Akash Prakash: When experience is a liability

Analysts and investors are optimistic on India, but it is difficult to be as bullish.

The strength of the Indian stock markets over the past month has been nothing short of breathtaking. Crossing the proverbial wall of worry, the market has shrugged off huge equity issuance and just kept on powering ahead. To be fair, this is a global phenomenon, with new highs being registered in both the US and the broad emerging markets indices as well. Despite the obvious distress in the US sub prime markets, and some spillover into debt spreads, the contagion from a possible $50-100 billion loss to the financial system has been remarkably muted. Confidence seems to be all-pervasive and equity markets Teflon-coated.

The Indian markets have been able to shrug off the huge issuance of equity paper as new sources of capital have been tapped, which enabled issues to sail through with minimum disruption and diversion of capital. For the Sterlite fund raising, many of the orders were put in by specialist commodity funds, hitherto inactive in India. For ICICI Bank, a core group of shareholders were joined by a large PE fund putting in a billion-dollar cheque. DLF had huge participation from the Gulf. ICICI Holdings also attracted a bunch of atypical private equity and venture capital players.

Obviously, the India story continues to gain traction and suck in new investors. We have already crossed last year's total FII inflow number of $8 billion by July itself, with July turning out to be the best month for FII inflow ever.

To complement the broadening of the global investor base, we are also seeing the growing influence of domestic insurance companies in the equity markets. Due to unit-linked schemes (with a very high weighting in equity) being the most popular type of insurance being sold, we find a new and sustained demand for equity developing under the radar of most market participants and daily SEBI reporting. Some insurance industry veterans estimate that this year over Rs 15,000 crore will be pumped into the equity markets from the private sector insurance industry alone, and if you include LIC the number jumps to Rs 30,000 crore. This is something like $600 million a month and growing at 50 per cent per annum. This money also tends to be invested in large, well-established and more liquid equities, given the eligibility criteria laid down by the IRDA. This flow into the markets is secular and structural, and more than half of these flows are coming from non-metro centres. The insurance industry, with its huge distribution reach and focus, has spread the cult of equity far wider and deeper than what mutual funds have been able to. One unintended consequence of private sector entry into insurance may be that we have finally found our bulwark against the power of the FIIs!

Maybe this is part of the puzzle when one tries to understand who is buying in these heated markets, as most of the old India hands maintain that they are underweight in the market and unwilling to buy.

I have also been surprised by the enthusiasm of some very large global investors I have had the privilege of meeting recently. They continue to feel that India is much cheaper than China for similar earnings growth and that Indian companies are much better-run than most in Asia and will continue to blow away analysts' and investors' earnings expectations. They feel that the strong inflow into India will continue and see no reason why markets should come down. India without currency gains has actually lagged the region, and with most investors feeling that the RBI is done with the tightening, the only obvious headwind to India catching up with the rest of the region has lifted, to their mind. Earnings and economic growth will accelerate again 12 months down the road""this is their feeling.

They were actually arguing that one should expect to see country rotation driving money into India over the coming months. While they acknowledge that valuation is not cheap, they say that no market with the type of long-term visibility of earnings offered by India is cheap anywhere on the globe. They feel paying 17-18 times earnings is not out of line for 20 per cent long-term earnings growth.

While I can see their point of view and they may also be right I still find it difficult to be as bullish. It is true that the RBI is probably done and the next move in interest rates is south. Also most of the so-called smart money is cautious, and mutual funds have raised Rs 6,000-7,000 crore in the past month or two, of which very little has been deployed, and if the experts are right we are in for another year of 9 per cent plus economic growth. The market is also acting very well indeed, shrugging off short-term worries on the rupee, corporate profitability and politics. Price action indicates great underlying strength in the markets, and any correction is unlikely to be driven by local factors.

Yet it all seems too easy.

In my experience whenever making money becomes deceptively easy, one should be on high alert, for it is in the best of times that the worst mistakes are made. In an environment like today one can easily get carried away and forget about risk.

Experience has become a handicap today, as people with long memories tend to lose out to the young Turks in identifying and backing the hot new entrepreneurs and companies of the day (many of whom have a long and chequered past). The new kids on the block seem prepared to pay for embedded value and the sum of the parts in just about any company and have little concept of execution risk or business cycles. The older more experienced lot tends to be more cynical and, having bought into ten-year visions in the past only to see it all crash and burn, cannot pay up now. They know markets cannot go up forever, and having seen tough times before are finding it difficult to compete with a set of investors who have only seen a rising market. In today's market the more questions you ask before buying, the lower the returns you are likely to deliver.

Confidence is overpowering caution and anything seems possible. Markets are actually rewarding equity issuance and focused only on top line growth, ignoring profitability and capital efficiency. Investors are scared to sell and are being pressured to buy without adequate preparation and analysis. For any deal there are multiple suitors, and money appears to be the ultimate commodity. Times like these do not last forever, they cannot, but as always it is impossible to predict when a nasty shock is just around the corner.

I still believe in the long-term India story, and believe one can make superior returns on a 3-5 year basis, but we need to tone down our exuberance; as soon as we forget about risk, that's exactly when it will magically reappear.