Numbers still look positive

Market Insight

While a price-earning valuation of 24 of the Nifty may scare Indian investors, the FIIs think it is quite reasonable.

Keynes once compared successful stock-picking to the art of predicting the winner of a beauty contest. You must find the stock (or the woman) that the majority will find attractive, not the one that pushes your personal buttons. One can refine the application of this Keynesian theory if we remember that the market is democratic but it operates on the principle of one share, one vote. Understanding what a big investor, who buys many shares finds attractive, is therefore more important than understanding the tastes of a thousand small investors.

One reason why this rally has taken most Indian investors by surprise is a failure to understand how two of the largest players think. In one case, this is because the attitude is opaque and there isn't enough information. In the other case, it is due to a failure of the imagination rather than lack of information.

The two big groups in question are foreign portfolio investors (who are the largest block of players in Indian equity) and Indian insurance companies (who may be the second-largest block). Quite a lot of information is disseminated in near-real-time about foreign institutional investors' (FIIs) trading patterns though some pieces are missing from the jigsaw puzzle.

But very little is known about the attitudes of Indian insurance companies. Over the past year or so, they have, to an extent, become prisoners of their own success in selling unit linked insurance plans (Ulips). They control much more resources than the mutual fund industry and they have less compulsion to trade short-term because of automatic lock-in periods.

They have a mandate and a compulsion to deploy much of the premium they receive in equity. We don't know how much though the evidence suggests that they have bought heavily through this rally. But their purchases and sales are not reported session-by-session or even month-by-month or year-to-year. Therefore, we don't have a clear idea of insurers' attitudes. Their shareholdings in a given stock are only reported as and when an individual holding crosses 1 per cent. So we cannot track this easily either.

However, if life insurance continues to grow at its current rates and Ulips retain current market-share in the life market, insurer-attitude will be critical to the market's health. It would be desirable if Sebi or Irda reported daily trading patterns but it's not likely to happen due to tangled jurisdiction. Much more is known about FIIs. We know their daily trading patterns in both spot and derivatives markets. We know their gross and individual holdings in given stocks as well.

One important thing we don't know is the participatory note contribution to overall inflows. If available, this would tell us what percentage of the FII flows was 'hot'. Another important factor is the currency origin of FII funding. It would be helpful if one had a clear breakup of yen, euro and dollar fund-flows into the rupee, though this can be guessed, by poring through RBI bulletins.

For simplicity's sake, we can assume that the bulk of the FII funding is US dollar by the time it hits Indian bourses. It may have been borrowed in the yen carry-trade or euro in origin, but it is usually US dollar when it is transferred here. People have remarked on one aspect of the obvious. FII flows have increased substantially because of the strong rupee and created a feedback loop, leading to further rupee strengthening.

There is another obvious aspect that is under-appreciated: acceptable valuations are different for a dollar-investor because interest rates are different. For an Indian, with the 364-day rupee T-bill trading at about 7.5 per cent, the Nifty trading at 24 P/E seems very over-valued. However, the equivalent risk-free dollar return, the 1-year US T-bill is trading at about 4 per cent. For an FII, the Nifty trading at 24 P/E seems quite acceptable. In fact, an FII would see Nifty 25 P/E as "safe", while the rupee-dollar trend remains one-way.

If US T-bills yield 4 per cent, a P/E of 2/5 is implicitly close to fair value. The Nifty has a five-year earnings growth rate of over 25 per cent per annum, which means that the P/E to growth (PEG) ratio is also okay. An annual rupee appreciation of 7 per cent is the icing on the cake. While these numbers remain in the 'green zone', it's likely that FII inflows will continue.