Dancing on air? - The Honest Truth By Ajit Dayal
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Investing in India - Honest Truth by Ajit Dayal
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14 JANUARY 2013


It is sweet to dance to violins
When Love and Life are fair,
To dance to flutes, to dance to lutes
Is delicate and rare
But it is not sweet with nimble feet
To dance upon the air


- Oscar Wilde

With these lyrical words, the poet Oscar Wilde was describing and comparing the movement of feet on two separate occasions: in one instance there is a certain joy that results in a dance; in the other, a man is being hung - and he is dancing "upon the air". So, is the rally in the Indian stock market for real -or is it a dance on air?

Graph 1: Is a peak just around the corner? The BSE Index from its peak in January 2008 (RED) and from its next peak in November 2010 (BLUE) (in INR).

As indicated in previous columns, the price of an Indian asset is set by foreign money flows. But the value of an Indian asset will be determined by what happens in Indian economy.

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The calendar year 2012 belonged to foreign flows during which time the Indian stock market saw an inflow of USD 24 billion from Foreign Institutional Investors (FII). While this was short of the record USD 29 billion of inflows in CY 2010, the surprisingly strong FII vote of confidence was sufficient to).

Table 1: Foreign investors show their love for India. They have bought 50x what Indians have bought since 2003!
Period Net foreign Activity (US$ m) Net Local Fund Activity (US$ m) Total (US$ m) Change in BSE-30 TRI
in that Period (% USD)
CY 2003 6,628 88 6,716 +86.5%
CY 2004 8,669 -253 8,416 +20.5%
CY 2005 10,707 3,049 13,756 +40.2%
CY 2006 8,106 3,413 11,519 +51.6%
CY 2007 17,655 3,222 20,877 +67.0%
CY 2008 -11,954 2,501 -9,473 -60.80%
CY 2009 17,458 -1,132 16,326 +90.3%
CY 2010 29,362 -6,049 23,313 +24.1%
CY 2011 -358 1,343 985 -35.80%
CY 2012 24,372 -3,854 20,518 +24.5%
Cumulative 110,625 2,328 112,953 +490.5%
Source: www.Sebi.gov.in

While foreign flows clearly set the price of Indian assets, the domestic macro environment and policy-making failed to add significant value to the underlying businesses represented by stock prices.

After a solid start in early 2012, a misguided attempt in March by then Finance Minister Pranab Mukherjee to tax foreign investors on offshore transactions of India-domiciled assets - retrospectively! - pushed India into the same league as China in terms of "questionability of contracts". Coupled with the impending elections in Greece, FII flows swooned into negative territory dragging stocks down. An impasse on the path to reforms and inconclusive debates on how to deal with corruption saw the Indian Rupee (INR) lose 20% of its value in 8 weeks - a reminder of the skittishness of FII's and a replay of the fallout after Lehman's bankruptcy.

Moving into damage control, Prime Minister Manmohan Singh "promoted" Mukherjee to the harmless role of President and brought in P. Chidambaram as the Finance Minister - for the second time during the reign of this regime. With rapid-fire announcements of the reversal of the retrospective tax reforms, allowing foreign direct investment in retail and in airlines, promises to encourage investments in equity markets, share prices have moved sharply higher since July. The BSE-30 Sensex, in INR terms, is now within 10% of its all-time high. Of course, the continuous and committed running of the printing presses by the ECB and Fed has added fuel to the fire. On September 12, 2012 the US central bank committed itself to further injections of billions for what was effectively an unlimited time frame. With money being given to them for free and low interest on "safe" government bonds, foreign investors are scouting the world for "better returns". At the blink of an eye, India has gone from bearing the tag of "avoidable" in March 2012 to "bullish" by September 2012.

Higher share prices have ignored the lack of "value creation" at corporate India and the macro and social tensions that have, in our opinion, worsened in the past year. India remains enveloped in corruption. The renewed call by Prime Minister Singh to revive the "animal spirit" could exacerbate the economic divide between the few who have v/s the growing number of those who are denied a fair share of the economic pie. Most Indian business groups continue to generate wealth based on connections. On a recent interview with CNBC Awaaz, I asked the anchor to name me 10 Indians who have made USD 100 million over the past decade - and earned it honestly. She shook her head in silence: We are dancing on air. And that, too, on foreign air! Indians have hardly put any money in the stock market; foreigners have invested 50x what the Indians over the past 10 years. Given all the scandals and mis-selling to retail Indian investors that is hardly surprising.

Graph 2: BSE-30 India is close to peaks of January 2008 and November 2010 in INR, but a long way to go in USD terms
Source: Bloomberg, from January 2008 to December 2012

Beware the drummers and their enchanting beat

The drum-roll of "reforms are back on track" and the flood of money entering India have, true to form, caused a widening gap between perception and reality.

Shares of many companies run by managements we would not trust or are based on shaky business strategies, are not only showing signs of rebirth but are prancing around in a fashion that would make Gangnam style moves seem like a duck walk.

