»The Honest Truth by Ajit Dayal

Common sense should outweigh the fear
30 MAY 2011


"What happened", wrote the upset reader, "to the view that the BSE Index would be 26,000 by June 2011 and 31,000 by July 2012?"---------------------------------------------- Don't Miss! ----------------------------------------------

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The comment is a reaction to my statements since June 2010 (when the Index was 17,000) that the Indian stock market was a great place to invest. The growth in the Indian economy would see a growth in earnings and - matched with steady foreign flows - share prices would head up.

Based on the earnings estimates made by the army of sell side analysts employed by the herd of brokerage houses, I applied an average PER multiple to these estimates - the price that foreign investors would likely pay for earnings - and arrived at the "forecasts" for the BSE-30 Index widely seen as a proxy for the stock market.

And I made this comment: Many others should note that a "prediction" of the Index is really a prediction of the direction of share prices in general, and don't get hooked on to a specific number like 19,000 or 21,000 by July 2010 or 30,000 by July 2012.

With that background in place, it is time for the confession.

With June 2011 coming up in another day of trading, the 26,000 Index is not likely to happen! Even if the FII flows turn unusually strong as they did in September 2010. And this is not because the earnings have dramatically failed to deliver or live up to initial expectations. Despite the margin squeeze caused by higher costs of raw materials (and higher salaries), profits for the year ended March 31, 2011 have increased some 15% over the reported profits of March 31, 2010 - with the exception of State Bank of India which has taken a "write down" of assets. While the earnings numbers were admittedly a little muted, what failed to happen was the buying by the foreigners.

Graph 1: How $16 billion can shake a leg: BSE-30, July 2010 to April 2011
Source: Bloomberg

Now we love you, now we hate you.

In September 2010, foreigners loved all emerging markets, including India. With the US Federal Reserve led by Helicopter Ben intent on destroying the value of the US Dollar and stoking inflation all over the world, the printing of money led foreign investors to shovel bags of money to India. Some USD 12 billion wound its way into India as the BSE 30 Index crossed the 21,000 level in November 2010. But then, the flood of US Dollars globally also saw the surge in prices of commodity like oil, rice, wheat, and metals. The fears of inflation have rattled most emerging markets. It is interesting to note that, so far this year, the Russian stock market (back by energy prices) is the only BRIC market to have recorded a gain. China, India, and Brazil have all seen declines of -7% to -12% when measured in US Dollars.

Table 1: Foreign "investors" were buyers in April...but sellers in May
Source: www.Sebi.gov.in

The importance of flows.

While earnings are a key reason to buy stocks for the long term, it is the flows of money that determine the near term movement of share prices. Facebook or LinkedIn may not have any real substantial profits but, if people believe that it is the best invention since sliced bread - well, the shares will surge. Money talks - at least in the short term.

In India, we save some USD 450 billion every year but less than 2% finds its way into the equity markets through stable vehicles like mutual funds and insurance products. As Table 1 above shows, FII money since 2003 is some USD 86,611 million and Indian flows are USD 4,839 million. And it is because the power of foreign flows has been some 18 x what the Indian flows are every movement of the Indian stock market is a function of money flows. With an estimated sale of some USD 1.5 billion in May by FIIs and a net sale of USD 500 million so far this year, any near-term surge in the Index is a pipedream.

How did we get rich?

Just a quick aside on one of my favourite topics: how the financial services industry globally is self-serving and selfish and has failed to add any value to its customers.

Despite a wealth of savings and a booming stock market, the Indian retail investor has generally been left out of one of the biggest bull markets in Indian history. In 1992, FIIs were allowed to invest in India. In 1993, UTI lost its monopoly position in the mutual, fund industry and the private sector was allowed to launch mutual funds. These two reforms - around the same time - have changed the nature of the Indian stock market.

For much of the period since CY 2003 the Indian mutual fund industry has been focused on "gathering assets" and - in partnership with an opaque distribution channel - has been shovelling your money from one "scheme" to the next "scheme".

While the rotation of your money made them great fees, the sad part is that they did not spend their time trying to convince you to add more of your savings into the stock market. Why bother? After all, the simple rotation of your money made them rich! The national cost of the focus of the mutual fund industry on enriching itself, and its distributors, is that the price of an Indian asset - the level of the Indian stock market - remains hostage to what the foreigner investors will do. The mutual fund industry has not delivered a rising base of investors. It blames the ban of entry loads for the recent decline in its asset base when the truth is, that the greed and focus on bonuses and distribution commissions is what has led to its dismal failure.

