The Hindu Business Line : Heady equity prices — Reality check to avoid distress

STOCKS sizzle at close to all-time highs, driven by robust trends in the economy and liquidity, courtesy FII flows. Investors must now ensure that they protect the gains of the past two years and avoid nasty surprises. If FII flows and economic numbers remain buoyant, the upward trend could continue, albeit more moderately, interspersed with corrective phases. The big risk continues to be oil prices. In this backdrop, we examine key factors that need to be tracked carefully:

Enjoy comfort levels: The absolute levels of the Sensex or the Nifty ought not to make you uncomfortable. There is, especially, a tendency to be bothered by the Sensex levels, which have slipped slightly after touching new highs, as many investors tend to identify with its movement. A 7000-mark Sensex is close on hand. But given the scaling up of revenues and earnings, a large part of the gains over the past couple of years are here to stay.

Cut to the US, where the Dow had crossed 10000 five years ago. Despite a meltdown in tech stocks in 2000, the Dow remained close to this level before it slipped post-9/11 and recovered towards end-2002. Subsequently, it has hovered close to the 10000-level. This despite the index being widely perceived as overvalued. In India, the equity market is not overvalued now, unlike in 2000.

Track several indices: The Nifty and Sensex have long ceased to capture market sentiment though they remain in the limelight. To have a comprehensive idea of what is happening in the market, indices such as the CNX-200, CNX-500 and BSE-200 should be tracked closely.

As the bullish phase has been concentrated on mid-cap stocks, the CNX Mid-cap touched a new high six months ahead of the Nifty and Sensex, and has subsequently moved higher. The spurt in the market-cap of the market — now at Rs 16 lakh crore — is captured better by the CNX-500 than the Nifty or Sensex. The Web sites of the NSE (www.nseindia.com) and BSE (www.bseindia.com) provide a plethora of indices that offer a finer view of what's happening in the markets. To benchmark the performance of funds as well as your own portfolio, these indices may be appropriate unless you invest only in large-cap stocks.

Reap gains from re-rating: Quite a few sectors, which were in the dumps prior to 2003, enjoy market fancy now. The mark-up in valuation levels in banking, textiles, oil and gas and construction has been pronounced. Even if the business environment turns less favourable, price-earnings multiples in these sectors may not slip to the low, single-digit levels they were at earlier.

In these cases, the historical PEMs may be of limited relevance. Other commodity-oriented sectors, such as steel, cement and sugar, have enjoyed fancy in the past, too, and slipped subsequently. This could be repeated if the bullish trend in the commodity price cycle ends. This, however, appears unlikely, at least over the next couple of quarters.

Benefit from larger FII base: Going by the pace of FII flows this year so far, we may be headed for a third successive year of record inflows. But it is the more-than-60 per cent rise in the number of FIIs registered with SEBI since early 2003 that is more significant. This crop of FIIs appears to be backing their registration with significant investments, unlike their earlier counterparts.

A small number of FIIs used to dominate the market till about 18 months ago. In 2001, for instance, of the inflows in the first quarter, a single FII group accounted for more than 55 per cent. As the number of active FIIs rises, and they begin to trade actively, the divergent opinions make for a better balance.

The market is also less vulnerable to a pullout by a few FIIs. Many new entrants have long-term mandates. These changes are as positive for equities as size of FII inflows.

Avoid mutual fund IPOs: There has been a plethora of new funds launched by various fund houses. They promise to focus separately on large-cap, mid-cap and small-cap stocks or invest across market capitalisation levels. These IPOs have attracted investors in large numbers. We do, however, believe that almost every fund house has existing open-end funds that are superior options. You have the benefit of track record over three-to-five years, investment strategy and portfolio details.

These provide a better base to make an investment decision. A new fund would be worth a serious look only if it offers something distinctive and not so far available. The last such fund was Birla Dividend-Yield Plus, launched three years ago.

