Building a local bull - The Honest Truth By Ajit Dayal
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Investing in India - Honest Truth by Ajit Dayal
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12 JUNE 2008

Over the past 5 years the welcoming policies towards unknown "foreign" buyers into the Indian stock markets has created a fake bull market in the Indian stock exchanges. The P-Notes or participatory notes were even recognised to be fake by the creators of these instruments: they are called "synthetics".
Like the synthetic materials that artificially shape a human body to perfection.
It is fake because there is nothing real about it.

Investing in India - the unreal thing.
Every morning the anchors on television channels chimed in unison that they were looking for "global cues". They scanned the horizon for a sign of that ship - even for a shadow - to tell you where the global cues were going to lead the Indian stock markets on any given day.

For all our chest-beating, the sail winds of India Shining, India Resurgent, and Incredible India were being blown by the butterflies flapping their artificial wings in some remote financial capital.

There is nothing wrong about foreign money coming into India. But there is everything wrong about not knowing why that foreign money is coming in; how long it intends to stay; and who owns it.

But neither the BJP-led NDA coalition nor the Congress-led UPA coalition paid much heed to the warnings of the Reserve Bank of India. Bankers - the traditional ones that we thankfully have at the RBI - are, by nature, cautious. They ask questions: "Good morning. I believe you wish to invest in the Indian stock markets", they would ask a typical foreign investor, "that is so very nice of you. But, I beg to know, who are you and what do you want from this investment in India?"

Hey, this is the 21st century and the world is fat with money sloshing around. Who has time for questions and filling in all those badly drafted FII registration forms? Just take it as it comes, baby. Turn on the P-Note tap. Flood me with your synthetics.

And so the bull market began. The synthetics came bouncing around and jiggling all over. The surging Index had the media and the government officials into a salivating fit. Every trading day for the past 5 years (approximately 1,320 trading days) the foreign investors bought a net of Rs 3 crore of stocks in every hour of trading.
About Rs 5 lakhs every minute.
Looking good, baby! Jiggle away!
And the share prices went into a dance and then into a wild dance in September 2007 when the pace quickened by 8x to Rs 24 crore every hour.
That is Rs 40 lakhs every minute.

But every dance comes to an end.
Every sailor heads back home.
The butterflies stop flapping their wings.
The mighty sail of the Indian stock market flutters in search of direction and then folds.
Marooned in a sea of red, everyone wonders what happened. The markets are down. There is no global cue on the horizon. You see the plastic on the floor - that is a residual of the synthetics. The central bankers shake their head in a "we told you so" motion. And they, like true bankers, help to clean up the mess.

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The Indian slow dance.
Meanwhile, the poor Indian investor kept on giving their two-bits to the mutual funds and the Indian stock markets. No minister came to meet them in Jalandar, Patiala, or Secundrabad. No one sent them any invitations to attend any conferences in London and New York and Hong Kong about what a wonderful investment destination India is. The local investors took out 2% from their annual savings of USD 300 billion and plonked their Rs 3 lakh per minute investment into the Indian stock market. Most of this found its way into the Indian stock markets via a mutual fund or a unit linked insurance policy (a bad choice of vehicles, most likely, but that is a topic for another Honest Truth!).

This kathak-like pace is no match for the synthetic foreign investors who are now running for the exit.
Running as if they are in a disco that has caught fire. As the foreign investors dump their shares, the buying power to match that selling is just not there in India.
In simple economics, when supply exceeds demand - when sellers of shares are more than the buyers of shares - the share prices have only one way to go: down. Sharply down. Like the panic sales you have seen recently.

Shift the beat to a disco bhangra.
But this gentle pace of the Indian kathak, can turn into a sustained disco bhangra.
A bhangra that will match the selling by the foreign investors.

Another law of equilibrium in economics: when demand matches supply, prices will be stable.
So far this year foreign investors have sold USD 5 billion worth of shares. That is Rs 53 lakhs every minute of trading.
The Indians are buying at the rate of Rs 3 lakhs per minute.
"Houston, we have a problem."
Supply (Rs 53 lakhs of selling by the foreign investors) is more than demand (Rs 3 lakhs of buying by the Indians). Ouch!
When supply is more than demand, prices have only one way to go: freefall!

There is a way to make the Indian supply zoom really quickly. This is to allow the pension funds to start buying into the Indian stock market. However, given the fact that this proposal has been sitting with the government for a few years, the reality of coalition politics will ensure that nothing will happen.

But there is another way: extend the benefits of Section 80 C.
Currently, any individual can use up to Rs. 1 lakh to buy shares (locked in for 3 years in an ELSS), repay a home loan, and contribute to a PPF. This entire Rs 1 lakh is freed from any income tax obligations.

