The Hindu Business Line : FIIs: Winning streak in Indian equities

FOREIGN institutional investors have developed a fancy for Indian stocks on a scale unparalleled in the last decade. The last couple of years, in particular, have seen a 50-per cent increase in the number of FIIs investing in India. FIIs that entered India in the 1990s reaped rich dividends, mainly in the sustained bull market from mid-2003. Those that joined the party over the past couple of years too have done quite well. And this is likely to augur well for Indian equities.

The experience of the new entrants, however, is in sharp contrast to that of their earlier counterparts. Not accustomed to the ways of Corporate India, it took the latter a couple of years to get over the initial shocks and become wise to market realities.

The new entrants, however, had an easier time of it, buoyed by wealth creation in the market, backed by robust fundamentals of India Inc and a booming economy. This trend, about two years old now, appears to have the momentum to keep going for at least another year.

Indeed, this has raised FII interest in the country. In the past month-and-half, equity prices have moved to historic highs, as the upward trend has been boosted by robust FII flows; this is a mini turnaround of sorts as the FIIs were net sellers in April and May. At $7 billion, the inflows are well on their way to best the $8.5 billion that poured into Indian equities last year — about 25 per cent of it in seasoned equity offerings and IPOs of several large-cap companies. In contrast, a larger proportion of inflows this year has gone into buying from the market.

On a comparable basis, FII inflows this year are already at record highs. It is now certain that, even in absolute terms, they will set new marks for the third year in a row in 2005. This would ensure that Indian equities retain much of the higher valuation levels they command and close the year with sizeable gains.

Sea change in FII portfolio: An investment of about $22 billion between July 2003 and now has completely altered the FII profile:

Inflows during this period account for about 60 per cent of FII exposures in India and dwarf the volumes of the last ten years. The actions of the FIIs that invested in this period could be significant determinants of market trends. About $15 billion of exposures from this period are in-the-money positions, and the FIIs are well-placed to revamp their portfolios.

For FII funds invested in Indian equities in this period, a Nifty level of 1800 would be a cushion on the downside (it is now at about 2350). They enjoy a similar cushion in the Junior Nifty and CNX Midcap, which have to be considered as the FIIs are now invested in several mid-cap stocks.

The funds invested before July 2003 would be deep-in-the-money positions requiring only a Nifty of about 1200 for break-even. This comfort level, especially for the plethora of new entrants, is indeed high.

As the scale of the investment in India has risen manifold in recent years, the FIIs have had to invest in a larger number of stocks. They now have exposure in more than 500 companies. And this at a time when the economy has been notching up healthy growth rates and, more important, when Corporate India is in its best ever shape.

In terms of sector preferences, too, the FII portfolio is more diversified than at any time in the past. This, too, is a significant positive for the market.

To understand why, one has to look back a bit. The last, and the only, occasion when the FIIs held exposures in so many stocks was in 1994-95; the investment universe was smaller, too. Then, the FIIs were blindly buying into anything Indian. Stock selection was conspicuous by its absence.

A classic example was the 350-stock portfolio that Morgan Stanley built within a year of its launch of its domestic fund.

Such a blind`Buy India' strategy meant the FIIs would be taken to the cleaners, as a host of Indian companies issued global depository receipts at exorbitant prices. They were.

Then, the FIIs changed tack and adopted a focussed approach to sectors and stocks. FMCG, pharmaceuticals and IT stocks dominated their portfolios in 1996-98, and IT/telecom/media stocks in 1999-2001. Only from 2002 did they start to diversify their sector preferences.

The FIIs remained just investors till 1997; it was not hard to zero in on sectors and stocks that attracted their attention. Their trading levels rose manifold between 1998 and 2000, as they churned their portfolios vigorously. But they play an even greater role as traders now.

Their trading volumes this year may be three times the 2000 level and, on most days, their buying and selling accounts for about 20 per cent of the trading volumes.

Factor in their activity in futures and options, where they account for a fourth of the Rs 20,000-crore market, and the extent to which they can influence price trends becomes clear.

Interest to be sustained: With Korea and Taiwan, India is one of the preferred FII destinations in Asia since mid-2003.

Indian equities are expected to figure prominently in FII preferences for the following reasons:

Rising market capitalisation, an increasing number of large-cap stocks and would-be large caps that have good potential, an expansion of quality stocks in the mid-cap space and a string of IPOs have expanded investment opportunities.

Corporate restructuring, cost reduction efforts and a revival in sectors such as steel, sugar, textiles, chemicals and fertilisers, which rarely figured in investor preferences between 1996 and 2002, have also provided more investment options.

The valuation levels still appear attractive, with Nifty trading at about 15 times its earnings for FY-05 and at about 12 times the expected FY-06 earnings. For large-cap stocks, such valuation levels are attractive, especially for investors with a longer-term perspective. Yes, valuation levels of mid-cap stocks in many cases matches those of their large-cap counterparts.

If liquidity flows remain strong, higher valuations in this space cannot be ruled out.

The earnings card for the April-June quarter was more robust than expected and this trend is evident across sectors. Industrial production has also moved into the double-digit territory the past two months, and interest rates and inflation are likely to remain at current levels. If these trends continue, expect the FIIs to court Indian equities as assiduously as they have done over the past couple of years.

The comfort offered by the stable rupee, with a window for appreciation if the yuan rises against the dollar over the next year or two, will enhance India's attractiveness; the widely-held view by experts on the likely weakness in the dollar over the longer term is likely to ensure that emerging markets, including India, figure prominently in FII preferences.

The risk to equities is the high and rising price of crude. If the Government keeps price increases in the broad economy at moderate levels and puts in place a mechanism to protect the interests of the oil companies, growth may not be affected. Sectors that could be among the preferred plays for the FIIs are engineering and construction, cement, IT and finance and select stocks in metals, oil and gas, sugar, chemicals and automobiles.

Is there evidence that the fundamentals do not support a liquidity-driven uptrend? At present, there is none. Nor is a spurt in prices of the 2003-2004 kind likely to be repeated, even if FII flows provide support.

But if and when the liquidity-fuelled upside takes the broad market or select stocks to levels not warranted by fundamentals, book profits aggressively.

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