The Hindu Business Line : Bracing for a reversal in fund flows

Setting aside the immediate impact of Lehman-Merrill-AIG crisis on the Indian markets or institutions, what Indian investors may really have to brace against is further shrinkage of the FII pie available for investment in Indian stocks.

Despite their pullouts this year, FIIs still remain the largest stakeholders in Indian companies (they held 15.1 per cent of the outstanding equity in Indian stocks as of June 2008); dwarfing domestic institutions such as mutual funds (3.9 per cent) and insurance companies (4.9 per cent).

It is clear that the mammoth proportions of the credit crisis unfolding now will have far-reaching implications for FII flows into India. For one, individual FII exits and a reshuffle of their equity stakes will remain a constant worry for Indian markets over the next few months, as more global financial institutions and investment banks are engulfed by the credit crisis and opt for consolidation. This may also curtail the flow of private equity investments into sectors like real estate and financial services.

Two, the surplus liquidity sloshing about in the global markets in search of investment options is bound to evaporate on the back of the wealth destruction brought on by recent events. The crisis may also keep global investors risk-averse over the next few months. Equities as an asset class, and the emerging markets within the category, have the most to lose from the heightened risk aversion.

Though it has been clear for over eight months now that emerging economies such as China and India may deliver the strongest growth rates in a slowing world, liquidity has continued to gush out of these markets, into alternative avenues such as US stocks and money-market funds. Recent data (as of September 12) from funds tracker EPFR, show net outflows of $28.6 billion from emerging market equity funds so far in 2008 (net inflows of $10.7 billion same period last year).

Surprisingly, even as BRICs equity funds witnessed outflows in every one of the past 11 weeks, US equity funds saw inflows in nine of these weeks. Data from the US-based Investment Company Institute show that money market funds managed $3.4 trillion in assets in mid-September, a sign that outflows from risky assets such as stocks may have found their way into a safe harbour.

Given that a reversal in fund flows can be quite difficult to predict, what is the course of action an Indian investor should adopt now? Here are some pointers:

Short-term liquidity flows may make market moves volatile and quite difficult to predict. Avoid highly leveraged positions or short-term trades that require you to bet on market direction.

Gold remains one of the few alternative asset classes available to Indian investors, which is a good diversifier to equities. Add Gold ETFs to your portfolio to even out blips in returns.

Avoid large exposures to sectors such as IT, financials and banking, where individual companies may have direct/indirect exposures to afflicted institutions. Though these stocks may appear to be “value” buys after their recent falls, the heightened risks to these businesses indicate caution. A global de-rating of valuations in these sectors also cannot be ruled out.

Look for holdings by domestic mutual funds and insurance companies, while selecting stocks. As domestic institutions may remain the key buyers in the Indian markets during these volatile times, stocks fancied by them may fare better in the event of FII liquidation.

Though current indications are for a range-bound market, the market is not devoid of buying opportunities. Several bluechip stocks which bounced off their lows in July haven’t participated in the recent rout. Remember, if you are a long-term investor, stocks are available at their best prices only in bad times such as these.

Look to accumulate solid sector leaders through phased buying. L&T, BHEL, NTPC, Tata Power, Suzlon Energy, Shree Renuka Sugars and Tata Steel are a few good ‘buys’ that spring to mind.

AARATI KRISHNAN