In 2008, look beyond the Sensex when investing

D.Murali and Jagat Guru

Chennai: Year 2007 was one of the better years for investors in stock markets. Starting off from just 60 points shy of 14,000, the magical year saw the next peaks fall like ninepins. Doubling in value, the Indian bourses truly created wealth.

What about year 2008? Will it be different? Which sectors to bet on? "Look beyond the indices," advises Mr Bhavesh Shah, Vice President (Research) of Asit C Mehta, Mumbai.

"Investors should do their homework before investing in stock market, if they are taking investment decisions in the absence of any professional guidance," he adds, in the course of an exclusive interaction with Business Line, over the e-mail. "Market efficiency will increase only when there are informed investors."

Excerpts from the interview.

The Sensex gained nearly 40 per cent in 2007. What do you think year 2008 will offer?

Year 2007 was a volatile year for the market. If one looks at the point-to-point movement, it shows gain; but, during the year, the market corrected sharply and recovered with the same intensity.

Till September, market was in a broader range of 12,500 to 16,000. With the emergence of turbulence in the credit market due to the sub-prime crisis, the US Federal Reserve was forced to cut interest rate.

This, in turn, prompted huge liquidity flows towards the emerging markets. India was one of the prime beneficiaries of these flows. As a result, there was a buying spree in equities, and the market scaled record highs during the remaining part of the year.

Sectors that had visible opportunities to grow, companies with earning potential and order books in their favour, and companies that had a potential to unlock value for their shareholders fascinated investors, both big and small.

I think in 2008, corporate performance and liquidity flows are the two major factors one should look for. Those companies which fail to perform, or fail to convert the invisibles into visibles will be punished with profit-booking. And the efficient ones will be rewarded.

Economic dynamics are also challenging. Rising rupee, and increase in wages and material cost are putting pressure on margins on the one hand and, on the other, demand-supply equilibrium is also changing in some sectors (such as cement, base metals, and steel).

Ability of a company to raise its efficiency bar under these conditions will be put to test. Those with a clear vision and scalability are expected to do better.

India's economic growth is projected to be in a higher trajectory (8 to 9 per cent) in the next three years. Infrastructure spending, domestic consumption and investment will continue to drive economic growth. And growth will attract increased capital flows, be they long-term or short-term in nature.

Looking at the overall picture, I expect the BSE Sensex to be around 23,000 at the end of year 2008. My advice to investors is this: Look beyond the index and invest in companies that are growing, and have sustainable businesses and clear competitive advantages. Company-specific focus will provide enough opportunity to investors to get a return higher than that of the benchmark indices.

Infrastructure, real estate, oil and gas dominated last year. Which are the sectors that investors should put their money into in 2008?

India's sustainable economic growth story depends on two key dynamics as far as new investment is concerned. First, infrastructure (road, bridges, ports, airports, etc.); and second, resources (power, oil, gas, minerals and metals). These sectors are expected to outperform in 2008.

Among other sectors, passenger and commercial vehicle, telecom, selected pharma, capital goods, engineering goods and services, logistics, chemicals, banking and financial services are also attractive. Investors with a purely long-term investment perspective can also buy top-tier information technology (IT) companies at declines.

FIIs (foreign institutional investors) who were active in the better part of 2007 seem to have gone a bit slow now. When do you see the FIIs returning to the markets?

Fund flow from overseas is expected to be bullish especially with the SEBI (Securities and Exchange Board of India) allowing the registration of entities such as pension funds and endowment funds.

Anecdotal evidence suggests that India was the recipient of higher portfolio investments from hedge funds and private equities. If one looks at the size of assets under management (AUM), pension funds and insurance companies are very large. Collectively, these institutions have $40 trillion under their management compared to $2.2 trillion held by hedge funds and private equity players.

Secondly, pension funds and insurance companies are stable, long-term investors.

What effect did the following really have on the Indian equity markets: sub-prime crisis, tight credit conditions worldwide, and the fear of the US economy slowing?

Sub-prime: Sub-prime crises in the US and the UK are localised as far their direct impact on the financial sector is concerned. There will be some companies in the IT sector, which provide BFSI (banking, financial services, and insurance) solutions or services to US corporations, but India's direct exposure to sub-prime crisis is very minimal.

However, due to increased integration of global financial markets, sub-prime's effect on sentiments cannot be ruled out. These sentiments will increase volatility in the market. One must understand that sound fundamentals (economic growth, corporate profitability) are a precondition for stock market investments.

Credit conditions: The Federal Reserve and the ECB (European Central Bank) cut interest rates, and pumped in money to rescue the troubled credit markets. This eased the situation a bit. I don't expect money supply being tightened, or a rise in interest rates at the global level. Rising energy and food prices are a challenge before the central bankers. Situation is uncertain as of now and I think the first quarter of 2008 will give us a clearer perspective.

