It has now become fashionable to be underweight India in portfolios or talk about which stock or sector will get hammered next. In any survey of fund managers one reads, India is a consensus underweight in global, emerging market (EM) and Asian portfolios. Sell-side strategists marketing in Asia and Europe report the same phenomena, deep bearishness on the country and everyone claiming to be either short or below benchmark weight (depending on the type of fund). A major global investment bank reported that in January, their single-biggest demand for downside protection in all of EM was India. So, the stars all seem to be aligned, and India has had a tough start to the year, delivering the worst relative performance of any of the major EM markets. When compared to the developed markets, we have already opened up an adverse performance differential of over 12.5 per cent in less than a month (India down 9 per cent in dollars, US up about 3.5 per cent).
Now when a trade is this much consensus, and so well-understood and obvious, it very rarely works. The market has a tendency to not allow you to make money in such a simplistic manner. The pain trade from here would clearly be if India were to actually go up, as no investor seems to be positioned for this. A short, sharp bounce, to force investors out of their bearish complacency, is quite possible.
The bear case is quite obvious, the markets are going through a period of PE compression, driven by inflation, rising interest rates, commodity price spikes, governance and reform concerns and fears around a slowing GDP growth and earnings trajectory. Multiples are also compressing, as the premium India received for its more domestic-oriented growth model will recede in an environment of strengthening US growth. The bears concede that earnings are still likely to come in at about Rs 1,200-Rs 1,225 a share for the Sensex for the year ending March 2012. If you put a multiple of 14 on those numbers (approximating the median of the last few years), you get a Sensex target of about 16,800 to 17,000, compared to about 19,000 today. These numbers give a potential downside of about another 10 per cent. This fairly simplistic analysis simply brings Indian valuation multiples down from the stratosphere to a more normalised level, without any significant haircuts to expected earnings.
In that sense, it is by no means a disaster scenario, things could get far worse, with lower multiples on lower earnings. The bears also argue that given the lack of fiscal discipline, long-term supply constraints on agri-products, infrastructure and skilled labour, India runs the risk of being caught in a structurally higher interest rate regime, leading to structurally lower multiples. The final point is simply on flows, India received about $28 billion in FII inflows in 2010, all of this cannot be long term and structural in nature, some money will flow out as price and earnings momentum turns against the Indian markets. With limited equity flows into domestic institutions, partly due to regulatory changes and partly due to rising rates, where will the buying come from to offset the foreign outflows? Whatever limited buying power exists with the domestic players will be conserved to ensure the PSU divestment programme goes through. The Indian markets are extraordinarily vulnerable to even minor outflows of a couple of billion dollars.
The bull case rests on things improving from here, India has an inflation issue. But so does the rest of the EM world and India is far further down the road of normalising monetary policy than most. The bulls also feel that all these scams will ultimately lead to systemic improvements, and reforms will be forced on the government. The headwinds of rising oil and commodity prices, and asset allocators preferring North Asia will fade as the US eventually downshifts back towards 2.5 per cent long-term GDP growth. While the markets are down about 9-10 per cent in dollars, many stocks are down 20-25 per cent, thus on a stock-specific basis, valuations are now getting interesting. India has always been a bottoms-up market, and as individual stocks start looking interesting, money will come in. On flows, the bulls point to the noticeable lack of selling thus far. Despite the market declining by almost 10 per cent in dollars, the total selling by FIIs on a net basis is less than $700 million. To the bulls, this indicates that a majority of the money which flowed into India in 2010 was more sticky and structural in nature, coming from long-term real money accounts, making a genuine long-term bet on the country. This capital pool does not seem to have changed its view on India’s long-term growth prospects, it seems to be viewing current economic and political developments as only short-term noise. If this is true, the risks of a big outflow of capital are minimal.
The key issue remains, to my mind, FII flows. I don’t see how all the capital coming in last year could be from longer-term sources. None of the India dedicated funds received much by way of inflows, these flows being a country-specific allocation, you would guess would be more permanent in nature. Instead of through country funds, at least $6-7 billion of inflows were through ETF-type structures, which given the nature of the instrument, you would think would be more momentum- and retail-oriented. One would think that this capital would flow out as soon as India begins to underperform, which has already started. Yet no major outflows to date. Are these investors still holding on, thinking that this is just a short-term correction? Has the downwards move been so quick (a matter of only about three weeks) that they have not yet reacted?
It is difficult to tell, but this holds the key, if we continue to see no major outflows, then it looks unlikely that markets will cave in further. We could see a slow and gradual drift downwards on low volumes, and the market will be in a broad trading range. If we do get a couple of billion dollars of cash-based selling, then the risks of the market being pushed down another 10 per cent quickly are quite clear.
Unfortunately, as has been the case in India till now, the foreigner on the margin will drive the market and holds the key to short-term market direction. Foreign investors till now seem to be still believing in their long-term thesis on the country. Let us hope the consensus bearishness has it wrong.
The author is the fund manager and chief executive officer of Amansa Capital
