Bull Run? Beware of being scammed!

It's the trouble with good news. You risk mistaking image for content.

Consider the ten factors we're listing here and it's almost impossible to argue why the stock market can't soon be 50 to 100 per cent higher: FII inflows are strong; there's furious fund-raising and subsequent deployment by mutual funds; the interest rates aren't stifling; top-tier corporates face good credit availability; corporate performance is good; the top stocks' valuations are still competitive against past market highs; more retail money is flowing into equities; there are no immediate macro-economic fears; domestic and global players have economic confidence in India; and there are signs of more investor-friendly market regulation.

But this is India, and the land that gave the rest of the world instant karma also carries many useful lessons in cosmically deeper levels of meaning. Dig hard enough, and you'll find there are enough spoilers attached to many of these compelling positives, hanging on like leeches.

Rest assured, there will always be fair opportunity for making money. But it's most certainly time we bust a few myths. Here's a quick run-through of what we're concerned about; we'll lay it out for you in much greater detail -- plus advice on how best to lighten these risks.

A great system: Investors and traders are minting money, making it easy to ignore problems that might otherwise have been highlighted earlier. There are suspicious fund flows into local equities through the FII route, there is an ongoing problem with allotments and applications (and the scams this creates), there is evidence of price manipulation and you can't be sure if brokers act in your best interests.

All these point to systemic lacunae. Yet only a good trading, settlement and regulatory system guarantees the quality of your investing experience.

At current market levels, investors can at least exit profitably or de-risk their portfolios. But it's important to know what these risks are, and how to avoid them.

Booming markets: Sure, one market is booming. But as a retail investor, what's in it for you? FIIs and other institutional buyers have size and liquidity criteria for their picks. They are close to their investment limits in many of the best stocks, so how much more can they drive them? Only a few good shares still have the room to grow on the back of institutional investment inflows.

Look for quality amongst these large stocks and you should still make some money in the long run. That's fine for a conservative investor, but where will the dramatic gains of the past three years come from?

They will come from the, right, mid- and small-cap stocks, but which ones? Daily advance/declines show that only the bigger stocks are in the positive range. Indian institutions are active in some smaller stocks; many have good track records and reasonable analytical and institutional coverage. Still, without big money driving these stocks you won't necessarily see massive gains.

And the picture for smaller stocks is largely negative. Several are being overtly manipulated. Invest at your peril -- this is pure scamster territory. This is absolutely not a boom.

Great corporate performance: Companies are doing well, but the profit growth -- an important driver of market valuation -- is tailing off, as our analysis shows. The first sets of figures coming in as we write this, for the financial year and for the fourth quarter, confirm the trend. In the best firms, though, the underlying reasons are sound; they are trading off short-term profitability for much-needed capacity building. Lower profit growth or not, their stocks will serve you well, because they have the backing of the smart money on Dalal Street -- it is for quality with a bottom-up, stock-specific view.

Read on to see how best to refine that strategy for your personal stocks and mutual funds portfolio.

Reining in a Wild Run

The one lesson history teaches in the financial markets is that there will come a day unlike any other day. At this point, the participants would like to say, 'all bets are off', but in fact, the bets have been placed and cannot be changed: Martin Mayer, author of Nightmare On Wall Street - Salomon Brothers and the Corruption of the Marketplace.

Unfortunately, the market regulator, the Securities and Exchange Board of India (Sebi), seems intent on ignoring history. Even though the bull run has been prolonged to the point where prudent investors are asking if the valuations are all bull, the regulator remains complacent.

The government is intent on taking credit for the bull market, claiming that it's all due to enlightened economic policy. Sebi seems content to let the government do this without trying to pin down the sources of the funds driving the market.

This is unfair to you as an investor and it is dangerous to the long-term health of the economy. Investors have the right to trade under a good regulatory system, which guarantees the right to invest in shares at prices that are not distorted nor manipulated. It is the duty of the regulator to demonstrate that it is continuously tracking market action.

Unfortunately, all indications point instead to a lack of regulatory investigation of the funding that has sustained the frenzied buying of stocks, particularly of the stocks that make up the major market indices. And it's not because Sebi lacks the power to order brokers and their clients to disclose the sources of their funds.