The Mayan calendar predicted the destruction of the bad stuff on 12/12/1/2 from which better life forms were to evolve. Punters in India's share bazaar seem to have missed that message and are content to worship the stone idols.

The continued rise in many small-cap and mid-cap stocks and in companies run by less trustworthy managements could see "value" managers with disciplined research and investment processes begin to "underperform" - just as many did in the BRIC go-go days of 2005-2007. On a fundamental valuation basis, the market is not expensive. With the BSE-30 Index trading at a PER of 18x historical earnings, it is still "cheap" when compared to the peak PER's of 23x to 25x of previous peaks. But we all know what happens from a peak - that is why it is called a "peak"! ☺

Table 2: Small caps and mid-caps are still way below what they were in July 31, 2007...and note the returns from gold.
(all returns in USD) % change for Quarter
ended December, 2012
% change in CY 2012 % change in CY 2011 % change in CY 2010 % Gain/Loss since July 31, 2007
(Bear Stearns funds in trouble)**
India - BSE-30 TRI -0.2% +24.5% -35.8% +24.1% -0.6%
India - BSE Mid Cap +3.6% +34.7% -44.6% +21.0% -21.8%
India - BSE Small Cap +1.2% +29.3% -51.7% +20.5% -32.5%
Brazil - Bovespa +2.1% -2.0% -27.1% +5.9% +2.6%
China - SHCOMP +9.7% +6.9% -16.5% -9.7% -32.5%
Russia - RTSI$ +4.2% +14.6% -20.5% +23.9% -16.5%
MSCI EM Free +5.6% +18.5% -18.4% +19.0% +8.8%
S&P 500 -0.4% +16.0% +2.1% +15.1% +10.5%
MSCI World +3.0% +16.8% -6.9% +13.3% +0.5%
Berkshire Hathaway +1.0% +16.8% -4.7% +21.4% +21.9%
Gold -5.5% +7.1% +10.1% +29.5% 152.2%
Oil -0.4% -7.1% +8.2% +15.2% +17.4%
Source: Bloomberg;

Most investors rush to buy small cap and mid cap stocks - as they have since July 2012 - because they are "cheaper" than the "more expensive" large caps. Well, the small cap and mid cap stocks are "cheaper" for many reasons:
  1. The founders may not be reliable,

  2. The businesses are small - there are challenges to grow a small business into a large, successful, and profitable business,

  3. It is not easy for small businesses to attract management skills and talent and to retain that talent for years to enable the company to grow under good stewardship,

  4. Sometimes, the small size may limit their ability to get financing (debt or equity) on good terms to grow the business,

  5. The liquidity in the stocks is poor - so if a large investor starts to sell the share price can collapse very quickly (just as when the large investor wishes to buy a few shares, the share price can spurt very quickly.
In addition to "size", the business plan of the company is crucial - and whether the company has taken on excessive debt to grow. The long term viability of the business will also depend on whether any favours were received from the government along the aggressive path to growth.

While this animal spirit stuff is good for a few rounds of dancing around the tribal fires, the underlying strength of businesses built on sound strategies run by sound managements is the best way, in my opinion, to create long term returns - without getting the grey hair and tension that tends to accompany most investments in share markets.

Graph 3: Real estate remains an opaque business: DLF and Unitech have "performed" well in CY 2012, but not since the Jan 2008 peak.
Source: Bloomberg, January 2008 till December 2012

Graph 4: ICICI has done well, but still lags HDFC Bank since January 2008
Source: Bloomberg, January 2008 till December 2012

Graph 5: ...as has boring retailer Trent compared to the more flamboyant - and leveraged - Pantaloon...
Source: Bloomberg, January 2008 till December 2012

Graph 6: ...and the same story with media mogul Zee and its competitor, TV Eighteen?
Source: Bloomberg, January 2008 till December 2012

Subsidies, interest rates, and gold

While we have long argued that subsidies are not good, we reiterate that India has no choice but to provide subsidies to the poor. To plug the "leakages", the recent initiative to send subsidies directly to bank accounts of those the governments wish to help could help control deficits in a big way. But the large leakages in the system have been to rich business families who lobby for natural and national resources to be given to them at favourable prices. Their supra-normal profits end up in bank accounts in Singapore and Switzerland! That direct transfer needs to be stopped.

Successive Finance Ministers have been making strong suggestions to the central bank to cut interest rates to spur growth. The Reserve Bank of India has refused to budge and maintains (correctly) the government needs to show some deficit cutting action before the RBI can initiate a decline in interest rates. The obstinacy of the RBI probably inspired the Ministry of Finance to recently refuse an extension to one of the independent Deputy Governors.

While in most parts of the world the role of a central bank is relegated to ordering the ink and security paper required to print more notes, the role of the RBI is still taken a little more seriously in India. The RBI has done a remarkable job of keeping the financial theiftains at the gate, shutting out creative engineering, and ensuring that banks stick to boring work. Now the RBI has the tough job of convincing a "quick-fix" Ministry of Finance that expenditures need to be cut - and the challenge of trying to convince Indians that gold is not a good investment (Table 3).

