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Investing in equities because...

Jan 12, 2005

In view of the stock markets logging consistent gains and achieving newer heights in the final quarter of 2004, we conducted a poll on Equitymaster to find out our readers' choice of the preferred avenue of investment in 2005. Considering the euphoria on the bourses over the last few months, it was not surprising that an overwhelming 83% of those who participated in the poll opted for equities as their preferred choice. Post this, we conducted another poll with the objective of finding out as to what was the cause of their optimism towards equity investments. In this article, we try and analyse some of the aspects that have/are likely to prompt investors to invest into equities.

The poll on Equitymaster was, "I am investing in equities because...". The three options provided were - 'attractive valuations', 'Foreign Institutional Investors (FIIs) are buying' and 'it's a bull run'. And the results - attractive valuations (46%), FIIs are buying (18%) and it's a bull run (36%). Let us consider each of these aspects in a little detail.

Attractive valuations:  The Indian markets are currently hovering near the 15x trailing 12-months price-to-earnings multiple, which is consistent with the average valuations that they have enjoyed over the last decade or so. It must be noted that this is largely in line with the CAGR earnings growth delivered by India Inc. at about 16%-17%. The current momentum on the bourses has also largely been sustained on the back of similar arguments, which at the face of it seem acceptable. Thus considering the fact that a similar performance would continue over the next 2-3 years, the market valuations at about 10x-11x in FY07 looks attractive.

Further, if one looks at the expected GDP growth for the Indian economy over the next couple of years and compares it to the growth rates of other economies, India remains amongst the fastest growing economies in the world. India, in recent years, has taken some good steps in terms of policy announcements for infrastructure development and also considering the reforms process currently underway in the country, the climate looks conducive for growth.

However, while we do advocate that a certain part of investments must be allocated to this investment class considering the risk-return profile of the investor, it is always prudent to keep in mind the downside from the current juncture. One such challenge that India Inc. is likely to face over the next couple of years from hereon would be the impact of higher domestic interest rates. With interest rates cycle having reversed in recent times and the capex cycle also showing signs of resurrection, the average borrowing costs for corporates are likely to increase, though not dramatically. Thus, while in a falling/low interest rate regime, corporates are able to increase profitability by reducing their interest expenses, in a rising interest rate scenario profitability is adversely affected.

FIIs are buying:  FIIs have been the primary drivers of the bull run on the Indian bourses over the last couple of years. This is evident from the record US$ 6.7 bn that they pumped into Indian equities during 2003 and topped it with another record beating US$ 8.5 bn in 2004. Continued strong corporate earnings growth (15% YoY sales growth and 24% YoY PAT growth in 1HFY05 of top 200 companies), reasonably attractive valuations (approx. 10x-11x FY07E earnings) and improving corporate governance in terms of transparency and competency are amongst the few positives that have attracted the FII community towards India.

However, we believe that investing because FIIs are bullish and pouring money into Indian equities is not the appropriate way to approach equity investing. It must be noted that akin to any investor, even FIIs look for better returns. Thus, with US interest rates lying at historic low levels of 1%, which coincided with the emergence of India as they restructured their operations and improved efficiencies, many of them achieving global recognition, saw the FIIs turn their attention to Indian equities. However, now with US interest rates firming up to 2.25% and clear indications of further and sharper interest rate hikes in the US, the possibility of the 'hot' FII money flowing back to the safer US bonds cannot be ruled out. Thus, investors should not base their investment decisions on when and where (in which stocks) are FIIs investing, as these stocks will be the worst hit (not to say that the markets will be spared) when FIIs decide to pull out of India.

It's a bull market:  What can one say about this being a reason to invest into equities? Except that this is definitely not the right reason to investing in equities. But, unfortunately, many of us do 'speculate' on this premise, which is rather unfortunate. While it is true that almost every stock goes up in a bull market, it must be noted that those that are devoid of fundamentals would be the first ones to tumble at the slightest scent of a trend reversal. Moreover, it is the bull markets where the so-called 'punters' and 'tippers' thrive and their prime motto of investing is to make a quick buck at the cost of innocent retail investors, who more often than not, do get carried away in a bull market.

Thus, our advice to investors at the current juncture would be that while they should keep a close watch on valuations, they need not get overly worried about the FII behaviour, provided a long-term investment approach is being followed. Investors need to realise that a fundamentally strong company will attract investors over the long-term, once the true value of the company is understood. Thus, to conclude, while there may be many reasons to invest into equities, but investing on the basis of fundamentals is the only sure-shot and foolproof method of earning adequate returns.

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