Table 2: Mutually not yours: how Indian mutual funds failed Indian investors
Year% of Indian market cap owned by all mutual funds% of Indian market cap owned by FIIsMoney earned by all employed in the mutual fund and distribution industry
1992/199310% by UTI aloneLess than 3%This would be a great number to research...
2010less than 3%More than 20%...so would this!
CommentIndians own less of their own booming marketFIIs own moreThe fund industry still got rich - even though it failed to deliver your savings to the share market!

When will the foreigner buy?

Given the focus of most employees of Indian mutual funds on their own salary and bonus, the retail Indian investor is doomed to be a marginal player in the "flow of funds" story. So, our gaze is back to the foreign investor with the question: when will they buy again? Can the BSE-30 Index reach 31,000 by July 2012?

Since November 2010, global investors have rightfully focused on inflation and interest rates. Higher oil and food prices have increased the rates of inflation. But that does not mean the end is upon us and that civilization - or the growth in emerging markets like India - will grind to a halt.

The Reserve Bank of India (RBI) was criticized for being too early in raising interest rates in CY 2009. Now, it is being criticized for being "behind the curve". While inflation is a globally feared phenomenon, one could argue that its impact on the varied developing economies is different than the impact on developed economies. And the central banks in emerging economies - like the RBI in India - have more experience in how to tackle such a threat.

Graph 2: The RBI is watching: 10-year yields and inflation since 1990.
Source – RBI, Bloomberg, Data from Jan 1990

Since 1990, India has had 4 occasions when inflation has accelerated to above 10% and the policy response - on the monetary side and the structural supply side - has been to tame it. With 13 successive rate increases since 2009, the RBI cannot be accused of complacency.

Though inflation is a genuine concern, we are not in the camp that argues that the higher interest rates needed to fight inflation will have a dramatic impact on the real rate of growth of GDP in India. Between 1994 and 2000, real interest rates were high (Graph 2) but India's GDP (Chart 1) was not affected - GDP grew comfortably above 6% p.a.

Chart 1: Real rate of GDP Growth rate across 9 governments has been 6.2% p.a. over the past 31 years
Note: 9 governments of which 6 were coalition government | Source: Quantum Advisors Private Limited

Ultimately, it is in the earnings.

The focus of attention for any sustainable climb in the BSE-30 Index has to be on earnings.

The estimated earnings of the BSE-30 Index from the analysts working at the brokerage houses still show a positive trend. But there is some nervousness over these earnings estimates in light of the higher interest rates and inflation.

Table 3: Is a 31,000 Index plausible?
Year ended March 31EPS for BSE 30 (E)BSE 30 Index (P)P/E ratio
200882415,64419.0 x
20097929,70912.3 x
201091217,52819.2 x
20111,12419,13617.0 x
20121,334 estimate31,000 estimate 23.2 x estimate
Source: Bloomberg consensus estimates

A 31,000 BSE-30 Index by July 2012 would suggest a 72% surge in the markets from the present levels of 18,000. And the BSE-30 Index would be trading at 23.2 x historical earnings of March 2012. The 13 year average P/E ratio is 18.7 x.

Looks tough, doesn't it?

To reach the 31,000 level by July 2012, the markets will need to see positive FII flows of maybe USD 24 billion in the next 12 months - a number surpassed in CY 2010 (see Table 1 above).

And some sort of "earnings upgrade" by 10%.

Both could happen. Or neither may happen.

Even at an average PER of 18.7x the estimated earnings of 1,334 would suggest an Index of 24,946 and a potential upside of +39%.

But the point is not to get hung up on an Index number - or a date. When asked on a recent CNBC show on what would be the trigger for the market, my response was "common sense".

Long term investors should not buy for specific sell limits and targets - they should buy for direction. Stay focused on the growth of earnings in companies and don't miss out on your fair share of profits as the growth of the Indian economy potentially generates significant investment returns over the next decade.


Suggested allocation in Quantum Mutual Funds (after keeping safe money aside)
Quantum Long Term Equity Fund Quantum Gold Fund
(NSE symbol: QGOLDHALF)
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% 20% Keep aside money to meet your expenses for 6 months to 2 years

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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.