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"With the markets coming down, we are putting some of our cash back to work...." - Views on News from Equitymaster
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  • Oct 31, 2005 - "With the markets coming down, we are putting some of our cash back to work...."

"With the markets coming down, we are putting some of our cash back to work...."
Oct 31, 2005

The stock markets have surprised investors yet again. This time on the downside. But is now the time to get into the markets? Or is there more downside from here? In an exclusive interview with QIS, Ajit Dayal answers these questions and more. Ajit Dayal is the co-founder of Quantum Information Services Ltd. (owner of Personalfn and Equitymaster) and founder of Quantum Advisors Ltd.

Quantum: Please share with us your views on the current state of the stock market. Where do you think the market is headed in the short term and long term?

Ajit:  We have seen another sort of era between May and October 2005 where the markets ran up pretty sharply, just as they did towards the end of calendar year 2003 and early part of 2004, driven largely by foreign money.

Interest rates in America have been quite low for a few years and there has been a huge surge of money supply creation in the developed world. A lot of that excess money has found its way to emerging markets like India. So we saw a very sharp run up in share prices across the world and in all emerging markets from April 2003 right to now.

Interest rates in America have started to increase since the start of this calendar year, since February 2005. But however it takes a while for people to recognise that rates are moving back to a long term normal average. And then they respond accordingly.

So, the markets in the near term will be driven largely by what happens to foreign money flows. And in the long term India will continue to attract serious long term money, which I must add has not yet started entering India. So short term, things may not look very optimistic; long-term, India with a GDP growth of 6% per annum long-term average in our view, which is about twice the global averages will have companies with significantly higher sales and profit margins than those in the developed world so should attract long term money.

Quantum: You have been talking about, for over a year now, that rising interest rates in the US will lead to a pull out of FII money from India. Is this what is leading to FII selling now? How long do you think this will last?

Ajit:  I have no statistic to prove that interest rates in the US that have risen recently have been a cause for the pull out. But I can speak from experience as one who asset allocates money across the world. Typically, when you look at short-term hedge funds, they have been fairly fashionable since 2000-01 and now control US$ 1 trillion of assets from close to US$ 100 bn in 2000. So these hedge funds, which have grown about ten times in size over the last five years have been looking for spectacularly short-term gains. And the winning entry for the lotto ticket if you will, which they had for the last two years was a weak US Dollar, strong foreign currency and low interest rates in America. What they did was they would borrow in American Dollars at low interest rates, invest that money abroad in Europe, in Japan and within emerging markets like India. And they had a wonderful one way winning ticket because they made money on the foreign exchange gain. As I said, the US Dollar was weak and so when they took the Euros or Yen or the Rupee back to America, they got more US Dollars. This was a plus. Plus interest rates in the US were lower as compared to rates of return that they got in stock markets in Europe, Japan and emerging markets like India.

Now with rates in America increasing, and the US Dollar strengthening by nearly 12% to 15% against most developed currencies like the Euro, they then start seeing losses. And I guess this is very short-term money looking for the next trade. So the smart trade is no longer to invest outside America. The smart trade given high interest rates, given a stronger US Dollar is to be back in America.

Quantum: The foreign money that is being pulled out now was labeled, by fund managers like you, to be largely short term in nature. With short term money moving out and valuations becoming relatively more attractive, do you think India will be able to attract the large pension funds?

Ajit: Again, I have no statistic to indicate that the money, which has come in to India is short term money or is long term money. But anecdotal evidence from people that you speak to and things that I have been seeing and hearing around my travels would suggest that it has been the short-term hedge fund type money that has come into India. The good thing about the recent spike in all emerging markets including India has been that it has attracted the attention of the long-term pension money.

