Stock markets take a beating: time to buy? - The Honest Truth By Ajit Dayal
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Investing in India - Honest Truth by Ajit Dayal
Stock markets take a beating: time to buy? A  A  A
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9 FEBRUARY 2011


The signs of weakness in the markets were there in December, 2010. Foreign flows, as I have often said, set the price of India assets but what happens in the Indian economy - and in the earnings of companies - determines the long term value proposition.

Foreign Institutional Investors were net sellers to the tune of USD 1 billion in January. The FIIs were sellers for 13 of the 20 trading days in that month. And their selling has set off a sharp decline in the Indian stock markets.

Graph 1: Fasten seatbelt for an exciting rides: BSE 30 Index, Jan 1, 2005 to Jan 31, 2011

Just six months ago, India seemed the toast of the investing world with USD 16 billion being pumped into the Indian stock markets between August 2010 and December 2010. This was in anticipation of the printing money party hosted by Ben Bernanke, the Chairman of the US central bank. The wild music at the Quantitative Easing 2 (QE2) party, took the BSE-30 Index to a new peak of 21,005 on November 5, 2010 (see Graph 2).

Graph 2: What $16 billion can do: BSE-30, July 2010 to January 2011

As the large cap stocks got "expensive", buying interest shifted to the mid cap and the small cap stocks (see Graph 3) as it typically does in such wild parties. After a couple of drinks - and Ben Bernanke gave a lot of free ones - every woman and every man looks attractive. But, as foreign buying slowed down to a trickle in December (barely positive with USD 500 million of foreign flows), fatigue set in - and the Indices began their sharp decline.

Graph 3: The mid and small caps fall: July 31 2010 to Jan 31 2011

Whether India's high inflation numbers spooked the foreign investors, or whether they were nervous about the "expensive" Indian markets will be a point of debate. Some of the selling by foreigners could also be linked to the series of corruption scandals erupting all over India. With much of this "FII" money allegedly Indian-sourced money round-tripping its way into the Indian stock markets via Swiss bank accounts and Mauritius-based companies, it is possible that this money sought safer havens by selling Indian equities and staying buried in cash in nameless accounts in sheltered tax havens. Or maybe foreign investors think India is ripe for a revolution.

Is India an Egypt or a Tunisia?
The intriguing part of the decline of the Indian stock markets in January is its similarity to the sharp declines in the stock markets of Tunisia and Egypt - both the targets of revolutions. Egypt fell -20.9% in January while Tunisia lost -13.3%. Given that there are, to quote author V. S. Naipaul, "a million mutinies" at any point in chaotic India, the -12.8% decline (in US Dollar terms) in the Indian markets seems excessive.

Table 1: India takes a beating in January 2011.
(all in USD) % change for month ended January, 2011 % change in CY 2010 % Gain/Loss since July 31, 2007   (Bear Stearns funds in trouble)**
Quantum Long Term Equity Fund -11.3% +34.1% +42.0%
India - BSE-30 TRI -12.8% +23.7% +8.4%
Brazil - Bovespa -4.7% +5.9% +36.8%
China - SHCOMP -0.7% -9.7% -24.9%
Russia - RTSI$ +5.6% +23.9% -3.1%
MSCI EM Free -2.8% +19.0% +9.3%
S&P 500 +2.4% +15.1% -4.5%
MSCI World +1.6% +13.3% -6.2%
Berkshire Hathaway +1.6% +21.4% +11.3%
Gold -6.2% +29.5% +100.6%
Oil +0.9% +15.2% +17.9%
Source: Bloomberg; * Q India Equity Fund numbers are price returns, net off fee and expense and reflect the reinvestment of dividends and other earnings. ** Return not annualized (based on last trading day of month, January 31)

India is unlikely to be heading towards revolution anytime soon. And, much as most Indians want a better life, who will we revolt against? Most Indians have paid a bribe and treat it as a way of life. All Indians are subject to the torture of being ruled by a selfish political class - one that they have helped elect. In Tunisia and Egypt an entire generation has been ruled by people they have never seen - very different from the reality of us having elected our own crooks! So, while India (under Prime Minister Nehru) and Egypt (under President Nasser) were the founding members of the Non-Aligned Movement fifty years ago in 1961 (President Tito of Yugoslavia and President of Sukarno of Indonesia were the other 2 founding members), the perfect alignment of the movement of the stock markets in Bombay and Cairo in January 2011 was probably not on their agenda.

