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On A Crash Course

A more difficult situation seems to be in the offing

It is difficult to understand the dimensions of the US Subprime crisis. Estimated losses could amount to $1.5 trillion — roughly 11 per cent of US GDP. Wall Street and its famous investment banks have been wiped out. Mortgage giants have gone bankrupt. The contagion has spread to Europe, to India, and around the world.

India has got off relatively lightly. Despite rumours about ICICI Bank going bust, Indian banking has relatively low exposure to the US. The crisis is unlikely to wipe out the net worth of any Indian bank or financial institution.

The losses for India are more indirect but nevertheless, massive. Indian investors must worry about several things. One is the flight of capital out of portfolio investments. Another is the negative effects on Indian exports, especially of IT and ITES to the US financial industry and the US overall. The third is the scaling back of expected investment flows into India over the next couple of years.

The third factor is unquantifiable though it could actually have the largest negative effect on GDP growth. All macro-economic projections and corporate expansion plans of the next few years are based on expectations that ample capital will be available. In 2007-08, FDI inflows were $16 billion and between April-July 2008, it was $12 billion, with hopes that 2008-09 targets of $30 billion would be met.

If that capital isn’t there, expansions in general will slow down. Large infrastructure projects which are capital-intensive will be especially hard-hit. Power, telecom, real estate, construction and roads are among the sectors most at risk.

The market has reacted to the weak export scenario. IT and IT-enabled shares have seen sell offs. NASSCOM is revising export projections down. Most IT majors have issued warnings and Q2 results are likely to come with lower guidance for the fiscal.

There are two cushions. One is that the rupee has fallen sharply. This inflates the value of forex earnings. The second is that the IT industry is cash-rich. It doesn’t need to access capital to sustain itself. It could even grow on the basis of cheap acquisitions during the crisis period.

The flight of capital has also had an obvious effect on overall stock market valuations. So far in calendar 2008, the FIIs have sold over $9 billion worth of Indian equities. That has been a big factor in pushing the market down by 40 per cent since January 2008. It has also been an important variable in pulling the rupee down.

As the crisis plays out, Indian investors will have to reconcile themselves to a more difficult environment. It is likely that the stock market will take a long while to recover. It is even more likely that the recovery will be uneven.

Every market cycle sees certain sectors being favoured over the others. In the next phase of this bearish market, the sectors, which have drawn the most FII interest in the past three or four years could be actually the ones to suffer the biggest losses. If the dollars keep flowing out, these stocks will see the sharpest declines.

On the basis of shareholding data available until June 2008, banks and real-estate companies have seen a major pullback in terms of FII exposures. Also on the FII negative list are cement, construction, engineering, auto and auto-ancillaries and pharmaceuticals. These trends got worse in the last quarter since the FIIs continued to be net sellers but we don’t have the company shareholding data yet.

These sectors are all classic growth plays. That is, they have grown quickly in the past and they had high valuations. However, they require cash infusions to sustain the growth pattern. Right now, that cash isn’t there. As the growth projections are revised downwards, valuations (in terms of PEs) may also drop.

The Dronacharya of value-investing, Benjamin Graham believed the best way to invest in a recession was to assume growth would be zero. The FIIs arrived in India with a completely different mindset, seeking very high growth. How they restructure portfolios over the next few months will give an indication of their mental adjustments. Indian investors will have to play follow the leader, at least if they are interested in the same universe of stocks.