US economy: At this juncture, it is too early to talk about any particular impact of slowdown in the US economy. We need to see whether or not problems in the housing market, and thus on the credit market, have any impact on other sectors. We need to wait for Q4 GDP (gross domestic product) data from the US and the response of the US economy to the steps taken by the Federal Reserve in subsequent quarters.

The US being the largest economy, slowdown will definitely have an impact on Indian economy. However, any impact on India would be marginal compared to that on China or Japan, where exports to the US are a key driver for growth.

Broadly, I can say that domestic consumption and investment are the growth engine of the Indian economy, and that at the domestic level we are going to see a stronger growth in the coming years.

Do you see the domestic investors – retail, financial institutions, and mutual funds – being more active in the coming 12 months?

Even in 2007, whenever the FIIs were booking profit or curtailing their exposures to Indian equities, domestic investors, especially institutions, remained very active in the market. According to the latest data, mutual funds are flush with cash. I expect mutual fund investment to increase in 2008.

There is a perception that Indian markets would be called overvalued, if there were no China around. How far is that true?

I don't agree with this argument. One should not compare one market with another market. Price to earnings (P/E) ratio is one of the methods – not the only method – taken into consideration for stock investments. Relative P/E valuation would not take into account other factors like corporate growth and sustainability, investment climate, risk, etc. As I mentioned, sound fundamentals such as economic growth, and corporate profitability are the preconditions for any stock market investment. Investors will not commit their investment in the absence of the fundamentals.

The Sensex is trading at around 25-27 P/E multiples. But the price/book value is at around 6.5, which makes the Indian benchmark the most richly-valued among the global indices on this parameter. Would the domestic equity markets justify these numbers, going forward?

There are several issues one must take into consideration before valuing a market. Rather than looking at the past, I would like to look at the earning potential and the sustainability of growth, going forward.

If one looks at forward P/E for Sensex it is around 21 to 23 for FY08. One can conclude that Sensex companies are fairly valued at this juncture. Then we should start discounting earnings for FY09 and FY10. This will give us a clearer picture.

As far as price to book value (PB) is concerned, though it sets the base value of a company it does not take into account the future earning potential of the business. Also, while calculating net worth, assets are valued at cost.

PB is a method mostly looked at by investment bankers. Companies in the US and Europe have higher public holdings. If one intends to takeover the business he will not have to price in premium to be paid to its promoters. Indian scenario is different, wherein most of the companies are promoter-controlled and hence a premium needs to be paid to acquire such a business. This premium is also reflected in current stock prices.

Barring a handful, companies in IT, pharma and textiles have been laggards in 2007. What's your outlook on them for the New Year?

I think selective pharma and IT companies will continue to do better. Sector as such will remain under pressure on account of rupee appreciation and other challenges before the sector.

What is your take on SEBI allowing short selling to all classes of investors?

A welcome decision. It will increase market participation and liquidity in the markets. Now people with a counter view (bearish) in the market can also participate.

How will short selling benefit the investors?

It will provide an opportunity to market participants to take a contrary view on the market or with regard to a particular company. At present, when share prices of a company move northwards there is no mechanism by which an investor can have a bearish view on that scrip. Short selling mechanism will curb unprecedented upward movement of share prices; and with a reduction in volatility there will be an increased stability of the market.

We have seen the market regulator stating its position on issues such as Participatory Notes. Do you see SEBI being more active in 2008?

As a market regulator SEBI's objective is to provide conducive market conditions for all concerned. As and when the situation warrants, it can take a view and announce policy, regulations and norms for the same. As a market participant, I am comfortable as far as SEBI is willing to consider the views of all concerned.

Do you feel that a mature equity market can choose to say no to foreign inflows or perhaps, desist the same for some time?

The mantra for the way ahead is to raise the efficiency and competitiveness parameters. Indian markets are in a development phase; and as a country we are not in a position to say no to foreign capital. India needs capital for investment. Capital flows are, therefore, welcome, though the flows can cause the rupee to rise.

Lastly, do you feel that the small investor is safe in today's equity markets? It's often seen that the big guys get out first, while the small investor is left in the lurch. What would be your words of precaution to small investors as we enter another year?

We are in a better position as compared to the past, in terms of risk management, compliance and protection of the interests of small investors.

Investors must ask basic questions. Such as: What are the company's products? How are the company's products better placed compared to those of the competitors? What is the company's past financial performance? What are the initiatives that the company is taking – to mitigate competition, to manage risks associated with the industry, and to grab opportunity, if any?

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Bio:

Mr Shah, a management graduate, is an analyst tracking sectors such as steel, base metals, entertainment and media, with an experience of over ten years in the commodities and the capital markets. He began his career as a journalist in Gujarat and extensively covered beats such as economic policies, politics, agro-commodity spot markets, and equity markets.