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Who's driving this bull run?

Sunil Nayanar | October 06, 2003

". . . . India is the stock market with the greatest short-term and long-term potential in Asia." - Christopher Wood, in a foreword to CLSA's investment strategy report, summer of 2003.

On April 25, 2003, the BSE Sensex was as far from the 5,000 mark as the moon from Earth. The index had slumped to 2,924.03, and the bulls were considering a summer vacation.

And yet, by October 3, the Sensex had closed at 4,552.92, up more than 55 per cent from the end of April - and just a hop, step and jump away from the magic 5,000 mark.

What powered the huge rally? Who played bull? And what's different about the current run? It's easy to say the FIIs did it, that the good monsoon helped things along, and that sound corporate fundamentals lent sinew to bull power.

But there's more. Says Ajay Bhatia, head of research at Enam Securities, one of the boom's early cheerleaders: "The current rally is different from the one witnessed in the last decade. The 1992 rally was driven by liquidity as money got diverted from the debt market to the equity markets, while the next rally built was on the back of Indian companies going abroad and raising money. The 1999 rally was basically driven by the technology sector, and nothing else really moved. In the current rally, however, all sectors have participated."

It is different in another way, too, say market watchers. Unlike previous rallies, this one is mostly driven by people who have more 'staying power.'

The biggest investors this time around have been the FIIs, followed by retail participants.

And the good news - which can only be confirmed if we see a scam-less run for some more time - is that the current rally in not driven by any individual stock operator or a group of individuals whose failings could make the markets tumble.

The FIIs have poured Rs 13,911 crore (Rs billion) this calendar, more than any other year since they were allowed into the Indian market, but that's not the whole story.

FIIs - old and new

While the rally has FII written all over it, that's old hat. What's new is the entry of several new FIIs who weren't there before.

The usual suspects - the Singapore government, Capital International, Janus Fund and Vanguard Fund - are all part of the action, but funds from Australia and New Zealand have also begun dipping their toes in Indian waters.

"As far as foreign investors are concerned, those who have been active this time are the ones who have not tested the Indian markets before. They are possibly coming in for the first time here," says Jamshed Desai, head of research at Mumbai-based Taib Securities.

Abhay Aima, head of private banking at HDFC Bank, agrees. According to him, 80 per cent of the investor class among FIIs seems to be new investors rather than the traditional ones.

"India has been too often ignored by international portfolio investors; indeed even by equity investors in Asian stock markets who have tended historically to focus on Japan and Hong Kong and, more recently, Taiwan and Korea," noted Christopher Wood in a CLSA report earlier this year.

That's about to change with FIIs investing nearly $4 billion in the Indian equity and bond markets this year. If inflows continue at this rate for a few more months, 2003 promises to be a golden year.

The previous best figure for FII inflows was recorded in 1996, when net investments totalled $3 billion. In rupee terms, 2001 saw the next best inflows on account of depreciation.

"This has been largely an FII-dominated rally, but domestic participation has also been good. The other major change has been the fact that unlike the Ketan Parekh and Harshad Mehta-driven rallies of the early and late 1990s, this has not been a sector-driven or scrip-driven rally. This market has been more broad-based," says Aima.

Outside factors too may've helped tilt the scale in India's favour. "The main reason why FIIs are looking at the Indian markets is that India is currently the second best market after Taiwan to invest in," notes Hiten Jhaveri, director of

According to a recent ABN Amro Asia (ex-Japan) report, while the firm is overweight on markets like India, Indonesia, Malaysia and Thailand, it is underweight on China, Singapore, South Korea and Taiwan.

According to Desai of Taib, the inflows are not limited to India. "Overall, the exposure to emerging market funds has increased the world over, which has resulted in incremental capital inflows into Indian markets, too," he says.

Nitin Khandkar, vice-president of East India Securities, agrees. "Basically, the phenomenon of ample liquidity globally and a low interest rate regime has led foreign investors to look for fresh avenues to invest. This has resulted in most emerging markets seeing heavy inflows," says he.

But are FIIs shifting money from the developed markets to India? There is a school of thought which says that higher valuations in developed markets may be forcing foreign funds to look for cheaper, undervalued markets.

According to a mid-year Merrill Lynch survey of 270 fund managers, most fund managers were growing wary of US and other western markets; they also said that markets would go up in Asia, including India.

"Investors are in a mood to shift their money from the US markets mainly because of lingering apprehensions of economic recovery, the burgeoning US fiscal deficit and mixed news flows. The rally in the US markets has also led to high valuations in those stocks, which led investors to look elsewhere for cheaper valuations. Another point to keep in mind is the fact that an oil price hike could lead to a further weakening of the dollar. The sheer size of India and the relative stability the country offers are other obvious plus points," notes Khandkar.

Desai differs. "I don't buy the theory that FIIs are looking at Indian and other emerging markets because of the weakness in the US and other developed markets. Basically, they seems to be betting on a global economic recovery, which should see emerging markets clocking better growth rates," he argues.

