Hope And A Prayer

Sometime in mid-July, Singapore-based Helios Capital Management, a hedge fund, raised $11 million for an India-focused fund. The ‘Helios India Jai Ho Fund' targets stocks that are slumdogs and, over time, will make millionaires out of its investors. The amount it raised till now is well short of its $50-million target, though it is open till the end of July. Only 14 investors ponied up for the fund — the minimum investment required is $100,000.

A study by Hedgefund.net found that since 1 January, India-focused funds have seen average returns of 19.6 per cent; since 2005 end to September 2008, total assets allocated to India-focused funds rose from $2.8 billion to almost $14 billion, about 500 per cent in three years.

This latest offering, many say, reflects renewed investor interest in India, and may be a big part of the reason why the Sensex has been moving up rapidly over the past two weeks (from 13769 on 9 July to 15369 on 23 July). In the past month or so, foreign institutional investors have put in about $1.4 billion into Indian stocks, or 25 per cent of the nearly $4.5 billion that they have put in since the beginning of the year.

"The world has always been underinvested in India," says Parag Thakkar, vice-president, equity sales, at Brics Securities in Mumbai. "Now, fund managers are marketing the huge demographic and infrastructure investment opportunities more aggressively."

Fair enough. But have things really changed that much to warrant the market's rise? Corporate financial performance has been bad — it may get even worse — so fundamentals are still weak. Global and domestic conditions could change rapidly, and collapse sentiment in a big hurry. Most importantly, we could be ignoring risks to the hoped-for economic revival that may end up being costly.

The Return Of Optimism: Too Soon?
Three things have underpinned the change in sentiment. First, there is more than abundant liquidity all over the world that needs a home. All the fiscal stimuli from so many governments have created oodles of cash. Second, there is greater global optimism that we are getting out of the crisis; government stability and some positive reform pronouncements have similarly boosted domestic sentiment. "There is a lot of short-term money in the market," says Jay Prakash Sinha, senior analyst at Quant Broking, a securities firm that specialises in servicing institutional investors. "And yes, much of that is foreign." He points out that the perspective on India is relative: we are doing better than the other economies, even some of our Bric (Brazil, Russia, India and China) contemporaries.

Until 15 May, the Indian stockmarket had gained just 25 per cent from the beginning of the year; other Bric economies had gained over 40 per cent. With the decisive mandate handed to the Congress in the elections, the market's gain since 1 January went up by over 50 per cent on 18 May (see ‘Catching The Pack'). The perception of a stable government was clearly a factor. The budget announced on 6 July was initially a wet blanket. But since then, the government has been talking up the market in a sense, making a lot of positive statements — including on disinvestment — where expectations were highest.

In the past two months, companies have raised nearly $6 billion through qualified institutional placements (QIPs), offers for sale and global depositary receipts. Investors were also encouraged by companies' attempts at restructuring their balance sheets and making them stronger by getting rid of costly debt. But the initial success of QIPs has moderated, and subsequent issues have met with lukewarm response.

Conservative Approach
This liquidity-driven push to stockmarket indices is all very well for now, but it may not stay. Trillions of dollars worth of fresh corporate debt across the globe is due for refinancing from 2010 to 2014. If things do not get better soon, there could be a new credit crisis. The deleveraging of corporate balance sheets is estimated to have cut liquidity by nearly $15 trillion because of the crisis. Will the $3 trillion of fiscal stimulus packages be enough to make up for that?

"The stability in India is an attractive draw," says Sonam Udasi, vice-president, research, at Brics Securities. "After the crisis and the deleveraging that followed, there is a growing feeling that all the debt is in the West and the assets in the East. And fund managers are allocating money accordingly."

True, but much less is being made of the ‘green shoots' than before. While the rate of decline is slower, things are still getting worse. Unemployment in the US is still reaching near-record highs — some estimates put it at reaching 11 per cent in parts of the country soon. This augurs ill for India and other emerging markets too.

Brazil's economy, for example, contracted by 1.8 per cent (annualised) in the first quarter of 2009; and for the first time since March 2001, it recorded a trade deficit. Unemployment touched 9 per cent in March, and industrial production fell 15 per cent in April from a year earlier.

"All the assumptions made by fund managers are getting more conservative," says Biju Samuel, senior analyst at Quant Capital. "For instance, open-interest positions in stock derivatives are at a three-year low. It is an indication that positions are much less leveraged, but it also means that confidence is lower, and thus there are fewer speculative bets."

