FIIs Set To Light Up The Market

There is no ambiguity whatsoever about the fact that Foreign Institutional Investors (FIIs) were, are and will remain one of the most potent forces of the Indian equity market right from the days they were first allowed to invest in India. So powerful is their influence on the markets that they are said to dance to the tunes of the FIIs. These entities are said to be the main drivers of equity returns. But, the fact is quite contradictory to this thought. The cause-effect relation between equity returns and FII inflows is often misunderstood. It is the high returns generated by the Indian equity markets that attract the FIIs and not the other way round. 

This fact gets validated If we look at the sectors where FIIs have increased their stakes in 2013 (calendar year). IT and Pharmaceuticals, the two sectors, which outperformed the markets, were able to attract more FIIs (See Top 5 Sectors where FIIs have increased their Stake). Similarly, sectors like Banking (PSU), Power and Steel that underperformed the market saw FIIs reduce their stakes into them (See Top 5 Sectors where FIIs have decreased their Stake). Nonetheless, there were some companies within the pharma sector like Ranbaxy and Wockhardt, which remained in the news for all the wrong reasons and hence witnessed a decline in the FII interest in them. 

Over the last 15 years ending 2013, FIIs have invested a total of Rs 653136 crore in Indian equities. Except in 2008 and 2011, every year FII inflows have remained positive. Even if we take the fiscal year the result is same. Last year, even when India was not faring well whether you looked from any point of view and through the comparison of any parameter, the FIIs continued to remain positive and pumped in almost USD 20 billion (Rs 112366 crore), the third highest inflow since they were allowed to invest in India. 

That inflow was the highest among all the emerging markets. This is after they had already invested USD 23 billion (Rs 127154 crore) in CY12. Even for CY14 we may see FIIs pumping in money to the Indian equities. When asked to Andrew Holland, CEO, Ambit Investment Advisors about the participation of FIIs this year (2014) he said “it will be at the similar level and will be between USD 15-20 billion”. However Indian mutual funds have not shown the similar interest and have sold to the tune of Rs 20800 crore during the same period and you know the difference between the two. So what explains this dichotomy? One of the plausible reasons is, for FIIs, India is part of the larger set of emerging market portfolio. They always search for relative performance and hence they are bullish on the Indian equity market as compared to other emerging markets. 

ATTRACTIVE VALUATIONS 

Relative attractiveness of the Indian equity markets will remain one of the key reasons why FIIs will continue to be bullish on Indian equities. In the last few years, emerging markets like India have deeply underperformed their counterparts in the developed markets and are now trading below their historical averages on various valuation matrices.

The MSCI Index of developed market, consisting of 36 indices of different developed markets, has generated an average return in dollar terms in the last one year and three year periods of 15.4 per cent and 4.6 per cent respectively. Compare this with the average returns provided by 33 emerging market indices in dollar terms. During the same period they have provided negative returns standing at -11.2 per cent and -6.7 per cent respectively. The Indian equity market (included in the emerging market pack) too has given negative returns of 8.4 per cent and 9.8 per cent in the last one year and three year respectively in dollar terms. The underperformance becomes even profound in the broader market consisting of mid and small cap stocks. 

Historically, Indian equities (the BSE Sensex is the representative set of companies and data since 1991 for the purpose of this comparison) have traded at an average current PE of 20.85x and a median PE of 18.05x. Despite the market rallying 20 per cent from its recent bottom hit in the month of August the current PE of the Sensex stands at 17.64x. Although it may look as if we are fairly valued, Andrew Holland opines that “Indian markets are fairly valued at moment and that is because the defensive sectors are trading at high valuation and PE is high. But if you look at other sector they trading at PE of 11 and 12”. 
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According to a report by CLSA, one of the largest equity brokers in the Asia Pacific region, the Sensex forward PE of 14x is nine per cent below its long term average. The other important valuation matrix is the price to book value or PBV. This too is below its long term average. For the 22 years ending 2013, the average PBV at which the Sensex has traded is 3.69x and the median is 3.43x. Currently the PBV of the Sensex is 2.58x, which is 30 per cent below its long term average. 

Therefore, we believe that attractive valuations will remain one of the prime reasons for FIIs to invest in Indian equity markets. Pessimists will argue that the economic growth rate has also slowed down to a decade low and hence is reflected in the stock market valuation. That should not be a worry. Here is why.

GROWTH HAS BOTTOMED OUT 

After exhibiting a GDP growth of more than nine per cent just a couple of years back, growth has almost halved in the recent quarters. A GDP growth of 4.4 per cent in the first quarter of FY14 has marked the bottoming of the economy and as we move forward in FY14, economic growth is likely to pick up. We already saw a 4.8 per cent GDP growth for the second quarter of FY14. The factors that will drive growth going forward will be a pick up in the investment cycle, better industrial production and higher growth in exports. All these improvements will have a spill over impact on the services sector and that too is going to see recovery in its growth. Improved policy environment, especially post elections (read more below) will facilitate the GDP growth. 

