Buy Before the FIIs Come Back to India

Editor's note: As you are aware, Equitymaster.com is a victim of a ransomware attack.

We will not let this come between you and the credible and honest opinions we publish for you. The entire Equitymaster team is all here and publishing daily as usual. It's just that you will receive our content and research updates over e-mail till we sort things out.

Meanwhile, my team and I continue to work hard towards addressing this ransomware issue.

Your patience and support are deeply appreciated.

One more thing...I will try and post regular videos on Equitymaster's YouTube channel and updates on my Telegram Channel. If you haven't already, please do join in here.

---

A billion dollars a day! FII sell-off worse than the 2008 crisis..

This headline in the Economic Times last week did not surprise me.

The US Fed has hiked interest rates and will raise rates again soon. The outlook for global macroeconomic stability has worsened. Regulatory issues in markets like China has led to flight towards safety.

Expectedly, FIIs exited Indian stocks to the tune of US$ 12 bn since October last year.

The FIIs are known to be fair weather friends.

From time to time, they abandon emerging market stocks. And this tends to have a lasting effect on markets.

Japan's "Lost Decade" was a period that lasted from about 1991 to 2001. The decade saw a significant slowdown in Japan's previously bustling economy.

This slowdown was caused, in part, by the Bank of Japan (BOJ) hiking interest rates. The central bank tried to cool the real estate market.

Even then, the MSCI Japan index has produced more than double the return of the MSCI China over past 3 decades. Japan has returned 164% against China's 75%.

In fact, the MSCI China has the poorest returns among emerging market indices over the period. The index had only returned about 1.9% p.a. over 30 years, including dividends.

China has its own set of economic challenges. Its zero Covid policy, crackdown on tech giants, and the stress in the property market, have all roiled sentiment.

But that was not the case until early 2021. All it took was a regulatory crackdown and increased government intervention in markets. China lost almost all its gains in the stock markets, especially in massive tech stocks, in the selloff in late 2021.

Now, was this expected? Aren't stock market returns supposed to mirror the performance of the economy even if with a lag?

Well, that's not always the case.

The chart below tells us the best performing stock market in the 20th century was Australia, closely followed by Sweden.

Neither had anywhere near the best economic growth rate (real per capita GDP growth) over that period.

Why was this?

Clearly, returns in a stock market reflect the returns of the stocks listed in that market. The quality of those businesses, valuations, cost of capital, regulatory environment, and economic megatrends all play a part in the stock market returns.

The stock markets with a history of poor capital allocation and government interference usually offer mediocre returns. Those with better governance, fewer state-owned enterprises, and healthy access to capital have done much better.

Therefore, large parts of the Chinese stock market were of no interest to foreign investors for a long time. The major listed stocks there were...

• State-owned banks, telecoms, utilities which are known to lack transparency.
• Heavy industry and mining stocks with problems of governance and overcapacity.
• Real estate with problems of overcapacity, opaque balance sheets, and government interference.

As a result, investors were left focussed on internet platforms, higher-end manufacturers, and technology stocks. These companies eventually attracted loads of capital. They grew so big so fast, that they cornered a huge proportion of the Chinese stock market by 2020.

Then came the barrage of regulatory embargos. Starting 2021, the Chinese government started banning or imposing regulations on tech business that almost made them unviable.

This caused foreign investors to re-evaluate their exposure and pull back capital from Chinese stocks.

Now the question arises - Could India witness a similar market correction?

First of all, with its private sector banks and companies being allowed to operate with less government interference, India has really lived up to the emerging market promise so far.

More importantly, the stocks with the largest weightages on the Sensex and Nifty currently do not have as much sector concentration as in the US or Chinese stock markets. There the tech behemoths dominate.

But that said, a lot of money has flown into Indian tech stocks in recent months. Many of the stocks are undeserving of the capital. And that is where the bubble could burst.

So, investors must be careful of these pockets of risks.

A lot of disruptive business may promise exponential growth based on number of visitors to the portal or may seek steep valuations based on what they call the gross merchandise value.

But we must keep in mind that a first mover advantage could only last so long and once competition catches up, the exponential growth numbers may not be sustainable.

Just as there is a wave of new listings in the disruptive tech space... there are also plenty of companies that fail to meet quality metrics. Yet they are able to fetch astronomical valuations.

Take the fintech ecosystem for instance, there are a variety of companies getting listed from segments like payments, insurance broking etc. These companies don't just have competition from the new age players but they're also competing against incumbents.

Banks that have adopted technology in a big way. So, with stiff competition and little differentiation, the path to profits is a tough one.

What is most worrying is that despite low profits, some segments have seen a flood of money from VCs and private equity investors in past year.

The fintech sector especially is flooded with unicorns. I won't be surprised if many of them don't make it to the other side of the market bubble.

Now that you are aware of such downside risks, be extra cautious. Be sure to identify the most sustainable technology stocks.

Buy them at a discount before the FIIs head back to India.

Watch this video to know how I and my colleague Richa are doing this.

Warm regards,


Tanushree Banerjee
Editor, StockSelect
Equitymaster Agora Research Private Limited (Research Analyst)