With gold prices near record highs in INR and with global gold prices registering a 12th successive year of gains in USD, convincing Indians not to buy gold - by threatening a higher import tariff - is a losing proposition. The argument for individuals not to buy gold can only be made when Indians perceive the government to be disciplined and not running a wasteful regime. Or cleanse the rot in the retail mutual fund and brokerage industry that has wiped out the savings of trusting investors. Indians are under-owned in equity (Table 1 above), the best performing asset class, because they do not trust their western-modelled, Wall Street look-alike financial intermediaries. The government and the regulators should punish those who wipe out the savings of investors - don't punish the wronged saver for stashing his money in bank accounts or gold.

Table 3: Gold imports result in a large current account deficit
(in USD billions) April to September 2012 (6-month) April to March 2013 (est.)
(current fiscal year)
April 2011 to March 2012
(previous fiscal year)
Oil imports 79 165 154
Gold imports 20 42 57
Trade Deficit 90 203 190
Software exports est. 30 67 61
Private Remittances 31 69 62
Current a/c deficit est 38 79 78
Funded by:      
FDI, est. 12.8 20 22.1
FII equity 5.5 22 7
FII debt 0.7 4 9.7
Bank debt, trade credit, est. 16.2 21 23
NRI deposits. Est. 9.5 12 11.9
Other NA NA -2.7
Total Inflows, est. 44.7 79 67.8
Fx reserves, est. 293 293 294
Current A/c deficit to GDP, % 4.3 4.2 4.2
Source: Quantum Advisors, Reserve Bank of India

Graph 7: The yo-yo of the Indian Rupee, Jan. 2008 - Dec. 2012
Source: Bloomberg

So should investors buy shares in CY 2013?

Most investors should always have something invested in the stock markets. How much or how little is a function of many factors which any investor need to discuss with a financial advisor (www.PersonalFN.com is part of a financial planning firm I helped set up and am an owner in).

The facts are:
  1. The global macro environment remains uncertain and unreal,

  2. India will see a national election by May, 2014. And maybe even in CY 2013,

  3. The market is not yet "expensive",

  4. Earnings of Indian companies are likely to be muted - maybe a growth of 10% or so - till the global environment and local policy-making get clearer;

  5. The mutual fund industry has not yet sent its army of distributors to tell you why investing in shares is the best invention since sliced bread (honestly, it is! But it depends on which side of the bread the distribution commissions are buttered! ☺),

  6. Foreign investors are still "under-owned" in India - as they have been for the past 20 years;
This combination of these facts will see the tug between the bulls and the bears.

I am "bullish" on India though a little less than I was one year ago - I increasingly worry where we could end up as a civilisation.

But, in the end, my approach to investing has always been about valuations and the ability (or inability) of the managements of the Indian businesses that one invests in to navigate through choppy times. That is why the CEOs should be given their salaries and bonuses: to make good decisions in any environment. The global and local uncertainty will result in wild swings in capital flows and in prices of various assets further complicating the conditions under which a management team needs to prove itself.

We recognize the debates of a dollar/euro debacle and sovereign debt defaults; the fight against corruption in India; the arguments over whether the poisonous technology of the global financial firms should be introduced in India; or the focus on monthly food and commodity prices. Yet, with a GDP that could comfortably grow at a long term average of 6.5% per annum despite the global storms (Chart 1), the opportunity to make sensible risk-adjusted returns by investing in the Indian stock markets should not be ignored. Over the past 33 years, an investment in the BSE-30 Index would have given - on average - a return of 19% per annum. In tis there have been many boom years (2009 and 2012) and many bust years (2008 and 2011). Invest, but tread carefully - the easy money is over.

Chart 1: Real rate of growth in GDP across 9 governments has been 6.3% p.a. over the past 32 years
Note: 9 governments of which 6 were coalition governments
Source: Quantum Advisors Private Limited, RBI data

Suggested allocation in Quantum Mutual Funds (after keeping safe money aside)
Quantum Long Term Equity Fund Quantum Gold Fund
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Quantum Liquid Fund
Why you
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An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% 20% Keep aside money to meet your expenses for 6 months to 2 years

Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"


Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.


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1 Responses to "Dancing on air?"

Deepak Maheshwari

Jan 15, 2013

Ref your article "dancing on air" and pls refer from the above or the below extract , "Indian Rupee (INR) lose 20% of it's value" , which you gave as a link , pls note that it does not lead to ant chart or graph showing this 20% loss but it leads to today's Ex rates only. Pls take care. Thanks & regards.
Extract from your above article :
An impasse on the path to reforms and inconclusive debates on how to deal with corruption saw the Indian Rupee (INR) lose 20% of its value in 8 weeks - a reminder of the skittishness of FII's and a replay of the fallout after Lehman's bankruptcy.

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