Market valuations worry FIIs

The good news first. After pulling out close to Rs 3,700 crore (Rs 37 billion) during the month of October, foreign institutional investors are back in the hunt.

Though, going by their high standards, net purchases of Rs 50 crore (Rs 500 millin) they made on November 2 might look piecemeal, they did arrest a run of 11 consecutive sessions when FIIs were net sellers.

Rather alarmingly, FIIs were net sellers for 16 out of a total 20 trading sessions in October. However, on a net basis, FIIs have still bought more than $8.6 billion worth of Indian equities so far this year.

While constraints in meeting profit targets for the year are said to be the main driving force behind the sudden change in FII trading patterns last month, there may be more reasons than what meets the eye, say observers.

However, encouragingly for the markets, FIIs still seem to be bullish about the long-term fundamentals of the Indian economy. The worry is more on the short-term valuations of Indian markets compared with other emerging markets, rising US rates, the ever- present political uncertainty and the resultant lack of will for policy implementation.

According to Andrew Holland, executive vice-president, research, DSP Merrill Lynch, Indian valuations vis-à-vis other emerging markets are the main causes for concern. "India's valuations are the highest among emerging markets. There was a feeling that at 8,800 levels, valuations were looking a bit stretched," says Holland.

Based on a trailing price-earnings ratio, India commands an earnings multiple of 15, which is way ahead of other leading emerging markets like Brazil, Russia and South Korea, which are trading at 9-10 times.

In a recent report, a leading foreign research firm has noted that while India's long-term drivers of the economy seem intact, it does appear that the markets have got ahead of themselves.

According to Arjun Divecha, head of GMO Emerging Markets Fund, future fund flows will depend a lot on whether Indian companies deliver earnings growth that justifies their high valuations.

"One must understand that fund flows follow fundamentals, not the other way around," he adds.

However, Holland points out that on a one-year forward basis, a P/E of 14-15 for the Sensex is pretty reasonable.

While valuations are one concern, there are other factors too, which have made FIIs jittery. For example, rising interest rates. The US Federal Reserve announced a hike in US rates for the 12th time in a row, pushing it to a four-year high at 4 per cent.

"Expectations of a rise in US rates also had an impact on liquidity, which led to a general outflow of foreign money from other emerging markets as well," says Holland. There are concerns on the currency front too. "With the rupee depreciating against the dollar, FIIs have taken a hit on their currency earnings as well," points out Holland.

According to UR Bhat, managing director of Alphaplus Investment Management Pvt Ltd, the continuity of foreign fund inflows will depend on incremental reform measures.

Apparently policy implementation, especially regarding infrastructure development, is one area that has been looked upon suspiciously by foreign fund managers. "The gap between high hopes and disappointment is not very big. It does not take much for confidence levels to come down," says Bhat.

"There is a general feeling gaining ground that the government is not serious about infrastructure development. The crumbling of infrastructure in Mumbai during the July floods and the recent spat between former Prime Minister HD Deve Gowda and NR Narayana Murthy of Infosys in Karnataka are also examples," notes Bhat.

But, even the most optimistic observers reckon that foreign inflows into India will slow down in the future. While the outlook has not changed much in terms of fundamentals, worries on the political front, apart from better returns elsewhere, are likely to keep inflows under check, say analysts.