Sebi has all the required muscle under the Sebi Act, Securities Contracts Regulation Act and its numerous regulations.

The Mystery Billions: The Indian equity market, like its peers in Asia, South America and Africa, is being swamped with an unprecedented flood of global inflows. Foreign institutional investors (FIIs) now dominate the equity market. The question that has been raised, but not addressed adequately by Sebi, is whether all the FII money is from clean, legal entities.

For instance, global equity data collated by a professional data company, Emerging Portfolio Funds Research (EPFR), indicates that the global equity funds it tracked had, as of 31 January 2006, invested about $15 billion in India funds directly and an unspecified figure through other categories of global funds (See below: Small Money, Big Impact).

According to Sebi, the total FII net equity inflows stood at about $30 billion at the end of January 2006. Is the EPFR tracking funds entering Indian equities via FII sub-accounts and participatory notes (PN)? This could account for a chunk of the $15 billion discrepancy.

The huge FII inflows should have been enough to trigger an in-depth enquiry. It is not that Sebi is in the dark about the dangers. An expert group on 'Encouraging FII flows and Checking the Vulnerability of Capital Markets to Speculative Flows,' constituted by the finance ministry in November 2004, said: "With PNs issued to various types of entities abroad, the identity of the actual investor need not necessarily be known to the regulatory bodies. The investor could be individuals or corporates who are not subject to Indian law. This has given rise to concerns that some of the money coming into the market via PNs could be the unaccounted wealth of some rich Indians camouflaged under the guise of FII investment. The money might even be tainted and linked with such illegal activities as smuggling and drug-running."

PNs & sub-accounts: Participatory notes and sub-accounts are two entry routes for suspect funds. Sub-accounts are generally foreign private companies and individuals on whose behalf a FII is permitted (under Sebi rules) to invest and who would otherwise not be eligible to register as FIIs.

Participatory notes are contract notes through which an FII invests in, say, Indian equities, on its proprietary account; but the purchase is funded by an overseas investor on whose behalf the investment is made. The expert group report admitted that "this helps in keeping the investor's name anonymous" and that such investors "prefer to avoid making disclosures required by various regulators."

From data that Sebi shared with the group (but not with the investing public) there are ominous signs visible. (See below: The Participatory Route). Almost half of all FII inflows appear to come through the PN route.

Yet the expert group did not ban the use of PNs or sub-accounts by FIIs, though the Reserve Bank held that the issue of PNs should not be permitted. In his dissent note, the RBI representative on the group said, "Trading of these PNs will lead to multi-layering, which will make it difficult to identify the ultimate holder of PNs. Both conceptually and in practice, restriction on suspicious flows enhance the reputation of markets and lead to healthy flows."

In fact, the RBI was also of the view that sub-accounts should not exist as a separate class of investors. But the rest of the expert group -- two finance ministry representatives and one from Sebi -- did not endorse the RBI's views. And so PNs and FII sub-accounts continue to play a big part in FII inflows.

Price manipulation: A cursory examination shows that certain stocks in particular are the targets of the hot money. Says Aunali Rupani, sub-broker with Motilal Oswal Securities: "FII and speculator money is chasing only about 150 stocks where derivatives trading is available, including index stocks."

Figures on derivatives trading volumes bring out the enormity of concentration succinctly. In March 2003, the average trading volumes per day in the cash and derivatives segments of NSE were Rs 2,500 crore (Rs 25 billion) each. Since then, the cash market trading volume has grown 3.8 times to Rs 9,500 crore (Rs 95 billion) per day, in March 2006; derivatives trading volume has zoomed to Rs 33,400 crore (Rs 334 billion), 13.4 times higher.

Though this is fuelled by FIIs delivery-based purchases in the cash market as well as their trading positions in derivatives, daily volumes of Rs 30,000 crore (Rs 300 billion) were once unimaginable. Who is stoking this fire?

According to NSE's last available monthly newsletter, of the exchange's 915 cash market members, the highest 10 brokers in terms of cash market trading volumes accounted for 24 per cent of total volumes in January this year, against 20 per cent during 2004-05.