So the long-term pension money has not yet come into India in a big way. It is trickling in; it is examining, studying India. But most of the long-term people that I speak to, and I have been speaking to a lot of them since 2003, have indicated that they found increasingly in 2004 and 2005 the Indian markets to be at a very high valuation number and that has been a barrier to entry for them to come in. So even though the Indian markets were trading at 16 times March 2007 earnings, indicating a 20% to 21% growth in EPS between today and March 2007 on a per annum compounded basis, they still found that to be expensive compared to probably the norm they look at in the emerging market universe; you have PE ratios 10 – 12 times in Korea and the emerging markets as a whole has been at PE ratios of 12 – 14 times. So India has been a little more expensive. Probably justifiably so in some peoples’ opinions. But in the pension world and in the long term money world, India has been an expensive asset class. They are circling it and they will probably come in to India when they fund valuations to be correct.

Quantum: Please share with us your view on interest rates, both in the domestic and global markets.

Ajit: I think interest rates around the world will increase. Because, in the US markets particularly, oil prices have been moving up and that has added to inflation. Labour costs are no longer declining and labour is a significant component of the consumer price index in America. And it is an economy that is running pretty much at full steam so there is very little slack capacity. I also think the Fed and many central banks around the world would be very keen to send a signal out that they are not going to let inflation get the better of them. So they will probably increase rates faster than the rate of inflation pick up to prove and to stand by their credibility as central bankers. So the similar downswing that you had in interest rates between 2000 and 2004, you could see not as sharp but much sharper than anticipated increase in interest rates. My personal opinion is that the American 10 year long bond which is yielding 4.58 – 4.59% (it was yielding as low as 3.00% in this calendar year) could end up at 5.50% by April – May 2006 and as high as 5.75 – 6.00% by December 2006.

India has an unusual scenario of inflation that is caused by oil; we also have a lot of demand from consumers and industry. So there is a lot more economic activity happening in India. And unlike America, India has a lot of bottlenecks in terms of infrastructure, in terms of meeting people’s demands and expectations quickly. To that extent, you will have more of an inflation threat in India. And the central bank in India will be in quite a bind in our opinion; whether they want to see growth carrying on at a rapid rate of 7.00 – 7.50% with inflation threats or would they rather see a more sustainable long term GDP growth rate of 6.00 – 6.50% with lower inflation led by higher interest rates. I do not have an insight as to what the policymakers think or will do. But if we had to guess, we would guess that they would be raising interest rates by more than what people expect.

And just to add another reason why they may be increasing interest rates faster, the Indian Rupee which has been branded as a strong currency, and I feel wrongly branded as a strong currency, is again weakening against the US Dollar. I think one should go back to 2003 – 04 when the US Dollar was a weak currency and all the other currencies became stronger against the US Dollar. Now that the US Dollar has become strong, every other currency is going to get in that sense, relative to America, a weaker currency. The strength of Indian Rupee has been a function of a weak US Dollar and not strong Indian currency compared to all other global currencies.

With inflationary threats in India the RBI may also take a view that they would not like to see the Rupee slip too much and that again would result in a higher interest rate regime in India.

Quantum: How do you think retail investors should deal with this scenario?

Ajit: Fixed income and debt market investors should invest in near-term paper given the fact that interest rates in India and around the world could be increasing more. As interest rates increase and maybe cross the 8.00% level from the present 7.20 – 7.25% levels, they can think about longer tenure paper and lock in this relatively high interest rate, which we think could unfold within the next six months in India.

For listed equity, it is really a function of people’s risk appetite. We always encourage people to invest in equity with a long-term view. We also encourage people to sell equities, some of it atleast and not the entire portfolio when stock markets go to what we think are unsustainable levels too quickly, to book your profits, wait on the sidelines and comeback when there is a sensible entry point. For our clients, we have been in significantly higher levels of cash than most other people in the period Jun – Sept 2005. Our cash position in many of the client portfolios was in the region of 20 - 30%. With the markets coming down we see some opportunities and we are putting some of this cash back to work. But we are still in cash. As of today we believe, and these things can turn in a matter of a day, there may still be some downside in the stocks that we would like to buy but will wait for patiently.

Right now, we are more than 70% invested in companies and stocks that we like because see value in them but at the same time 30% in cash.

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