s retail trade to foreign companies, the decision was later suspended due to political pressure from the opposition as well as from within the ruling coalition itself. A recently released World Bank report points towards this factor. According to the report, delays and uncertainty surrounding the implementation of policy reforms have hindered investment in developing countries.

Recent developments point towards a likely reversal of the trend in the next couple of months, more so if the UPA II fares well in the forthcoming elections in the five states that are slated to go to poll very soon. A step in this direction is that the government has asked 17 state-owned companies to begin using their reserves for spending on infrastructure projects and overseas acquisitions. This is expected to start from the next fiscal, with the total investment estimated to be around USD 35 billion, almost twice the amount of FDI we received in 2011. This will also raise the confidence of private companies, and will stimulate further investments.

Moreover, the recently appointed Empowered Committee of State Finance Ministers on implementation of the Goods and Service Tax (GST) has given in-principle approval to the union government to go ahead with the negative list, which is seen as a precursor to the GST. Under this, all services, barring a select few, would come under the tax net. It is estimated that the Indian economy will gain USD 15 billion a year by implementing the GST, as it would promote exports, raise employment and boost growth. 

We do not feel that the GST will be rolled out from the next financial year, as announced earlier. Nonetheless, it shows the inclination of the central government towards policy reforms. Moreover we believe that there are certain steps government can take without going into parliament like expedite allocations of coal blocks which should help address the sharp fuel shortage for power sector and also other industries like cement and aluminum which are heavily dependent on coal for their fuel feed requirements.  Hence, we believe that we may see some more policy action going forward in the following central budget, as we still have almost two years to go before any election comes up, which gives the government an opportunity to fill the policy gap. It may announce some tough policy action this year, and save the populist measures for the next year.

Inflation: Taming The Monster
Beside policy inaction, very high and sticky inflation was one of the biggest turn-offs for the FIIs. Inflation remained stubbornly high at more than nine per cent for the entire period of 2011. However, it is not inflation in itself that acts against the FII inflows. Rather, the action taken by the central bank to curb inflation has impacted the flows. The RBI has hiked its key policy rates 13 times (totalling 350 basis points) since March 2010 to tame demand and in turn, curb inflation. 

Since the FII investments are primarily driven by the stock market returns, which, in turn, depend on the corporate performance, a sharp increase in interest rates has and will probably impact corporate profitability. This has indirectly impacted FII investments in the stock markets. If we look at the rise in the interest cost (excluding financials) for BSE 500 companies between the March 2010 quarter, when the RBI started raising the interest rate, and the September 2011 quarter, it is up by almost 60 per cent. For the latest quarter (Q3FY12) out of 199 companies (excluding financials) interest cost is up by 33.62 per cent on yearly basis.


In terms of percentage of sales, the interest cost has increased from 2.2 per cent to 2.8 per cent of sales. This factor has played its own part in bringing down the overall profit margin of the companies from 9.8 per cent to 5.1 per cent in the same period. We believe that the interest rates have peaked off for now and we may see some sort of easing in FY13. Indranil Sengupta, Chief Economist for India at BoA ML, says, “We believe that the RBI will reduce rates by 200 bps in two parts, first by 100 bps in the first half of fiscal 2013 and then by 100 bps in the second half”. He further said that this will lead to “lending rates coming down by 150 bps”. This is definitely going to be a booster for the sagging Indian economy. The  CRR cut by 50bps effected by the RBI in its January 24 meeting is a sign of things to come. This cut itself is expected to inject almost Rs 32000 crore in the system.

Cut in lending rates will not only reduce the cost of companies and help them to post good numbers, it will also help in another way. Lower interest rates will help equities to attract an increasing amount of portfolio allocation between equities and bonds. The lower interest rate will make the equities look cheap (through lower discount rates while valuing equities), and will make the bonds unattractive. In 2011, we received Rs 42068 crore in debt compared to the outflow from equities. 

Data for the last few years also indicates that whenever there is a sharp decrease in interest rates, the FII investment increases with a little lag effect. For example, in 2009, we received a total of USD 17 billion of FII investment after the reduction in key policy rates by 1.75 per cent in addition to the 2.5 per cent that we witnessed in the last quarter of 2008. “Even during 1995-96, when the market was similar to what we saw last year, there was a huge rally immediately after the first rate cut itself”, says Jyotivardhan Jaipuria, MD & HOR, DSP Merrill Lynch (India). Therefore, we believe that a reversal of interest rates in 2012 is definitely going to reverse the trend of FIIs, and they will start investing in Indian equities again.

Rupee Will Strengthen Again
Although the broader market index declined by 25 per cent in 2011, the performance was even worse in dollar terms, because it declined by 36 per cent. The reason for such a dismal performance was a sharp depreciation of the rupee vis-a-vis the US dollar in the second half of the year. Last year, the rupee depreciated by 19.24 per cent against the US dollar, with most of the depreciation – almost 18.66 per cent – taking place in the second half of the year alone. 

For FIIs, it was a double whammy. First they suffered the wrath of a downfall in the equity market, and the second was the concern of the depreciating rupee. The volatility in the rupee remained one of the important reasons why the FIIs shied away from the Indian equity market. However, with the dawn of this year, things are taking a turn for the better. 

If we look at the rupee-dollar exchange rates, it primarily depends upon two factors – the balance of payment (BOP) and the capital flows (both portfolio and direct investment). Last year, the sudden and persistent rise in oil prices coupled with lower tax collections (owing to a slowing economy) made the BOP situation worse. 

