What ails Indian stocks

2011 has started off on a rather skittish note for the Indian stock markets, though the rest of the world is in a celebratory mood. The Sensex has fallen over 10 per cent year-to-date even as most other global markets have coasted along in the green. Foreign institutional investors (FIIs), faithful buyers of the India story for two years now, seem to have suddenly developed cold feet and have withdrawn some money in January. This has set off a veritable massacre in mid- and small-cap stocks. The BSE Midcap Index down 12 per cent but nearly 50 stocks in this index have lost over 20 per cent. But given that India Inc continues to churn out 20 per cent plus growth rates in its sales and profits, what's ailing the stock market?

Better bargains elsewhere

Relative valuations seem to be one answer. As Indian stock indices trebled from their March 2009 lows, this has massively expanded the PE (price-earnings) multiple of Indian stocks. Paying a PE multiple of over 20 times for Sensex companies seemed okay, when India offered a rare oasis of growth in a recession-ridden world.

However, with the developed economies now returning to growth (US GDP grew 3.2 per cent in the latest quarter), global investors may be beginning to wonder if there aren't better bargains back home. Bloomberg data shows Sensex to be among the most expensive stock markets in the world. It trades at a PE of 17 times the current year's earnings of its constituent companies.

In contrast, the Dow Jones Industrial Average is available at 12 times, the Euro Stoxx at 10 times and the Hang Seng at 13 times. US listed Microsoft, 3M and McDonalds currently trade at half the PE of Indian companies in the same sectors.

Portfolio reset

Portfolio rebalancing by FIIs is another reason. Global funds have been voicing concerns that their relentless pursuit of emerging markets may have brewed up a bubble. As FIIs reset their portfolios at the beginning of the year, they may thus be tempted to take profits in markets with stellar gains and put it to work in markets that offer better value.

In this backdrop, runaway crude oil prices and domestic inflation may have provided FIIs with the perfect excuse to sell. Soaring crude oil prices, with their impact on India's import bill and thus the rupee, have always made FIIs nervous as a weaker currency can reduce their effective returns from Indian stocks.

Domestic food prices too have remained stubbornly high, casting doubts on whether Indian consumers can continue to spend to drive the economic juggernaut. Threatening noises about inflation from the RBI have led to fears that the central bank could accelerate interest rate hikes and curtail liquidity. This will spell trouble for the capex cycle- another key leg of the economy.

Impact costs

Despite all these factors, FII selling of over Rs 4,200 crore in a month shouldn't really dent the Sensex by 10 per cent or force 20 to 30 per cent falls in individual stocks. Yet this has happened, probably due to the high impact of FII action in the Indian market context. Retail investors have been in wait-and-watch mode through this rally and new inflows into both mutual funds and insurance plans have suffered after regulatory changes. Thus, even if FIIs decided to cash in, the absence of serious local buyers who can take a contrary view on valuations and step in to buy seems to have triggered sharp falls in mid- and small-cap stocks.

Silver lining

However, what Indian investors need to note is that all the above risks need not necessarily materialise, to derail the ongoing bull market. If corporate profits do hold up, even as stock prices decline, valuations are bound to turn more attractive over the next few months. If you were willing to buy stocks or equity funds when the Sensex was perched at its all-time high a couple of months ago, the fall is no reason to turn skittish. In fact, the correction only makes this a better opportunity to add to your equity exposures for the long term!

What all this means is that the recent sharp corrections in the market may be a buying opportunity for retail investors who have been rueing their inaction. Given the uncertainties, investors should stick to quality stocks, select ones with a low PE and take measured exposures spread out over several months.

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