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The second chance... - Views on News from Equitymaster
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  • Mar 21, 2005

    The second chance...

    If the last week was yet another indication of what marginal selling (relative to the magnitude of money flow into the stock markets in the last two years) by the Foreign Institutional Investors (FIIs) can do to the stock markets, investors should be prepared for more. It is time to revisit some key factors that influence market direction.

    1. Economic growth: Amidst expectations of marginally over 6% level growth in GDP in the next fiscal, manufacturing leg of the economy continues to show promising signs. The continued buoyancy in capital good imports (typically import of machineries and other components used in the production of goods in India. This is the lead indicator to the industrial output) highlights the fact that there is one more year of over 7% growth on the anvil. While prospects for the services sector is promising, much hinges upon the monsoons as far as the agricultural sector is concerned. Poor monsoons not only impact food grain output but also tend to have a negative impact on GDP growth.

    2. Inflation: The period spanning the last three years has been a difficult one for India Inc. While stock markets seem to be happy at the way margins have improved in the corporate sector, the fact is that commodities (steel, aluminium, crude, coke, lead, iron ore, cotton and you name it) have escalated dramatically.

      The pressure points…
      Commodity 1994 2000 2004 Change*
      Crude (US$/Barrel) 14 29 37 27.9%
      Coal (US$/MT) 29 27 51 90.0%
      Aluminium (US$/MT) 1,336 1,594 1,635 2.6%
      Copper (US$/MT) 2,088 1,866 2,685 43.9%
      Iron Ore (US$/MT) 24 30 36 21.6%
      Cotton 160 134 133 -0.7%
      *2004 upon 2000, Source: World Bank

      While manufacturers have been able to absorb most of the price increase till now (owing to the restructuring exercise and improved productivity), sooner or later, consumers will face the heat. The graph highlights the trend in wholesale price index (inflation at the wholesale end) and consumer price index (inflation at the consumer level). Of late, there is a yawning gap between the two, which highlights the fact that we as consumers have been protected and have not felt the complete impact of the same. The governments have not increased diesel and petrol prices commensurate to the rise in input cost and that is the reason why oil companies are bleeding left, right and center. With commodity prices continuing to show firmness, there is a possibility that economic growth may be affected due to inflationary pressures.

    3. FII inflow: Much has been talked and discussed about the same. But we would like to present two scenarios here. One, the possibility of 'long-term' FII money continuing to chase the 'India growth story' is here to stay. On the other hand, there are some scary signs as well. In one of the recent research meetings with a big corporate house, the company opined that there have been many foreign investors wanting to be in India (they came to visit the company looking for a story) just because emerging market is hot without even understanding the dynamics of the Indian economy. It is upto the investors to understand that all is not rosy and therefore, one has to understand the risk of money flowing out. Buying into stocks just because FII are buying is fraught with risk.

    4. Valuations: The BSE-Sensex is trading at a price to earnings multiple of 16.5 times trailing twelve months earnings and based on consensus estimate for FY06, the multiple works out to be around 14 times. Though attractive on a standalone basis, on a relative basis to other emerging markets, we are trading at around 40% premium (Source: Ajit Dayal, CEO & CIO, Quantum Advisors). At the same time, there is an upside to the valuation, which to be honest, is very difficult to predict i.e. commodity prices. Since commodity prices are trading at highs (not just crude), if there is a softening of the same even towards the second half of FY06, this is likely to be margin accretive for corporate profits. But commodity prices are very volatile and difficult to predict and therefore, could be a blessing in disguise.

    These are only some of the factor and by no means, comprehensive. But yes, there is a sense of optimism in the stock market. That is probably the reason why every mutual fund is launching new schemes (with whatever caps, as they call it) and has shored their asset size. Every IPO has been oversubscribed and post listing, have yielded good returns to investors. But, in our view, this is no reason for one to invest in the stock market now. It is purely a matter of risk/return profile and for investors who prefer safety of capital more than returns, there is always a second chance.



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