Markets driven by liquidity

A change in attitude of FPIs could change the market's fortunes

Growth stocks can become absurdly overvalued.  The Information Technology (IT) industry threw up classic examples during the late 1990s. Companies like Infosys and Wipro were regularly logging very high growth during that period.
 
Infy recorded revenues of Rs 512.7 crore in 1998-99, which was almost 100 per cent growth over the 1997-98 revenues of Rs 260.4 crore. Net profits (NP) more than doubled, rising to Rs 133 crore over Rs 60 crore in 1997-98. In 1999-2000, revenues rose again to Rs 921 crore - an impressive growth rate of 80 per cent and NP rose to Rs 286 crore, which was over 100 per cent growth yet again.  That's truly impressive growth and consistently improving margins and it was coming off a good base. 
 
However, even though Infosys was obviously a great company and a growth story, the valuations were crazy.  It traded at an average price-to-earnings (PE) of 250-plus during that period and hit PEs of 700-plus at peak valuations. There is no way such valuations could be justified. Wipro had similar strong financials, with consistent high growth.  But it traded even higher, at four-digit PEs. Since it is a very closely-held company, Wipro was bid up even more enthusiastically than Infosys.
 
Other IT stocks saw similar mad valuations. Hot money chased anything with tenuous connections to infotech. Corporates even changed their names, adding coined words like “infosystems” to try and push up the share prices. Infy and Wipro are still very much around. The investors who bought into these stocks at the height of the boom and stuck around will not be too unhappy. But it took many years before those who invested at peak prices in 1999-2000, earned reasonable returns. 
 

Many other IT companies that hit incredible valuations during that 1998-2000 period. Some were fly-by night and quite a few of those eventually went out of business. Others attained such rich valuations that investors have never received adequate returns.
 
In the 2006-08 period, similar over-valuations happened in sectors like infrastructure and real estate. Multiple new businesses in those sectors listed during that time, and many of those received unbelievable discounts. Again, investors who bought those stocks during that boom have regretted doing so for the past decade.
 
The growth rates were good at the time and the economy was flush with cheap money. One other factor fuelling those booms was that the industries in question were relatively new. You could make good cases for investment in these new businesses, which seemed to have excellent prospects. But few investors actually understood nascent industries such as IT/ ITES, renewables, infrastructure, real estate, etc investors became overoptimistic - they could not assess the potential downsides.  The current situation of over-valuation is different. The movement is broad-based and it's not about specific new sectors receiving extraordinary valuations.  In fact, there are no new sectors as such during this particular rally.
 
The basic driver appears to be an oversupply of money. A very substantial proportion of that money is coming from abroad. Foreign portfolio investors (FPI) are betting on India because it is growing relatively faster than other Emerging Markets (EM) it is perceived to be politically stable with decent macro-fundamentals. The fiscal deficit is more or less under control, for example.
 
Indian policymakers have no control and little influence over that money. This over-valuation could be considered a by-product or hedge for the so-called Trump Trade.  The Trump Trade consists of investors entering US equities in hopes that Trump's fiscal policies would lead to a boom. Investors have sold US bonds, gone long on the US dollar and bought US stocks.
 
The main Trump Trade has been hedged by selective EM exposure. Some of the EM focus has been on India. If the Trump Trade breaks down, investors may increase India exposure. On the other hand, they could also pull money out of India and put it back into the US bond market or, if the trump Trade works, they might go back to US equity.  A domestic investor compares rupee debt returns to rupee equity returns. The foreign portfolio investor looks at the exchange risk and compares rupee equity returns to other EM equity returns, and to less risky, or risk-free returns from hard-currency equity and debt. The priorities for FPIs are different and a change in their attitudes could trigger a massive crash.