It's the same old story

Bizarre behaviour, not to mention nepotism, is not a strictly Indian construct. How else do you explain the popularity of Gangnam Style? It has not only become the most viewed video on Youtube, but has also led to a 500% rise in the stock price of the semiconductor company owned by the portly rapper’s father.

If that seems illogical, how about this: the European Union gets the Nobel Peace Prize. Athens still sees frequent rioting and Spain is on a boil, so just what peace are we talking about? Last heard, prime minister Manmohan Singh was refusing to do the Gangnam Style; he believes he deserved the Noble, given his saintly reaction to all the criticism hurled at him. Amidst all this wacky stuff, the Indian stock market is on a roll and foreign investors have ploughed in some $10 billion over the past four months. Why this frenzy and can this momentum really sustain? 

The 9th annual India Investment Forum organised by international finance publisher Institutional Investor is just the place to look for answers. We find ourselves in the shimmering ballroom of New York’s Grand Hyatt, where some 300 investors of all size and styles from across North America are in attendance.

These include the omnipresent Goldman Sachs and Morgan Stanley (more on page 44) as well as hedge funds and family offices that are just getting initiated to the India story.

And to narrate the India fairy tale this time around are some of India’s best brand ambassadors from the private sector and a horde of bureaucrats. They have a tough task at hand — selling the India story this time is not exactly a walk through Central Park. 

The build-up to the forum has been anything but auspicious. Just a week before the forum was to begin, the Mamata Banerjee-led TMC withdrew its ministers from UPA II. Perhaps fearing an unstable market, Sebi chairman UK Sinha withdrew his participation.

Soon after, UPA ministers Sushil Shinde, Veerappa Moily and Sachin Pilot decided to skip the event as well — perhaps they were not sure there would be a UPA II government by the time they returned. But in his opening address Ficci president RV Kanoria handles that tactfully: “The absence of ministers here only means that they are busy taking critical decisions.” 

There were already murmurs about the absent ministers — will this government last its full term? Since nobody has an answer to that 2014 question yet, Nirupama Rao, Indian ambassador to the US, chooses to re-iterate India’s much vaunted potential. She diligently reminds the audience about the great Indian consumption theme — “In India, income levels continue to rise and this is going to drive the consumption boom that is expected in the next few decades.”

After emphasising that the New Manufacturing Policy will open up new opportunities for India-US business co-operation, she conveys an implicit expectation, “The estimated expenditure on infrastructure in the 12th Plan is expected to be about $1 trillion. We expect a large chunk of it to come from FDI.” 

That may be government speak, but the session break chatter thereafter is forgiving, expressing relief that a comatose administration is finally flaying its arms to show that it is alive and breathing. The really old India hands like Alliance Bernstein and Janus, though, are in no mood to listen to the spiel.

They are anyway clued in and are here to get an update from company managements that include, among others, Bhel, Mahindra & Mahindra, Titan Industries, Apollo Hospitals and GMR Infra. Not all of them are here to raise capital; some are here just to tell their stories and reassure their longtime investors. 

But despite concerns over the government and the lack of reforms, if investors are still interested, it is because there are companies that have flourished with very little assistance from the government. So when HDFC chairman Deepak Parekh speaks, the audience is all ears, not just because he represents one such institution, but because he himself wrote a letter to the prime minister last year expressing concern over the policy paralysis in the country.

The veteran banker, though, is glad there has been a turn in investor sentiment, and says the small measures by the government make one hopeful. Chairing a panel discussion on banking regulations, Parekh, while acknowledging the central bank for managing the country’s finances well during tough times, argues for more liberal regulations for the banking sector to foster growth. 

The Indian central bank may have its own reasons for the restrictions it imposes on banks, but no one can argue about the need for a better environment for growth today. When the going was good, all the policy action or inaction seemed irrelevant. But over the past year, the BRIC pack lost sheen as an investment destination as overall growth slowed down. In the case of India, the policy inaction became much more glaring as, unlike other emerging markets, it is heavily dependent on foreign capital flows. It is this unique dependence that forced the hand of the government since a downgrade threat loomed. The negativity hasn’t gone away entirely, but it’s certainly lessened. 

Half full

Not just the rating agencies, every investment manager present at the Grand Hyatt, it seems, is eager to find out if FDI in multi-brand retail will get ratified at the state level and if more ‘reforms’ are on the way. But the stock market is not waiting for answers — it is marching to its own beat and Sinha’s fears have largely been unfounded so far. In fact, even as the mood is still sombre, the outperformance of equity markets in India and worldwide is among the biggest surprises so far. The Sensex is up about 24% year-to-date and about 11% y-o-y.

