Standard portfolio theory puts risks into different buckets. There are company-specific risks, peculiar to a given management or a specific location or some other factor unique to a given company. There are industry-specific risks which affect every company in a given industry. There are country-specific risks that affect every business in a given country.
A company-specific risk can be reduced fairly easily. Let us say, the investor believes a given industry, say cement, has good growth prospects. But cement Company A has more management issues than Company B. He buys B and avoids A. This doesn't work with a monopoly, of course.
Industry-specific risk cannot be avoided so easily. For example, every thermal power company has a dependency on coal. So if coal is in short supply or high-priced, every thermal power company has to bite the bullet in terms of managing supply issues. However, an investor can reduce exposure to an entire industry if he chooses.
Nation-specific risks are related to policy, political stability, currency risks, macro-economic imbalances, and so on. The only way to reduce country-specific risk is to hold a portfolio with exposures in several different countries. This isn't easy for an individual Indian, given our complex regulatory regime.
Domestic investors without the option of diversifying abroad have grown increasingly unhappy with India's country-specific risks. Huge fiscal deficits, slow growth, high inflation and policy paralysis have contributed to Domestic Institutional Investors (DII) disenchantment. Some industries are better off than others, of course, but nobody is doing particularly well.
However, the foreign institutional investors have looked at the same numbers and seen a different story. The FIIs compare risks and growth rates in different countries and allocate portfolio weights to various nations accordingly. India has been viewed reasonably favourable in such comparisons.
India has a big listed sector with a wide diversity of businesses serving a big domestic market as well as running global operations. Although growth has slowed a lot, India remains among the faster growing of developing economies. The policy environment is familiar to FIIs because India's legal system is based on the British.
Over the past couple of years, FIIs have been the only enthusiasts in the Indian equity market. Domestic institutions have been net equity sellers. Households have also down-shifted equity exposure. In the past 12 months, FIIs pumped in a net Rs 139,000 crore into equity while DIIs sold Rs 23,000 crore. FIIs effectively make the market. In the last couple of weeks, there has been some FII selling and this has terrified Indian players.
If the FIIs lose interest in India, the market will surely drop further. This is an interesting variation on "greater fool" theory: Indian players have been happy to buy equity at inflated valuations in the hopes of selling on to FIIs at even higher prices. It's impossible to make a valuation-based case for the Indian stock market at the moment. Growth has slowed through several quarters. Early bird results suggest it will slow further in Q4, 2012-13. Whether one uses growth-based PEG models, or interest rate yield comparisons, the average market PE looks high.
A passive index-based investor must simply soldier on in such circumstances, neither reducing nor increasing equity exposures. If you're making active equity investments, you must be very selective. Don't buy into stocks with valuations that make you uncomfortable and assume longer holding periods for all your investments. It may take one or two years before things turn around.
Warren Buffett is often quoted in this context as somebody who believes in holding stocks forever. That is an extreme position. It prevents Buffett from buying depressed cyclicals, for instance. But the holding period for equity investments has definitely lengthened because of the country risk.
The investment line of least risk is consumption-oriented plays. These are less likely to lose further ground and more likely to see a quick comeback. The aggressive strategy would be to look at beaten down cyclicals across sectors like capital goods and automobiles, on the grounds that these stocks would rise the most on turnarounds. A mix of aggression plus safety would be to look for beaten down stocks which have decent dividend yields.
Whatever you buy, don't assume that there will be an FII waiting to buy the stock at a higher price. The FIIs may or may not be around next week, or they may decide to wait till next year before they increase India exposures. You would be the fool if you bought stocks you didn't believe in, and hope to pass them on.
