Follow FIIs on large-cap segment alone

Use the buy-and-hold strategy for three to five years and you are most likely to be a winner

Financial planners would always advise retail investors not to dabble in direct stocks. After all, there are enough good quality mutual funds schemes available. But most investors do want to try their hand at direct stocks. Prateek Sinha (name changed) carries a small diary of investments made in different stocks. He makes small investments, either through tips from friends or he watches stocks which big investors like foreign institutional investors are buying or selling. His argument: Since they are the biggest investors in the stock market, they would make the right calls.

One can hardly argue with Sinha's logic. With foreign institutional investors (FIIs) pumping in as much as Rs 1.23 lakh crore in the past year, it is a good benchmark. If one goes by shareholding pattern of BSE-500 companies, FIIs have increased their stake in Repco Home Finance, CEAT, Persistent Systems, PVR and other (see table). So should investors jump to buy them?

Whom to follow?
But things aren't that simple. Says Nilesh Shah, MD & CEO, Axis Capital: "There are different types of foreign institutional investors such as hedge funds, long-only funds, emerging market funds, exchange-traded funds (ETFs) and others. All these funds have different strategies. So who does one follow? For instance, a long-only fund will be prepared to stay for 5-10 years and might not mind if the stock falls 20-30 per cent in that period, because they are prepared to wait for a whole cycle. In comparison, a hedge fund could have an investment horizon of only two to three months. Exchange-traded funds will copy and replicate that index. If they are following an emerging market index, they will sell stocks if that index falls. If you are a medium to long term investor, look at long-only funds. These would give you a good idea about stocks that they are betting on."

Don't follow them in the short term
According to market players, even if you are an active investor and completely clued on to markets, it is important to follow only the FIIs with a track record in India. "Importantly, don't follow FIIs in the short term. For all you know, the large sale or buy order could be because they are doing pure arbitrage," says Arun Kejriwal of Kris Research. In other words, the FII might be buying a stock in the cash market but selling in the futures market or vice versa. Within a week or days, the FII will reverse its position and you will be in trouble. Consequently, it is important to understand the reason for the sale or buy positions.

Understand the buy or sell order
When you see large trends emanating from FIIs, understand the trend and if the reason is external, ignore it. But if it is internal or something specific to that stock, you can follow it. There are a number of factors involved in the buy or sell order. Besides arbitrage opportunities, there could an exchange-traded fund that has the mandate to follow the MSCI index and will invest accordingly. So, if there are new stocks entering or exiting the index, the ETF might be forced to take similar calls. So sharp buy or sell calls are not necessarily the view of the FII.

Says a fund manager: "Clients of FIIs have a completely different mindset. If the corpus is supposed to follow a particular mandate, even a slight deviation can lead to withdrawals. They can be quite happy with benchmarks being followed and steady returns."

For instance, if the fund is supposed to follow the Nifty, if the fund manager does some active trading and improves the returns, he may not be appreciated because he is taking a risk which can go either side.

Clients of FIIs are usually satisfied with returns that are higher than the US treasury or other banks offer whereas in India, with a fixed deposit giving 9-10 per cent, are looking at higher post tax returns. This could lead to disappointment among those investors who follow FIIs' buying patterns.

Long-term strategy
Another caveat is to follow them only in case of large-cap stocks, and not with mid-cap or small-cap companies. Since one isn't sure of the strategy of the FII, it doesn't make sense to do so. "Caveats apart, there is a case for investing like FIIs do, provided you are investing in a large-cap stock for a few years. There is money to be made," adds Kejriwal.

Another benefit from FIIs with a good record is that they buy stocks of companies with good corporate governance and having good liquidity. All these are steps any equity investor should follow.