Crank up the volume!
The Equity Linked Savings Schemes (ELSS) are mutual fund schemes that are designed to keep your investment locked in for 3 years. Furthermore, your investment in this fund (up to a maximum of Rs 1 lakh) is free of any tax.
After 3 years, the capital gain on this investment is also free of tax.

In the past year about Rs 3,500 crore of money has come into the ELSS mutual funds. The government can dramatically increase the inflows into a locked-in class of shares issued by any mutual fund.
There are an estimated 36 million tax payers in this country. We do not have any statistics on how these 36 million tax payers used the Section 80 C benefit: how was that Rs. 1 lakh broken up. How much was invested in ELSS mutual funds, how much was used to repay home loans, etc.

But, let's take a few guesses.
What if the government announced that under Section 80 C, individuals could invest in any equity mutual fund (in a special class of shares with a 3 year lock up) to the tune of Rs 10 lakhs per person.
And this Rs 10 lakhs was also exempt from tax.
Such an exemption would cost the government about Rs 3.5 lakhs in taxes for every person who does invest the maximum limit of Rs 10 lakhs.
The assumptions in Table 1 below indicate that there would be a buying power of Rs 141,500 crore every year from the local Indian flows.
That is a buying power of Rs 179 lakhs every minute.
This is over 3x the selling of Rs 53 lakhs per minute by the foreign synthetic investors so far this year.
Back to economics: when demand for shares (the buying from local Indians) is more than the supply (the selling by synthetic foreigners) then share prices will increase.

Table 1: Encouraging long term domestic investments in India.
Number of taxpayers Amount invested Total pool in mutual funds Tax loss to government Tax loss to government
360,000 Rs 10 lakhs Rs 36,000 crore 35% Rs 12,600 crore
360,000 Rs 5 lakh Rs 18,000 crore 30% Rs 5,400 crore
35 million Rs 25,000 Rs 87,500 crore 10% Rs 8,750 crore
Total 36 million   Rs 141,500 crore   Rs 26,750 crore

But there is a huge tax cost to the government in terms of tax revenues not collected. This is a huge Rs 26,750 crore - which is equal to 25% of the total direct taxes collected by the government from the individuals.

Surely, this idea of increasing the Section 80 C benefit to Rs 10 lakhs per year is idiotic!
Well, not if you see the benefit the government gets from all that buying of shares by the local Indian investors.

In addition to the Securities Transaction Tax (STT) that a buying of Rs 141,500 crore would directly generate - and the indirect increase from more investor interest in the market and higher STT collections - there is the direct benefit to the government from an increase in share prices of companies in which they have ownership.

The government has significant ownership of companies like State Bank of India, ONGC, and BHEL to name a few. The share prices of these companies have declined by 30% this year. The loss in market cap of these companies has cost the government a loss in value of their shareholdings of probably USD 100 billion (Rs 400,000 crore). With the local Indian money coming into the market, share prices will recover - and the government will see a recovery of its USD 100 billion loss, at the very minimum.
The government could easily sell down its stake in many of these companies over the next few years to offset the loss of tax.

So, a loss in the revenue side of Rs 26,750 crore from lower tax collections could see an enhancement of over Rs 400,000 crore in the value of the government's holdings. A sale of 5% of these holdings would generate Rs 20,000 crore in money back to the government. A 7% sale would see a total recovery of the "loss in tax" amount.

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More importantly, India will have built a more robust local demand base for long term investing.

India is an economy in a long term bull phase, in stock market terminology. But the market structures - with the dominance of the synthetic P-Notes - is so messed up that our stock markets act like we are about to enter the dark ages!

The government needs to shovel more local savings into the Indian stock markets and allow the long term foreign investors quicker access via a more refined FII process. If Bollywood can dance, why not give Indian investors a chance to shake with the real thing, too.

Meanwhile, while we all wait for the government to encourage us to buy more, keep in mind that valuations of many stocks in our opinion, are really attractive.

Read about the new Index ETF that Quantum AMC has just launched. You can invest in the long term direction of the markets without worrying about selecting any individual stocks or type of mutual fund scheme. All this convenience at a low cost.

Suggested allocation in Quantum Mutual Funds
Quantum Long Term Equity Fund Quantum Gold Fund Quantum Liquid Fund
Why you should own it: 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% 15% 5%

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"

Note: Ajit Dayal, the author is a Director in Quantum Information Services Private Limited and Quantum Asset Management Company Private Limited. Views expressed in this article are entirely those of the author and may not be regarded as views of the Quantum Mutual Fund or Quantum Asset Management Company Private Limited or Quantum Information Services Private Limited.

Mutual Fund Investments are subject to market risks. Please read the offer documents of the respective schemes before making any investments.


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