Even if you knock off the rupee depreciation of 11% y-o-y, the market is still up 13% in dollar terms. However, the popular perception about “reform measures” driving FII flows seem a little misplaced. For one, FII flows have been positive for most of the year. Even when the market was losing ground in May, outflows were not substantial. 

Ironically, domestic funds have been sellers to the tune of Rs.15,000 crore in CY12 with the selling having particularly accentuated in September 2012. In FY13 so far, they have sold stocks worth Rs.9,200 crore. While redemption pressure can partly explain the contrary behaviour of domestic institutions, much of it has to do with their superior understanding of the local market. 

And if anyone out there was worried about this local scepticism, ex-Sebi chief M Damodaran had a modest defence to offer (his comments were not specifically on local mutual fund outflows).

Given that he chairs a committee to suggest measures to improve the investment climate and that his talk is about rebuilding Brand India, he says, “Indians by nature are more sceptical and that makes things look worse than they actually are. Sure, not everything is hunky dory, but things are not as bad as they are projected to be.”

While that may be true, Indian fund managers are a more worried lot as their assets under management are not being buoyed by quantitative easing (QE). Also, the substituting of investments with consumption has resulted in the government’s books going into deep hock. It does not help either that the environment that we are in now is one of high inflation and low growth. The latest WPI reading came in at 7.8%, the highest reading since December 2011. 

That is why Subir Gokarn, deputy governor of the Reserve Bank of India, stands out for candidly talking about the stress emanating from food inflation, the fiscal situation and the current account deficit (more in excerpts from the address at the India Investment Forum 2012).

What seems worrisome to him is “the increase in the fiscal deficit has come on the back of consumption and less of the expenditure has been on asset formation.” The audience might have deduced that although capital flows will continue, courtesy the unlimited QE from the Fed and ECB, it is unlikely that Indian interest rates will fall dramatically given the current level of inflation. 

The market, too, is conscious that none of the policy actions announced so far — except diesel subsidy reduction — have high immediate economic impact. The FDI in multi-brand retail is also symbolic. Not only will it be a long while before any impact is felt, it also does not address infrastructural bottlenecks.

Due to weakness in the US and Europe, exports are not expected to pick up either, even with a depreciated rupee. The trade deficit for H1FY13 is about $90 billion and exports for the first six months were at $144 billion against the target of $360 billion for the entire year. So, given the lack of intent to cut expenditure, the only way to bridge the deficit is by getting inflows.

Unlimited QE 

Fortunately for India, this is one thing that is going right. In the search for higher returns more flows are expected to come into emerging markets. George Hoguet, managing director of State Street Global Advisors, enjoys a bird’s-eye view of the shifts happening in global portfolio flows. SSGA is the world’s second-largest institutional money manager with $2 trillion in assets. Hoguet says QE3 has revived interest among institutional investors wanting to invest in emerging markets equities and bonds. Then comes the icing: “Most pension funds are 50% underweight emerging market equities. India should get about $5-6 billion a year just on the index side. Active bets will get in more.” 

Interestingly, money has been moving out of exchange-traded funds and fund-of-funds, which were key vehicles for new foreign investors till recently. Kunal Mehra, portfolio manager, New Vernon Capital, explains this phenomenon lucidly: “When people recover from a shock, they start underestimating risks regarding things they are familiar with and overestimating risk on things they are not familiar with.

Today the view is that the US is a lot safer than Asia and, therefore, emerging market managers and companies have to earn their credibility by saying we can give you differentiated return.”

Besides, in the past few years, several investors had become lazy about buying India — taking the index funds route or investing via exchange-traded funds (ETFs) rather than making the effort to invest directly. Now with an elevated market, fund managers will have to work harder to find the right opportunities. Therefore, even as intermediaries reduce, capital flow will continue, he adds.

While that sounds good, these flows can be volatile and volatility more often than not is driven by uncertainty. Therefore, when risk appetite is low, investors prefer hiding in their own market. This is a situation that Kathryn Koch, senior portfolio strategist, Goldman Sachs Asset Management (GSAM), is very familiar with.

Selling the India story had become a tough task in late 2011. As it was, equities were on a roller coaster, given the Eurozone uncertainty, and investors were wondering if the Indian government had the will and ability to enact much-needed changes.

