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Heading Into Hazards

The recent jump by the stock markets has come too fast for comfort raising the cost of acquisition

This column first appeared in the October, 2009 issue of Wealth Insight magazine. It looks to chart a path for investors through the fast-rising equity markets.

The sudden shift  in sentiment over the past three months has taken most investors by surprise. The stock market has risen 25 per cent. India has been touted as the fastest-growing economy in the world and the primary market has revived with several large, successful offers. What is more, analysts believe that corporate growth will accelerate through the second half of 2009-10.

It has been interesting to watch a shift in institutional attitudes. Foreign and domestic institutional investors have together pumped Rs 19,700 crore into the market in the past three months. However, their attitudes have changed within that period.

Domestic institutional investors (DIIs) have been net equity buyers to the tune of Rs 11,241 crore, but only Rs 438 crore of those purchases came in September. So the DII attitude has been one of increasing caution.

FIIs have been net buyers of Rs 8,487 crore since July 1. But they were actually net sellers of Rs 5,131 crore in July-August. In September, they reversed stance and bought a net Rs 13,619 crore.

It seems FIIs’ attitude has changed from being quite bearish to being extremely bullish, just as the DII attitude has changed from being very bullish to cautious. Given the holiday season and advance tax payments, DIIs may not be in a position to commit large resources for a while.

Unfortunately, the upmove has come too fast for comfort. Stock markets always anticipate future shifts in the real economy. The current discounts anticipate strong earnings growth over the next 18 months, that is, till the end of fiscal 2010-11. This means valuations are quite high.

The current Nifty PE ratio (of the last 4 quarters ending June, 2009) is 23. Consensus earnings estimates of about 15 per cent earnings growth suggests this is a forward 2010-2011 price-to-earnings (PE) multiple of about 17-18. If one uses the PEG (PE-Earnings Growth) metric for valuation, the PEG is overvalued at 1+ for 2009-10. If one uses the benchmark of one year fixed deposit (FD) rates of 7.5 per cent as a risk-free return, the Nifty would be fully valued at a current PE of 13-14, so it is well into the danger zone.

One cannot expect a significant drop in interest rates over the next six months since inflation is steadily rising. This is a double whammy. It rules out debt funds as alternative investments. It also means that sustainable PE valuations will not rise since PE and interest rates have inverse relationships.

A passive investor, who buys an index fund at the current values will take on higher-than desirable costs of acquisition. The only route for the die-hard equity investor is to selectively chase stocks and sectors that are capable of out-performance in the short term.

Here are some possible ways to implement a short-term strategy. The market is being driven by the FIIs — mirror their purchases over the next month or two. If they remain positive, this approach will work. Due to liquidity constraints, their universe is restricted to just about 250-300 stocks. 

Right now, FIIs are looking at banks, real estate and pharma. Of these, banks could see better balance sheets due to improvement on the non-performing assets (NPAs) front due to overall industrial recovery. But valuations could be hit if rates rise. Private banks will be more volatile, with higher betas than PSU banks. There are also constraints in terms of FII shareholding limits.

Pharma has proved an excellent defensive shield. Year-on-year, while the Nifty returned 25 per cent, pharma speciality funds have returned 35 per cent as a class. Most of the gains (around 30 per cent) have come in the past 3 months and there may well be a long-term upside since the industry is undergoing a re-rating. If you’re thinking of a fund, Reliance Pharma has been outstanding. 

Real estate was among the worst-hit sectors in the last recession. It is still fundamentally in the doldrums. But easing monetary conditions has made it possible for real estate majors to raise more cash. In anticipation, punters are bidding up valuations in big real estate stocks. If you time it right, there could be an upside for the sharp trader. 

Another possibility consists of PSUs. The successful IPOs of OIL and NHPC have focussed a lot of attention on the listed stocks in the BSE PSU Index. This is speculative, but if the disinvestment programme remains on track, there could be windfall gains in the better-listed PSUs.

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