The rise of retail investors

Regulators must be watchful of irrational exuberance

Market pundits have once again started talking about how the clear electoral mandate for the Bharatiya Janata Party (BJP) will lead to a revival of the animal spirits in the equity markets. The optimism became evident long before the election results: the benchmark indices are at all-time highs, up nearly 20 per cent since the beginning of the year. The average daily turnover at the National Stock Exchange crossed Rs 15,000 crore in April from around Rs 13,200 crore in the previous month and Rs 10,450 crore in April last year. This compares favourably with the average daily turnover of around Rs 17,000 crore in 2009-10, when the market touched a new high in the post-Lehman crisis rally. A sharp spike in the trading volume is attributed to greater participation of retail investors and return of foreign institutional investors (FIIs), which were bearish on India till a few months ago.

It is reasonable to expect this optimism to have a positive impact on the capital markets. Retail investors, which had shied away from investing in equities and had preferred the relative security of gold and real estate, are now likely to look at the primary capital market or initial public offers, or IPOs, more favourably. In the last three years, companies raised just Rs 13,600 crore through 105 IPOs. This represented a sharp drop in the total fresh capital raised in the two previous years - Rs 58,000 crore raised from 92 issues in 2009-10 and 2010-11.

A secular downturn in IPOs made it tough for companies to fund new projects, especially risky and long-gestation projects in the infrastructure sector. This forced many of them to go in for large-scale debt that proved expensive when the interest rate began to rise and economic growth slid in the latter half of 2011. The pincer effect of rising interest burden and sluggish revenues and profits pushed many companies to the brink of insolvency. At the end of 2012-13, net debt for nearly a third of BSE 500 companies (excluding banks and financial companies) exceeded their market capitalisation. Together, these firms had a combined net debt (adjusted for cash and equivalents) of Rs 13.3 lakh crore supported by just Rs 4.92 lakh crore of equity or net worth.

The current rally, therefore, provides a window to many of these debt-laden firms to fund their growth or raise fresh equity and retire a part of their high-cost debt. This will strengthen their balance sheet, making it easier to turn around their operations. An overall improvement in market valuations would also make it easier for firms to raise capital by selling non-core assets. Either way, it will help debt-laden companies to deleverage their balance sheets and prepare them for the new round of growth.

However, it certainly won't be a cakewalk, even though investment bankers report an increase in enquiries for IPOs and fund-raising plans. Capital is most likely to go to firms that have used debt to create real assets rather than to fund losses or meet working capital needs. Companies seeking capital would also need to demonstrate their ability to service the expanded equity by way of faster profit growth and higher dividends. In the 10 years of the rule by the United Progressive Alliance, India Inc raised nearly Rs 1.64 lakh crore through 476 IPOs, but less than a quarter of the issues were profitable for investors. Companies and their investment bankers need to reverse this trend if they wish to restore investors' faith in the IPO market.

Equally important will be the role of the financial sector regulators in preventing market optimism from mutating into irrational exuberance resulting in a crash, as had happened in 2007-08. It is to be hoped that the market regulator, promoters and investment bankers have learnt their lessons and would be more careful and keep these expectations under check. The markets can ill afford a repeat of what happened six years ago.