Meeting Expectations

The remarkable journey of the Sensex over the past three years can be best explained as a journey from discretion to default, and from selection to allocation. India has moved from being a part of exotic flavour through a country fund to becoming a selection from among emerging market funds to finding allocation among global equity funds. CY 2010 year-to-date has seen the highest ever FII flows, in excess of $17.9 billion. The Sensex is almost near its all-time high, contrary to the expectations of most domestic investors.

FIIs are bullish about India as they perceive her growing multifold over the coming decades. With low interest rates and abundant liquidity, FIIs are on the lookout for returns. And India provides the perfect opportunity with its improving macros and solid micros. Inflation is high, but will fall in future. Policy rates are rising but market rates, having discounted it, will fall. Fiscal deficit for FY11 is likely to be as per budget estimates (even though this is due to a one-time windfall income) and will fall in future. Current account deficit is high, but it shows the savings gap of a growing economy. Monsoon has been good. Consumers are unleveraged and are benefiting from the wealth effect of appreciation in land, gold and equities. Regulators have done a terrific job of managing the financial system. Growth is above average, and is driven mostly by domestic consumption. Going forward, it will be supported by infrastructure investment. Political stability has been reasonable and generally pro-inclusive growth. Corporates are not hugely leveraged, they are growing and making high returns on equity (RoEs).

Domestic investors are selling equities but that is actually an opportunity as their low equity allocation makes them future buyers. Infrastructure is poor but, again, that is an opportunity  — the developed world has supply but no demand; India has demand but needs to create supply. Some parts of the country may be facing law and order problems, but it is not affecting growth for the time being. Moreover, with the government pursuing inclusive growth policies, the intensity of dissent will come down.

In the stockmarkets, valuations may be at a premium, but then good things do not come cheap. You may lose one year's return, but for a long-term investor, volatility is acceptable.

India has become a sweet spot for FIIs as it has demonstrated growth during even the worst downturns. This creates an opportunity as well as a threat for India.

There is huge expectation from India, and it is priced for perfection. The execution has to be faster and timely. The growth momentum has to be sustained at higher levels for long. Earnings, which were stagnant from 2007 to 2009, need to maintain pace to justify the premium valuation. Corporates have to create value through efficient capital allocation and better governance. Somewhere, we need to have Sachin Tendulkar or Roger Federer-like consistency in performance to justify the high valuation.

On their part, Indian policy makers have to create an environment where the economy does not get overheated or where foreign liquidity results in asset bubbles. They have to augment foreign capital flows with our savings ploughed into investments — this will sustain our growth.

What goes up must come down. After a strong rally in the Sensex, it will not be a surprise to find some correction in the market going forward. The corrections are likely to be short and temporary, and likely to be event-driven, as long as we can maintain the growth and earnings momentum. In addition, there are many variables such as higher oil prices; global growth slowing more than expected; and a valuation gap vis-à-vis peers, which can create a much-hoped-for correction in the market. But markets are generally known for not behaving according to the majority's expectation.

While India is a rising tide, sectors such as auto, consumer staple, technology and pharma have done exceptionally well, and are trading at much higher valuations than historical averages. Capital goods, construction, power and telecom have underperformed the broad market and are trading below their historical averages. A trigger, like large order flows or quick execution, can provide a dramatic catching up in these sectors.

Retail investors, who have been on a selling spree, need to catch the moving train. While it may be potentially harmful to try and get on a moving train, it's better than standing on a platform waiting for the next train and missing the opportunity of reaching the destination.

The author is deputy managing director of ICICI Prudential Asset Management Company