Whither Profitability?
But it is the decline in corporate financial performance that has been more startling than anticipated. Corporate profitability ratios have declined precipitously for seven quarters (from Q1 FY08 to Q3 FY09), according to a review of the results of nearly 2,400 companies by the Reserve Bank of India (see ‘Cooling Off Fast') in April 2009. On 28 July, the updated review will probably show that the profits of these companies for all of FY09 will be much worse, even negative compared to FY08.

One number stands out: interest coverage, or the ratio of earnings before interest and tax (Ebit) to interest expenses, which demonstrates debt-servicing capability. It declined from 8.5 times in the first quarter of FY08 to just 2.9 times in the third quarter of FY09. A number close to 2 will mean higher credit risk for lenders; now banks will be more reluctant to lend.

"That 2.9 times is an average," points out Murali Krishnan, head of research at Ambit Capital in Mumbai. "If you take out the consumer goods companies and others that carry little or no debt, interest coverage could even be close to 1." Any more stress on balance sheets, and many companies may end up in debt restructuring plans or even go bust.

Banks will be even more reluctant to lend if interest rates go up in the face of a gigantic government borrowing programme. That means the huge treasury profits that banks booked last year would be absent in the current one. And the above-mentioned credit risk concerns could freeze credit availability for many companies, or raise their costs prohibitively.

Coming Full Circle
Financial performance for the first quarter of FY10 was disappointing, say analysts. Infosys, the bellwether, was "OK", though Tata Consultancy Services did reasonably well. Larsen & Toubro's profits from core operations were "dismal". None of this bodes well for corporate performance in the next two quarters.

"Don't forget that if the monsoon fails, the demand for food credit (to agriculture) could go up and crowd out corporate credit," says Indranil Pan, chief economist at Kotak Mahindra Bank. What will happen to growth projections and the recovery then is anyone's guess.

The vicious cycle thus gets completed: tighter and more expensive credit, fewer overseas sources of finance (including suppliers' credit), lower productive activity, and thus lower profits and growth. With earnings potential going down, company fundamentals will get weaker, and stocks will look more overvalued.

ONE WAY, TWO PATHS

Underscoring the uncertainties and volatility in the stockmarket is the trading pattern in the Indian cash and derivatives markets of foreign institutional investors (FIIs). The data (see ‘Hedging or Speculating?') in recent weeks seems to bring out a growing negative relation between the collective directional views of FIIs in the cash market versus that in the index futures and stock futures segment of the derivatives market. The FIIs are seemingly hedging their cash market positions by taking an opposite view on the futures market. For instance, in May, when the net collective FII inflow (purchases minus sales) on the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) was a total of Rs 13,886 crore, they showed a net outflow (sales being more than purchases) in futures (on S&P CNX Nifty index, other indices and stocks) on the NSE of Rs 8,070 crore. In July, till the 20th, the position was reversed with the FIIs registering a net outflow of Rs 3,516 crore in the cash market and a net inflow of Rs 3,267 crore in futures on stocks and indices. Secondly, analysts believe beta games are being played out. An FII, strongly bullish on some stocks, will buy shares in the cash market. Simultaneously, it will sell Nifty futures expecting the stocks to be more volatile than the index in either direction. If the market rises, it will profit on its stocks but lose in index futures. But since the stocks are high beta, its profit from stocks will be more than the futures loss. The attraction, however, is to limit the loss when the market goes down — stocks lose, but this loss is buffered by a profit from index futures. FIIs could be managing sudden inflows and outflows in their kitties by first executing buy or sell trades in the stock futures, and then over a few days unwind these and, simultaneously, buy or sell in the cash market. This is done to reduce the impact cost on trading in one go in the cash market. "Money is managed dynamically by global investors to retain their competitive edge," says a derivatives desk dealer at Enam Securities in Mumbai. Uncertainty and volatility can make a heavy cocktail. Rajesh Gajra

"We had put the earnings per share (EPS) for the Sensex (companies) at between Rs 780 and Rs 890 in September," says Krishnan. "We have had to upgrade those numbers after the recent upward movement in the index." At the same time, he acknowledges being uncertain as to whether the rise in the Sensex can be justified with so little foundation in ground reality.

Analysts are now projecting an EPS of Rs 1,000 for the Sensex, which makes it 15 times earnings, and thus overvalued. Most agree that a fair value would be a level of between 11000 and 12000. "That would be the bottom," says one analyst, who did not wish to be named. "That's where we cap our downside risk." Of course, no one's taking bets on the upside.

srikanth (dot) srinivas (at) abp (dot) in

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