According to Sengupta, however, “BOP risk is overdone for India”. He believes that the situation will improve from here on. “The reason is because the dollar itself is strengthening. We think that the dollar will peak at around 1.25 per Euro by March 2012, and will settle down at around 1.3 by December 2012. Moreover, we have a high current account deficit of three per cent plus, but that should be covered by capital inflows. We are surprised by the upside of inflows. ECB is USD 10 billion, FDI is high, NRI deposits have been high and the invisible numbers are high. If you see BOP, it is the same as that in September last year. So, it means that it is low as a percentage of the GDP”, he adds. 

Therefore, we believe that the risk to the rupee is less than what has been priced in. Also, out of the total external debt, almost 17 per cent comprises NRI deposits and a lot has been in trade credits to oil companies that will be rolled over. Even if we look at the de-leveraging of the European banks, it is not a concern, “as European banks in India have around USD 6 billion borrowing, which is not that big”, Sengupta explains. The market also seems to understand this and, it is reflected in the current strengthening of the rupee against the US dollar. Year-till-date (January 20, 2012), the rupee has already strengthened by 5.6 per cent, and in Sengupta’s opinion, it will be around Rs 49 per US dollar by the end of the year.

Corporate Performance And Valuation
A silver lining to last year’s fall in the index is that the Sensex is currently trading at a PE which is at its lowest in the last six years, barring the eight months post the Lehman Brothers’ fall. The Sensex PE has fallen from more than 22 at the start of the year to 17.31 currently, which is lower than its long-term average of 18.26 (last 10 years). Even if we compare India’s valuation premium to its Asian peers we, have seen a compression of 17 per cent last year. Therefore, the current premium of MSCI India of 13 per cent is far lower than what we had at the start of the year (30 per cent). On an average, MSCI India has commanded a premium of approximately 23 per cent in the last eight years over its Asian peers.


One could argue that the valuation premium may get further compressed. However, we believe that the chances of this happening are very low, as the return on equity (ROE) of India Inc., though shrunk from 5.1 per cent in CY09 to 0.2 per cent currently, is still at a premium to that of the other emerging markets. “However, the earning profiles are going to change after the disappointment in the last two years. Maybe in the next six to nine months, we could see some earnings momentum”, explains Jaipuria. Hence, the likelihood of the premium compressing is remote.

Additionally, with rate reversals on the cards, we may see the premium widening again. This will also help in another way. The rise in interest rates and the fall in the Sensex brought the spread between the Sensex earning yield and the one-year government bond yield almost to parity after being negative since August 2010.

In the past, a situation like this has always resulted in equity outperformance in the following period. If we look at India Inc.’s performance across 224 companies in Q3 FY12, though the net profit is up by approximately 3.62 per cent, the sales are up by 31.71 per cent. The reason for this subdued performance of net profit is the rise in expenses and interest cost, which will see improvement in 2012. 

In addition to these factors, Singhania opines that, “If we look at other BRIC countries, it is only India that offers huge breadth, depth and opportunity to invest. Other countries like Russia, for example, are basically dependent on oil, Brazil is based on commodity play and China is export-oriented”.

Conclusion
In addition to the reasons mentioned above, there are other international factors that are showing signs of FIIs channeling money into India in the next year.

First, the concerns over the break-up of the Euro zone are overhyped, as the Euro zone authorities are expected to do whatever it takes to hold it together. Although the Euro zone economies now appear to be sliding into a recession, we hope that this will last only for a couple of quarters. Bear in mind that the whole world has an interest in the resolution of the crisis. According to a survey by BoFA Merrill Lynch Global Research, “Almost eight out of ten fund managers expect some sort of quantitative easing in the US and Europe”, and this bout of liquidity will help not just the Euro zone but also countries like India. 

If we see the year-till-date trend of funds, there has been a shift in asset allocation from cash and bonds to equity and cyclical rotation of sectors. This shows a jump in the risk appetite, albeit from a very bearish level. This again is a positive sign in terms of FII investments, as the emerging markets as a whole are considered riskier investments. 

The rise in risk appetite is further validated by lower volatility, as measured by CBOE’s VIX, which fell below 20. This sudden drop doesn’t come as a shock, especially with the S&P 500 off to its best start to a year since 1987. The reason for such drop in CBOE’s VIX is that the world’s largest economy, i.e. USA, is showing signs of improving economic conditions, with data suggesting strong earnings from some of the bigwigs like Apple, Yahoo!, Altria, Ford and Chevron. This could lift sentiments. Add to this the rising home sales and falling jobless claims, and you can expect significant amount of improvement in the market sentiment.

Another major reason why the FIIs will allocate a higher amount of funds to Indian equities is the depth that the Indian market offers. There are a whole lot of sectors that are available to them while allocating funds here. Therefore, we believe that the FIIs will remain positive for the year, though possibly not at the levels witnessed in 2010. Moreover, even we take the most pessimistic GDP growth estimate of 6.8 per cent into consideration for the next yea, we believe it will still be the second best in world, which FIIs can hardly overlook in such turbulent times. 

The sectors that that are going to be most favoured in 2012 are those which were among the worst performers last year. After the tightening of rates for nearly 19 months and the rise in interest rate by 3.75 per cent, the rate-sensitive sectors have remained among the worst performing ones. The most affected was the BSE Realty Index, which fell by 52 per cent, followed by the BSE CG and BSE Bankex that fell by 48 per cent and 32 per cent respectively. These, we believe, are the sectors that will outperform in 2012. The trend is visible in the year-till-date numbers, where the BSE Realty index is already up by 24 per cent, followed by the BSE CG index that is up by 21 per cent. Hence we believe that the beaten down companies with good management from these sectors will be the right choice for investors in 2012.