Whatever the case may be, a perception is gaining momentum that foreign investors are here to stay. At least in the short-term. The exceptions, of course, are hedge funds.

Hedge funds were largely blamed for the sudden sharp falls in indices during the last month.

Unlike FIIs, hedge funds are not directly registered with Sebi, but they can operate through sub-accounts with FIIs. These funds are also said to operate through the issuance of participatory notes.

According to one estimate, more than 30 per cent of foreign institutional money coming into India is from hedge funds. This has led Sebi to keep a close watch on FII transactions, and especially hedge funds.

Hedge funds, which thrive on arbitrage opportunities, rarely hold a stock for a long time. And that is precisely what is worrying people like Khandkar.

"Any negative trigger could see the exit of these funds from the Indian markets which could make way for a dip. However, these funds constitute only a small part of the total FII funds parked in India and a partial withdrawal is unlikely to affect the markets much," explains Khandkar.

Bimal Jalan as Big Bull. . .

The FIIs may be the ones with the money, but the current boom would have had little sustaining power if interest rates were not heading south.

Unlike in the past, when interest rate declines were brief and sporadic, under former RBI governor Bimal Jalan India has seen the most sustained drop in interest rates since July 2000.

Yields on government securities have dropped from a high of 14 per cent on 10-year benchmark gilts in 1996-97 to below 6 per cent between July 2000 and now; the bank rate has fallen from 8 per cent to 6 per cent.

That's what set the stage for a complete rerating of stocks. Stock valuations and interest rates have an inverse correlation when seen over extended time periods - as a research report of Motilal Oswal Securities noted in December 2002.

In its annual Wealth Creation Study, Motilal Oswal said Indian corporate profits were depressed because of high interest cost and were discounted at low P/E multiples (corresponding to high interest rate).

The study argued that the Sensex was like a disguised bond as it was available with 2.5 per cent dividend yield, earning 18 per cent on book with a likely growth rate of 10 per cent in the next 10 years (last 10-years 16 per cent) at two times book giving an effective yield of 9 per cent against 10-year Government of India paper at 6 per cent.

The study also projected the intrinsic value of the Sensex with the above assumptions.

The study concluded that the "current profitability of Sensex companies (RoE-18 per cent) and discount rate (6 per cent) suggest substantial scope for appreciation."

Aima offers another perspective. "With the Sensex at 3000 levels (in April), the rally got wind purely on a correction in asset allocation. Till then, low interest rates had driven investors to look at debt instruments for capital appreciation and dividend yield in equities," he notes.

"The correction in asset allocation made it possible for the index to move up from the lows. Other factors which helped the rally along were the facts that FIIs were getting into it in a big way, and there has been an improvement in the demand-supply situation also. Unlike the previous rally, there has been no forced seller like UTI this time around - which sustained the rally."

With interest rates set to remain benign for the foreseeable future, stockbrokers do not see any major reason for unpleasant surprises as inflation, too, remains in check.

Enter, the retail investor

Even though it took some time to sink in, retail investors now seem to be convinced that the rally is standing on strong legs. Evidence: The number of trades is steadily increasing.

The number of trades - as opposed to total turnover - has nearly doubled in all stock categories, large-cap, mid-cap and small-cap, between January 2003 and September.

With index scrips and most A group scrips perceived to be beyond their grasp, small investors have been looking at smaller scrips, especially in the B2 segment.

By the end of August, the number of traded scrips under the B2 segment of the BSE had doubled to nearly 1,000 from around 500 towards the end of April.

That is when the BSE decided to get proactive and shifted a large majority of these scrips to the trade-to-trade segment - to prevent small investors from getting trapped in dangerous counters. Even then, the retail participation in the markets hardly seems to have petered out.

"Retail participation has been there at all levels, it's just that the smart ones always manage to get in at the bottom," notes Desai.

According to Aima, retail investors are getting rich after a long time. "During the technology market, very few retail investors actually got rich, which is not the case this time. And sentimentally, if you make money in a market, whether it's gold, real estate or debt, you tend to get back to the same market," he explains.

But sentiment is not the only reason driving the markets. Market players are almost unanimous in stating that the fundamentals are also strong.

"Global as well as Asian markets are doing well. Macroeconomic indicators like industrial output is rising while interest rates are at an all-time low. This has helped companies restructure their debt which has resulted in boosting the bottomline," says Jhaveri.

According to Bhatia, what we are seeing today is the result of all the corporate restructuring that has happened over the past decade.

"A number of companies have improved their return on capital despite customs duty reductions. In fact the EVA (economic value added) of India Inc has been improving steadily. This is similar to what happened in the US in the late 1980s," he observes.

The transparency of the current markets and the absence of scam hints have also been a welcome relief. "One of the real positives of this bull run has been the fact that we are yet to see names of groups or operators being bandied about as the key drivers," says Aima.