Koch recalls the reluctance of clients to commit money, “When you are worried about the volatility in your portfolio it is probably not the opportune time to add another country that has a very high volatility profile.” 

A year is a long time in the markets and as the recent turn of events show, it does not take long for perception to change. After the recent QE, George Soros’ famed theory of reflexivity has come into play. Getting in FII flows has helped the rupee move up, and that is sending a positive signal to investors on the sidelines.

But there are question marks on where the money is coming from. A Kotak Institutional Equities (KIE) report points to an inability to pinpoint the source of FII flows that have come in September. Their best guess is that participatory notes (PN) could account for a substantial chunk given the trend in July and August. Even for the $12 billion inflows that had come in till August 2012, KIE could account for only $7 billion among block deals, ETFs and sovereign funds put together. Interestingly, an increasing portion of PN flows has gone into derivative instruments.

Notwithstanding the concerns over the nature of FII flows, an appreciating or stable rupee and crude oil staying low could be a very good mix for India as it helps manage both deficits. But this state of bliss cannot be taken for granted. Benign commodity prices might have benefited end-users and held back inflation, but renewed Chinese growth could again change the inflation equation for India. While a stable or falling crude price is good for the Indian economy, the same cannot be said about other commodities. From a stock market perspective, though, falling commodity prices mean earnings for the bulk of the Sensex companies will be at risk. 

Junk proofed

While the downgrade threat has reduced, even if it happens, damage is expected to be India-specific rather than one arising from a global dislocation. Given the aura of ebullience enveloping foreign investors, a downgrade is not expected to result in much damage, says Arvind Sanger, managing partner, Geosphere Capital Management. “It will not be an outright surprise and might at most cause some weakness in the rupee. An inflation challenge will only arise if the rupee weakens considerably.” 

Even as the European Union meltdown risk is off the table with the ECB saying that it will support any member country that asks for help, that movie is not yet over. Yes, Spanish yields have retreated and the 10-year is now at 5.6%, down from the high of 7.6% that it reached in late July.

But there is fear that Europe will be in recession next year and the US will continue to grow below trend. Spain, too, in all probability will have to restructure its debt given its shrinking GDP and Greece might exit the EU. Hoguet says, “The markets have been calmed but the equity risk premium is still high. If the US 10-year is yielding 1.75%, you should have a much higher P/E ratio. We are only at 14 times.”   

Tense as they may be about overall global growth, investors continue to bank on emerging markets to pull their weight. There is a faint hope that global growth will accelerate next year driven by pick-up in China and India where scope for monetary stimulus exists.

The news flow from China has been mixed — while exports showed an improvement in September, manufacturers continue to lose pricing power. Manish Chopra, founder of Tiger Veda, a $400-million hedge fund, still looks at China as a work in progress. His concern comes across when he says, “The markets they are exporting to are not going gangbusters. How that economy transitions will be interesting along with the fact that they are attempting to transform themselves to a more consumption-oriented economy.” 

The institutional investors Hoguet interacts with also have niggling thoughts at the back of their head. But in their case, these have to do more with India than China where the government is more pro-active. While Hoguet agrees about growth acceleration coming from emerging markets, he says there is concern that India will not be decisive enough in some of the reforms that have been proposed. “Indian growth is subject to policy gridlock in some areas. Political isolation could mean that the pace of reform will be slower rather than faster.”

While that seems like an obvious fear, most India veterans would agree that India has always been big on announcements and low on implementation. New Vernon’s Mehra says while such fears are justified, not enough credit has been given to Indian policymakers. He elucidates, “One thing that you cannot overlook in India is that the government has been consistently yielding space to the private sector. We may disagree with the pace, but that is a real change happening over time.”

Allocation game 

India has always been a magnet for foreign investors looking to diversify away from developed markets, the draw being that it is a fast-growing economy with many internal drivers. Not that the structure has changed much, but with policy paralysis being a frequently voiced term, this unique selling proposition is increasingly being questioned. Will the risks to the Indian market, therefore, now be more internal than external?

While there is unanimity that risk appetite is driven by the latter, opinion is divided on the former. Says GSAM’s Koch, “External risks matter less to India because its economy is more closed than the rest of the BRICs. The fundamentals are mostly internal with the exception of the IT sector, which is dependent on selling to developed markets.” 

While Indian IT companies are indeed facing the heat, Tiger Veda’s Chopra thinks the outcome of the US presidential elections could be a point of discomfort for the market as well. “Even if protectionism is not on the agenda, we need to see whether the policies that will eventually be pursued will be market friendly or not,” he adds.