It is worrying that fewer brokers are accounting for more volume. However, NSE does not disclose the break-up of broker concentration for its derivatives segment. In derivatives trading, our equity market has a unique stock-centric focus; in no other market on Earth will you see 54 per cent of all derivatives trading volume concentrated in stock futures contracts as it is here.

The old-style badla traders are now enthusiastically playing similar games with stock futures. Of course, the risks to the settlement system are lower, as NSE's margining system is stringent. But where is the intensive scrutiny of big-ticket investors, including FII sub-accounts and PNs, in derivatives stocks? There has not been a single public statement by Sebi about the nature and findings of an enquiry, if any has been made.

Circular trading case: Sebi's intervention is necessary to cool down frenzied market participants. This became evident last year, when circular trading was hitting dangerous proportions in mid-cap and small-cap stocks. Sebi passed interim orders for some 8-10 stocks in September-October 2005. Even these few interim orders had the salutary effect of deterrence.

The Sebi orders stablised prices in mid-cap and small-cap stocks. Says Rupani: "Since September last year, we have seen two-thirds of all traded stocks touching new lows." But since Sebi has chosen to soft-pedal on FII sub-accounts and PNs and since these investments are primarily in index and derivative stocks, there has been a clear shift in trends.

The main indices have continued to shoot up, leaving secondary scrips trailing far behind. As on 30 March, on a year-to-date basis, the Sensex has appreciated 78 per cent, while other indices have offered lower returns. The Junior Nifty has returned 47 per cent, and the CNX Midcap, 61 per cent. Returns are negative in very many non-index stocks.

Even in the circular trading case, more follow up action is required. Six months have elapsed and Sebi has not passed any final orders in the 8-10 cases it investigated. In the IFSL stock, for instance, 13 connected individuals and corporate bodies executed manipulative market trades through eight brokers of which at least two -- Fortis Securities and Indiabulls Securities -- were big shareholders in IFSL with stakes of 3.5 per cent and 2.4 per cent respectively.

These trades, say market sources, would have emanated from large margin trading accounts of these brokers. So far, Sebi has not disclosed any fresh findings in this case.

Other disturbing signs: Outlook Money extensively covered the benami multiple application IPO scam since the news broke on 15 December through Sebi's interim order in the Yes Bank IPO case. The latest development is that Sebi has handed over the case to CBI. When will final orders be passed on the corporate and individual investors who masterminded the scam?

Adds Virendra Jain, head of Midas Touch Investors Association: "Under Sebi rules, it is the lead manager's job to weed out multiple application bids and we would like to know whether Sebi is going to take any action against them."

Demat insecurity: There's also worries about the security of your demat account. We reported one scary example of how some investors of Edelweiss Securities (a CDSL DP) saw shares vanish from their demat accounts.

And now, there's another case. About 20 investors (based in Guntur, Andhra Pradesh) holding demat accounts with UTI Securities (a NSDL DP) have experienced the same problem. We examined the documents of two of these investors and there's a clear sense of fraud being committed.

Says M. Dipak, son of Mittapalli Rangarao and Mittapalli Sobha, two affected investors who are senior citizens: "In January this year, we came to know that Tilak Associates, franchisee of UTI Securities, fraudulently transferred our shares to his or his associate account and went missing."

The value of the Mittapallis' vanished shares is about Rs 60 lakh (Rs 6 million); the total value of the missing shares of all 20 affected investors could touch Rs 5 crore (Rs 50 million).

So far, the DPs (depository participants) have not restored the shares to the investors, nor have the depositories taken any penal action against the DPs involved.

Another potential threat could arise from the agreement you sign with your broker and DP. Here too, no concrete action has been taken by the stock exchanges or Sebi against brokers such as Indiabulls Securities, Kotak Securities and HDFC Securities.

This regulatory inaction on the part of Sebi and all these systemic deficiencies in the Indian stock markets could threaten the foundations of the investing experience. Be aware of these pitfalls and beware of being scammed in this bull run.

• Part II: Is the Sebi doing enough?
• Part III: Will the stock market party end?

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