How about mutual funds? Rather surprisingly, they have been net sellers from April to September to the tune of Rs 365.20 crore (Rs 3.652 billion). "It is been a long time since we've had a market like this and it is natural that people book profits on every rise," reasons Tridib Pathak, fund manager at Principal Mutual Fund.

This rings true considering the fact that the best-performing equity funds have generated returns in excess of 50 per cent over the period. According to Pathak, the outlook on the markets remains very positive. A viewpoint that most market watchers agreed to.

Outlook. . .

"The current bull market should sustain till the end of FY04 or next March," hopes Jhaveri.

According to Khandkar, on a technical basis, the Sensex has support at 4,100 levels in the interim and on the higher side it could go up to 4,400.

(As at the end of last week, the markets had already breached that level.) Bhatia also agrees that things are looking good.

"In the longer-term, say two to three years, we are positive on the Indian markets," he says.

Even though the long-term outlook is bullish, there is concern in some quarters about the short-term fate of the bulls, keeping in mind the recent wobbles.

With the divestment process also temporarily going off the rails, what should be the strategy of retail investors going forward? The strategy should be to keep booking profits partially and always keeping a stop-loss, say analysts.

Looking into his crystal ball, Aima says: "From the current level onwards, the rally is likely to be driven by actual events - whether it is political, economical or divestment related news."

The rally's backbone

  • New FIIs: 80 per cent of the investor class among FIIs seem to be new investors rather than the traditional ones.

These funds are likely to stay invested in emerging markets (including India) betting on better growth prospects and attractive valuations.

  • RBI: Under former RBI governor Bimal Jalan India has seen the most sustained drop in interest rates continuously since July 2000, setting the stage for a re-rating of stocks.

Analysts feel that the full effect of the interest rate decline has not been absorbed by stock markets yet, and further re-rating is on the cards.

  • Retail Investors: There is evidence of increasing retail participation in stock markets. The number of trades - as opposed to total turnover - has nearly doubled.

Retail investors are expected to pour more money into equities as alternate investments opportunities dry up.

Hedge funds: Friend or foe?

Hedge funds are widely believed to be covert movers of the current rally in Indian equity. No one can say how important a role they have played so far.

Some estimates suggest that a quarter of the FII funds may be coming from hedge funds; others think that it may not be that significant.

However, all agree that they have some potential to surprise the markets by their very nature - which is to make sudden shifts from one asset to another based on arbitrage possibilities.

Hedge funds make money by identifying imbalances in the prices of asset classes, whether it is equities, debt or forex. These overseas funds enter and exit markets based on arbitrage opportunities in different markets.

Usually they cover their exposures in one market by taking a countervailing exposure in another. For example, they could go long in one scrip in the US and short it in India.

Unlike foreign institutional investors, hedge funds are not directly registered with Sebi and normally operate through sub-accounts of FIIs and through the issuance of participatory notes.

Participatory notes are normally issued to investors who do not want to go through the various regulatory processes in India which require them to make at least a minimum level of disclosure.

With a view to monitoring investments through participatory notes, Sebi had decided that FIIs must report details of these instruments along with the names of their holders.

On an average, hedge funds require a minimum investment of $500,000, thus making them accessible only to institutional investors and high net-worth individuals (HNIs).

Most of these investors are required to have net worth ranging from $1 million to $5 million. They typically have lock-in periods that range up to five years.

Most of these funds are US-based while the clients are believed to be mostly based in Hong Kong and Singapore.

According to sources, the most prominent among hedge funds operating in India are Kingdom, Standard Pacific, Tiger Management, Faqrralone Capital and Bayer Alden.

Hedge funds are mostly short-term funds and they rarely buy and hold any stock for long periods. This leads to sudden sharp drops and spurts in prices - as witnessed in April when Infosys crashed after a weak guidance.

Many prominent industry players, however, feel that there is nothing wrong with increased hedge fund activity in India, saying it is all part of the game.

"Hedge funds also take a view on the market like other institutional investors, but their mandate is different. Some of them take short-term calls on the market, but not all are like that. As an investor class they also want to make money and there is nothing wrong in that," says Gul Teckchandani, chief investment officer, Sun F&C Mutual Fund.

Rajiv Sampat, director of domestic securities firm Parag Parikh Financial Advisory Services believes that the markets are too strong currently to be dominated by one group.

"More than that it is the ability of the hedge funds to raise finance at much cheaper rates that have stood them in good stead. The markets are intrinsically strong now and are getting bigger in size. Though FII inflows have been growing rapidly, it is not just them that is behind the rally," says Sampat.

However, there is a growing feeling among market players that hedge funds may be looking for arbitrage opportunities by also playing the domestic derivatives market.

Around 20-25 per cent of the open positions in the F&O segment are held by FIIs, which has led to suspicions of hedging, noted one market analyst.

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