Given that the export sector is not very robust, most foreign investors continue to direct their monies towards sectors driven by domestic consumption. In Goldman Sachs Asset Management’s BRIC portfolio, India has the second-largest country weight with the preferred sectors being private banks, healthcare and consumer goods. It has been underweight energy for quite a while and that could also partly explain why Russia has the lowest weight in this portfolio. 

But can the much-chased defensive stocks continue to beat the market? Mehra says that while the category may be fully priced, one can’t say for sure if the outperformance has run its course. Albeit slowly, after being much battered, infra stocks are also attracting some interest.

Still, many investors continue to be sceptical of leveraged companies and their attempts to reduce debt by selling assets. There are stocks where there is hidden value but no one wants to wait 18 months to see if the cash flow can come in. “As asset sales are not going through, infra companies are not able to deleverage and, therefore, equity in the balance sheet is not getting appropriately valued. That could well change soon,” says Mehra. 

Sanger sees enough opportunities too. Geosphere’s India allocation has increased in the past two months, and is now the highest during the past one year. “We like companies that have financial leverage but where management is doing something to fix that leverage. These companies will benefit from an improving environment and a reducing interest rate cycle.” 

Interestingly, the small- and mid-cap exposure in GSAM’s India portfolio is much higher than the standard benchmark and the recent gains in the market is not preventing Koch and her team from going bargain hunting in mid-caps. Corporate governance and liquidity are the two biggest hurdles that institutional investors face when they go bargain hunting in mid-caps. But that has not fazed Koch. “Our rule of thumb for emerging markets is that we want to liquidate any position in the portfolio by being less than half of the trading volume over a 10-day period. And we do not invest without meeting managements.”

That’s a ritual no bottom-up stock picker will do without. Tiger Veda backed by the legendary Julian Robertson, too, runs a very concentrated portfolio and its $400 million is spread just over 30 stocks around the world. Chopra’s touchstone, “The price is irrelevant if we don’t like the management. And to assess management quality, we do thorough checks through competitors, previous stock owners, bankers and the business community in general.” 

Liquidity blast 

Post the market run-up, GSAM’s Koch thinks valuations are not cheap. The MSCI India index was down 39% in dollar terms last year and now it is up 25%; the fundamentals don’t quite justify a 65% gain. “It is possible that we have overextended ourselves this year. There is not a lot of room for policy mis-step,” warns Koch. 

In the unadulterated bullish camp is Sanger. He says that, given the potential for re-acceleration of growth from the current low level, the bias for the market continues to be upward. Over the next 12 months, 6,200 on the Nifty is achievable while the downside seems limited at 5,200, Sanger believes. The only spoiler for him is an excessively populist budget for FY14. “What makes me nervous is that going into an election, fiscal responsibility usually goes out of the window,” he says. 

But does Sanger’s biggest concern really matter to the market? In August 2007 after BNP Paribas declared that it had halted redemptions at two of its hedge funds because it could not value the securities that it was holding, the market went into a funk. But aided by Helicopter Ben’s rate cut, the Sensex galloped from 13,800 to 21,000 in under five months. There is nothing to prevent that from happening this time too, given how keen foreign institutional investors are, to rush into the Indian market. 

Koch believes that India will continue to trade at a premium compared with other BRIC markets. “Given the sector diversification, high exposure to the consumer sector, management quality and high asset turnover, India deserves to trade at a premium relative to BRICs,” she says. The BRIC average forward multiple for CY12 is nine. India trades at 14 times at the higher end while Russia trades at four because 80% of its market is upstream commodities. 

For CY12 so far, net FII flows into equity have been nearly $18 billion. Sanger says continued quantitative easing from the West is possibly setting the base for a new upturn. “Once you have unlimited QE, risk appetite does rise,” he points out.

Sceptics can purr that there has been talk of ‘reforms’ for quite a while but for active managers the reality is that they have to keep up with, or still better, beat the benchmark. That is why they have to turn with the tide and cannot maintain a rigid stance, whatever be their personal leaning. Brazil and Russia are tied to commodities. China’s market is not that diverse.

Naturally, among the BRIC pack, that leaves only India. Foreigners don’t doubt the potential and are predisposed to investing in this ‘stock picker’s paradise’. It is at moments like this that our cockiness about where else can foreign investors go seems justified. Time then to line up and welcome them Gangnam Style. 

To read excerpts from Ruchir Sharma and Subir Gokarn's address at the India Investment Forum 2012, click on the respective links.