The Investment cycle will pick up primarily due to a faster clearance and better execution of the existing projects which have been stalled for long now. Since its formation, the cabinet committee on investment (CCI), it has cleared more than 100 projects worth more than Rs 3.6 lakhs crore in just a year since it was formed. Anecdotal evidence suggests that credit is flowing into these projects that were stalled due to various reasons including pending environmental clearances. 

The impact of this will be visible in CY14. Pick up in mining and quarrying, which forms 14 per cent of the IIP, after declining by 2 per cent every year in the last three years will provide the much needed support to the overall IIP growth. 

We are already witnessing an improvement in iron ore mining and coal mining activities. Exports, which grew at an anaemic rate of 2.4 per cent in the last two years, is likely to revive going ahead as the rupee stabilises at lower levels giving Indian companies a competitive advantage. Exports will also get support from a recovery in the overseas markets specially the US and Europe. We have already seen exports growing at 10 per cent on a yearly basis in the last five months. Andrew Holland too see a economic growth picking up from here and “this year GDP will grow at 4.5% in FY14 and 5.5% in FY15 and 7% in FY16”. 

Corporate profitability has a very high degree of correlation with the GDP growth rate and therefore corporate earnings will react positively to the macro-economic improvement that we will witness in FY15. For a universe of 140 companies, profit for FY14 is expected to grow by 5.5 per cent and this would be marginally better than the FY09- crisis year growth rate. It will be almost two-thirds lower than the past decade’s average says a report by IIFL, one of the big brokerage houses based out of Mumbai. The report also points out to the fact that profit growth between FY11 and FY14 (when real GDP growth significantly slowed) for this universe averaged 7.5 per cent against the preceding five-year average of nearly 20 per cent. Moreover, out of the last six years, corporate profitability has lagged the nominal GDP growth rate. With growth on the cards we can expect earnings growth to again lead the nominal GDP growth rate. 
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The recent rally in frontline indices from their lower levels is purely due to expansion in the valuation and not due to earnings growth. Therefore, the next leg of growth in indices will come from the earnings growth, which will be irresistible for the FIIs to handle. This will help increase the depth and breadth of FII participation in the Indian market. The sectors that will lead growth will be cyclical, financials, information technology, Infrastructure, autos and telecom. Here is why. 

Financials: They are the nearest proxy to the improving macro-economic situation. As we have already seen deep earnings downgrade in the sector, revival in GDP is going to help restore the earnings. Moreover, as the government has cleared many projects, it is likely to reduce the NPAs going forward. 

Information Technology: This sector will continue with its good performance as demand situation improves in overseas markets. Valuations of IT companies still remains at reasonable levels, despite their outperformance last year. 

Infrastructure: As we are expecting the investment cycle to revive this year, infrastructure remains one of the prime beneficiary and will see an earnings upgrade. 

THE IMPACT OF TAPERING 

There are fears that as the US economy recovers, the Fed will dial back its bond buying programme. This might lead to huge outflow of FII money as we witnessed last year between the month of June and August. During that period, FIIs pulled out almost USD 3.7 billion dragging the Sensex down by 2000 points or 10 per cent. Tapering was bound to happen and the reaction in 2013 was over blown. Moreover, since then, the steps taken by the RBI and the government have largely mitigated the risk of any tapering that may happen in future. Although we may see some volatility in between as pace of tapering increases, it will soon return to normal as we have seen last year. We believe it is a stable government and right policy which will play a larger role in determining the course of FIIs inflows in CY14. 

THE POLITICAL THEATRE 

One of the most important and absolutely crystal clear factor that will impact the markets in 2014 is the shaping up of the political landscape. In fact the need of the hour for the economy to move ahead in a meaningful manner and hence for the stability of the markets is a strong and stable government with a decisive leadership at the helm. In fact FIIs have been gunning for the change in guard and have openly voiced their opinion on whom they would like to see taking guard. Developments over the past couple of months have however thrown expectations on the political front in a tizzy. 

The coming to power of the Aam Aadmi Party in the Union Territory of Delhi has sent some very mixed signals to the political observers. The focus is now on whether there could be fractured mandate thereby putting economic decision making into further jeopardy. But there is one side of it which needs to be considered. No matter who forms the government, taking forward reforms and quick decision making at the centre is quintessential today. 

There is no escape from this for anybody. Within that, if the saffron brigade finds its way to power with Mr Modi at the helm, you are bound to see a euphoric dance of the markets. The last of the probability is what the FIIs too are betting on right now. The cautious stand may continue for some time for now, but as 2014 picks up pace, FIIs will surely build positions to scale them up rapidly once the political fog clears out.