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Table 2: Foreign "investors" shy away from India - for now...
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 +86.3%
CY 2004 8,669 -253 8,416 +23.1%
CY 2005 10,707 3,049 13,756 +42.2%
CY 2006 8,106 3,413 11,519 +53.3%
CY 2007 17,655 3,222 20,877 +68.5%
CY 2008 -11,974 2,501 -9,473 -60.7%
CY 2009 17,458 -1,132 16,326 +89.7%
CY 2010 29,362 -6,049 23,313 +23.7%
Cumulative 86,611 4,839 91,450 +676.9%
Jan-11 -1,054 129 -925 -12.8%
Source: Sebi.gov.in

Inflation, interest rates, and GDP.
But, though a revolution is not on the cards, the cost of living is certainly on the rise. The makaan is not affordable for most of us. I imagine that 99% of people who live in big cities cannot afford to buy their own homes today. They own the homes for historical reasons, not because of present income levels. Globally, food prices have hit new peaks due to a combination of: (1) the decline in the US Dollar, (2) higher demand for food and fuels due to rising incomes in emerging and emerged countries, (3) disruptions in supply due to bad weather in Argentina, Russia, Ukraine, and Australia, and (4) the fact that money supply in most economies has surged some 40% over the past two years and food output has gained only 8%. If governments have printed 40 new notes, but the farmer has only produced 8 more bags of wheat, the price of the wheat will increase because 40 new notes are now chasing only 8 new bags of wheat.

In India, the price of onions surged from Rs 30/kilo to Rs 100/kilo due to unseasonal rains, making it the best performing asset class to have been invested in! Critics argue that these unseasonal rains were known in advance and the administration failed to connect the dots by banning the export of onions to ensure that there would be more supplies for the domestic market. But, say the experts, the onion crisis also exposes India's under developed agricultural supply chain. Over 20% of India's total production of fruits and vegetables rot each year for want of sophisticated transportation and storage facilities. Furthermore, since the farm markets are currently controlled by middlemen - some of them with political connections - farmers may not respond to price signals effectively. And middlemen don't have an incentive to add to the supply of food grains. For them, the less there is, the higher price they can sell it for - once they manage to corner the supplies, that is.

The Reserve Bank of India, one of the first central banks in the world to begin raising interest rates in the post-Lehman era, is now in a dilemma. Should it continue to raise interest rates to kill food inflation or ignore the price signals from the onion fiasco? Given that Ben Bernanke is still busy printing notes, bad weather could still disrupt food supply, and other economies may continue their inflationary ways, an increase in interest rates by the RBI may not have much of an impact on food inflation. Higher food prices are not a pure domestic problem. In fact, an increase in interest rates beyond 8.50% for the 10-year paper may stall industrial activity and hurt GDP growth.

Which brings us to the next challenge of a GDP-obsessed world: The Indian government, long charmed by the statistics of GDP, seems to have made the achievement of a 9% rate of growth in the economy an obsession. Speech after speech focuses on how India can soon achieve a sustainable GDP growth rate of 9% to 10% in the next few years. Now, the government has a choice. Go for the higher rate of growth in GDP and face the wrath of higher inflation or focus on killing inflation and live with a lower rate of economic growth. In my view, the government should pay a lot more attention to corruption to ensure that even a lower rate of growth is distributed evenly. GDP by itself is an idiotic measure of prosperity.

In general, I tend to be a little less concerned by the food inflation numbers and believe that responses from the farmer will, in the long run, see a decline in prices. But, with quick money able to speculate on any commodity anywhere in the world, sharp price swings cannot be avoided. And some of that QE2 money is definitely finding its way to speculative trades in corn, oil, rice, sugar, and wheat to name a few commodities.

Chart 1: GDP Growth rate across 8 governments has been 6.2% p.a. over the past 30 years -
6.5% is a good assumption for the next decade
9 governments of which 6 were coalition government | Source: Quantum Advisors Pvt Ltd

Ignore this fall, buy for the long term. The argument about the correct rate of growth for GDP is academic. India's economy will grow at a long term rate of 6.5% per annum to 7.0% per annum (Chart1) as it has for the past 31 years. The question to be asked is whether it will be shared fairly or will remain a victim of crony capitalism, as seen in Russia and now introduced in the USA.

Ultimately, it is in the micro and how your fund manager responds.
With all this macro noise all around us, in the end this is about buying shares of good companies at good prices for the long term. Or putting your savings in mutual funds that fit your risk-return appetite. A fund manager of the mutual fund you invest in has your mandate to look after your capital for the long term.

