The Hindu Business Line : Miles to go in equity analysis

RAJESH Chakrabarti of Georgia Institute of Technology has analysed the Indian stock markets in his new book titled, The Financial Sector in India: Emerging Issues, from Oxford (www.oup.com).

He opens with a discussion of FII (foreign institutional investor) flows. "Ever since the opening of the Indian equity markets to foreigners, FII investments have steadily grown from about Rs 2,600 crore in 1993 to over Rs 11,000 crore in the first half of 2001 alone," writes Chakrabarti.

Happening area, this is. For instance, recently the Associated Chambers of Commerce and Industry of India (www.assocham.org) predicted that FII exposure in Indian stocks is to touch $50 billion in 2006, from the cumulative investment level that stood at $40 billion in October 2005.

"FII flows and contemporaneous stock returns are strongly correlated in India," notes the book, on the basis of empirical analysis. The positive relationship is consistent with "at least four distinct theories," opines the author. What are these?

First, the omitted variables hypothesis, according to which the correlated variables have no causal relationship between them, "but are both affected by one or more other variables missed out in the analysis." The second is the downward sloping demand curve view, which is that FII flow creates a buying pressure and higher demand.

The third theory is that of base-broadening, which contends "that once foreigners begin to invest in a country, the financial markets in that country are no longer moved only by national economic factors but rather begin to be affected by foreign market movements as well." The fourth is the positive feedback strategy view, which asserts, "if investors chase returns in the immediate past (like the previous day or week) then aggregating their fund flows over the month can lead to a positive relationship in the contemporaneous monthly data."

Changes in country risk ratings don't seem to affect the FII flows, says Chakrabarti. He speaks of the possibility of `herding' effects, that is, "domestic speculators imitating FII moves", in individual stocks. "The relative stability in the exchange rate of the Indian rupee in the post-Asian crisis era," hasn't gone unnoticed by the foreign portfolio investors, he notes.

"International stock indices play an important role in cross-border portfolio investment," writes Chakrabarti in a chapter on `Market reaction to addition of Indian stocks to the MSCI index'. The author informs, "Stock indices most popular among international fund managers are the Morgan Stanley Capital International (MSCI) family of indices and the International Finance Corporation (IFC) family of indices." Last year, "the Indian index jumped twice as much as the regional gauge, exceeding a 30 per cent gain in MSCI's emerging markets index, reported International Herald Tribune (www.iht.com) on January 9.

Chakrabarti takes up the question, "Are ADR (American Depository Receipt) issues good news for domestic markets?" and to answer the same, he studies CAR (cumulative abnormal returns). He finds that it is difficult to generalise the impact of ADRs on "the qualitative relationship of the stock with the US market."

Of interest is a chapter titled, `Analyst recommendations of brokerage houses in India'. This is based on "an analysis of over 2,000 recommendations from 26 brokers involving 303 companies," during 1998-2003. What are the author's findings? That the predictions are optimistic; and that recommendations are of buys "considerably more often than sells". Most valuable are `clear buy recommendations'.

Chakrabarti observes that stocks in the `strong buy' list `do significantly better than the market' for `a run as long as 60 trading days or about three months from the recommendation'. Thereafter, "they stabilise at the higher price level". He infers that, unlike as in developed markets, prices aren't instantaneously absorbing the entire information content of the analyst reports.

Another difference the author mentions is that equity analysis in India is less organised and structured than in developed markets. "The approach in India is more akin to `selecting the winner' rather than `reporting and projecting' for a wide set of stocks followed by a large number of analysts in several competing firms as is the situation in developing countries." Chakrabarti postulates that this approach may be responsible for the less than full absorption by the market on the arrival of the report.

Part II of the book is on developments in forex markets, commodities futures, banking, micro-finance, and corporate governance. The author explains many concepts through boxes in the book.

Thus, you can learn about global financial architecture, `impossible trinity', purchasing power parity or PPP, forex reserves and money supply, basics of future contract, and so on.

The author sees a future for weather derivatives. "If properly designed such futures can help farmers hedge the climate and rainfall related risks," he states.

While on corporate governance, the author is happy that there are new norms for listed companies. The bigger challenge is one of implementation at the ground level, he points out. For, "even the most prudent norms can be hoodwinked in a system plagued with widespread corruption."

Useful reference.

BookValue@TheHindu.co.in