Foreign investors are the movers and shakers of the Indian markets. Domestic investors have very little money (as a % of net worth) invested in the markets. Thus, FIIs are in control of stock prices. Their decisions do not always make sense to the Aam investor. They control huge amounts of money. They claim to run their funds professionally. Yet they tend to behave as a herd does. Good news can cause them to rush into stocks. On the other hand, at the slightest sign of trouble, FIIs could stampede for the exit. The Indian markets are at constant risk of the latter.
Indian investors got a taste of this risk recently. FIIs pulled out large amount of funds from India in April 2015. The reasons were many. A poor quarterly earnings season was one. Then there was the heightened the chance of Greece exiting the Euro. Geopolitical concerns and crude oil prices were other reasons. But the real risk was the huge increase in investments that FIIs had made last year. It had made our markets vulnerable to their exit. The bad news is that more pain could be coming our way.
As per an article in the Financial Times (FT), capital flows in to emerging markets (EMs) like India could fall by 6.4% YoY in 2015. This might not seem like a lot until you consider the amount involved: US$ 67 bn. This is a big reduction indeed and India will feel the pinch. The increase in interest rates by the US Fed later this year would be the key trigger event. As per FT, this could cause the flows into EMs to fall to the lowest levels since 2009. After all, if FIIs can get higher returns from US bonds, why would they invest in risky emerging market stocks?
It's important to note this is just one of the reasons. No one knows for certain when the Fed will raise US interest rates, if at all. The fact is that FIIs are a fickle breed of investors. Not all of them invest for the long term. The ones, who enter and exit quickly, do so for a wide variety of reasons. This causes a lot of volatility in the EM stocks, bonds and currencies. India has seen its fair share.
The key point to keep in mind is that in the long term, stock prices reflect the performance of the business and not FII flows. If the underlying business is poor, no amount of FII money flowing into the stock should entice you. The opposite is also true. This is why we at Equitymaster always employ a bottom-up, fundamentals-based value investing approach. It is a proven and rewarding way to make money from equity markets. We believe more investors should do the same.