As a follower of what is called the "value discipline" to investing, my challenge as someone managing my clients' savings is: to understand and analyze the businesses; to decipher the valuations ascribed to these businesses in the stock market; and to understand the ability of the management to guide these businesses in challenging times - the unflinching question of leadership is crucial.

Yes, you can make money in India over the next decade. But the smartest investors, blinded by greed, may not see their fair share of profits for the identical risk taken by them as co-shareholders with many of India's creative founding families.

And paying the right price for the business at the right time would help long term returns. After being the first to predict a 20,000 level for the BSE-30 Index in November 2008, I then made the bold forecast that the BSE-30 Index could reach 30,000 by July 2012. Having made that "bullish" forecast, I suggested we needed to "be careful" a few months ago. At the recent equitymaster webinar, I said that the Index could decline to 17,000 to 18,000 levels.

I don't wake up every morning with a new random view on the short term or long term direction of the markets. I go by what the numbers tell me - and they do change. The "value discipline" suggested we needed to sell a few stocks during the QE2 party but were not able to deploy the cash generated from those sales into new stocks. This would suggest value managers had high cash levels. Now, with much of the risk priced in, value managers are more likely to resume their shopping spree.

But as an investor busy with a full time job and a career, tracking all these swings and deciphering what they mean is not easy. So, go ahead and make the "risky" decision to invest in the volatile stock markets of India, knowing that it is the job of fund managers with a disciplined, long term, value orientation to assess the risks of managements and valuations. This will allow you, as a long term investor, an opportunity to get a fair share of profits as the growth of the Indian economy generate significant investment returns over the next decade - just as it has in the past 31 years. Don't forget to read the documents of the various mutual funds and then decide which of them could best work for you. And, yes, do look at my favourite: Quantum Long Term Equity Fund - I may be biased because I helped set it up!

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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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9 Responses to "Stock markets take a beating: time to buy?"

sudhir patel

Mar 26, 2011

which stock to buy

Like 

Siva

Mar 22, 2011

Stock market take a beating: Time to buy?
Well, if someone had been watching a stock or studying a business of a company and if one thinks the valuations have become attractive with reasonable growth prospects and the stock is relatively cheap now comparing to its own price earlier or that of the peers, one should go ahead and buy. This should be easy for someone who studies businesses and performance of companies irrespective of the market movements (up,down,sideways).

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M F Glory

Mar 8, 2011

Yes its time to accumulate the bluechip and the midcap value added stocks.

Like 

Vinayak Kulkarni

Feb 25, 2011

My Sense is We will see 2011 as another 2008 may be the sequence of events would be different but more or less stock market will go for a free fall
FII will run from stock market like as if they are being chased by a devil
Market fall can be used by Indians to Invest at that particular Time hence i request Mr Ajit Dayal to be prepared with 4 Qualis to travel across the breadth and width of country to educate and get indians to invest during OCt to Jan 2012 Season that would be excellent act of social benefit (financially Speaking) if you do that

Like 

Jitin

Feb 23, 2011

Its a very well written article and gives emphasis to the valid issues which our Govt. is facing.
Inflation, Corruption and GDP Growth. I agree that a lower GDP with less corruption will be much better than higher GDP with corruption. For a long term improvement in the standard of living, we need to take all classes into consideration for the country to grow and wealth distribution.
But question is : is our Govt Listening ?

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rajesh

Feb 23, 2011

as the various indicators make together the countrys GDP,corruption is also the part of the same,means to say corruption was there from the starting era.....
only thing that make corruption letting down and the well process into the system is to increase the literacy level of the individual,colony city,distt,state finallly country...

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jeewan garg

Feb 16, 2011

Waiting for your articles in hindi

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Venkatesh

Feb 10, 2011

Its really thought provoking backed by data.Rather than boasting of higher GDP, we need to ensure the corrupt free system with 6.5% GDP, probably like what Mr.Nithish is trying in Bihar.Since this is hot money, we need to be clear where we are putting our money.

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Mohan Singh

Feb 9, 2011

FII selling is due to corruption cases and high inflation in India. These are the results of poor governance and greed of the ruling mafia consisting of politicians and IAS babus. Independent agency is required for tackling corruption. Inflation can be controlled by banning exports of all food products and raw materials as has been done by many countries. In India we heavily subsidize export of food materials, benefit of which is only for exporters and corrupt bureaucrats in commerce and finance ministry. If government has any concern for the poor people of the country they should withdraw all export sops for the export of food materials

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