Here is a short list of 10 funds that we prefer and could be preferred over the new funds: HDFC Top 200, HDFC Long Term Advantage, HDFC Tax Saver, SBI Magnum Contra, Franklin Prima, Templeton India Growth, HDFC Equity, HSBC Equity, Reliance Vision and Reliance Growth.

The NAV is irrelevant in making an investment in an existing fund; so is the Rs 10 at which units are priced by a new fund.

Avoid dividend bait: Mutual funds have been using dividend announcements to lure investors. It would be better to avoid investment decisions on the basis of dividend, and, instead it would pay to focus on performance, which alone matters. The dividend just cuts into the NAV and is, at best, wealth-neutral. If you are already invested in equity funds, move to a dividend re-investment option as that is more tax-efficient, with payments exempt from tax.

Beware of promotion campaigns: In a trend that is typical of a bullish market that has largely run its course, several companies of doubtful pedigree have started to issue large advertisements on matters that they need not advertise.

Proposed board meetings, the agenda, corporate actions proposed and earnings announcements are prominently splashed in newspapers/television channels, that seem to lend greater credibility to the company.

The numbers indicated have been of an eye-popping nature. These companies are typically looking to capitalise on hectic day trading by a few operators, and the greater fool theory that seeks a fresh set of investors who buy at higher levels, taken in by grandiose claims. Steer clear of such companies, even if their prices spurt.

Unless you can absorb hefty losses, steer clear of stocks recommended in chat rooms on the Internet as well as in gossip columns in business papers/TV channels. You may make money by acting on a few of them; but you could end up a net loser with hefty losses on others.

Ignore stock splits/bonus: A host of companies have resorted to stock-splits and bonus offers to trigger a further upward trend. In 2003, companies that made the most such announcements were ones with a conservative approach that did so just to improve liquidity in their stocks.

Over the past 12 months, stock-splits have become a fad and, gradually, prices are settling lower. Avoid buying such stocks, especially in the home-stretch to the date on which they would start to trade on an ex-stock-split or ex-bonus basis.

Beware of greedy pricing: Over the past few months, the pricing of rights offers, initial public offerings and seasoned offerings has become more aggressive. These offers may provide reasonable returns in a bullish market of the kind that has been under way for about two years now. But the picture could change if the market moves into a corrective downward phase or a protracted phase of sluggish prices. Jet Airways and UTV Software are the more recent instances of stiffly-priced IPOs that have listed at a premium to their offer prices.

A spate of IPOs and rights issues are in the offing, including a host of offers from PSU banks. The greed in pricing is reminiscent of the trend in the mid-1990s, though it has not yet touched the heady levels of those days when free pricing of equity was in its initial years.

Only few of the equity offers from the mid-1990s delivered attractive returns and, if pricing patterns do not become more realistic, a similar pattern may be repeated.

Be wary of growth stories: In the close-to-two-year-long bull market, most growth stories across sectors and market capitalisation levels have been uncovered and suitably priced in. News on areas such as accretion to order-book positions, preferential offers to FIIs, other institutional investors and promoters, and restructuring exercises and mergers has to be viewed with extreme scepticism.

In the 1999-2000 boom, there was a clear trend towards orchestrating the flow of `feel-good' news and there are signs of this process playing itself out again. An investment based on news flows of doubtful credibility may only lead to losses. If you are not nimble-footed to move in and out of momentum stocks, it may be better to stay on the sidelines or invest through a few mutual funds — such as Reliance Vision and Sundaram Select Mid-Cap — which have a good track record of capitalising on momentum in the market.

As FY'05 draws to a close, the focus will shift to earnings growth over the next year or two; that would come on a high base after two robust years for companies cutting across sectors. If fundamentals have to provide support to the bullish undertone in equity prices, much will hinge on economic growth. The pointers are encouraging, though high oil prices could play party-pooper.

If you have a deep, `in-the-money' (that is, a portfolio value which is higher than the cost of acquisition) position, book profits on 20-30 per cent of your holdings and re-enter stocks of sound companies at lower levels.

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