Indian Markets, FIIs and Global Macros

It is no secret that Indian market is largely driven by FIIs (Foreign Institutional Investors). This is more pronounced after the 2008 Financial  crisis as domestic retail participation in Indian markets went into a free fall from which it has still not recovered. The secular bull run from 2004 to early 2008 attracted plenty of domestic money through mutual funds and other financial products like ULIPs as if it was the Californian Gold Rush. It also ended in a similar fashion as 'They couldn't handle the truth' that bloodbaths are also part of the market. They were promised something different and the blame for it should largely go to the financial illiteracy that is common among Indian people and the way in which it was exploited by people who were selling these financial products. As it stands no effort is being made to resolve the issue of financial illiteracy and the million dollar question is who is going to take responsibility for that. You cannot expect the unscrupulous people that sell these products, purely based on which products is going to earn them the maximum commission, to do it. Is it up to regulator who has made a clusterfuck in its dealings with the Mutual Fund Sector which resulted in people getting duped into putting their money on ULIPs which were marketed as investment products (It says fucking Insurance which should be a good enough clue). How money and economy works, Financial products, economic history etc are not something that is covered in the school syllabus (it should be) and the Indian investor is left to learn through their own experiences which ends up with them getting driven away from the financial markets when they get burnt. No wonder that they go back to invest in physical stuff like real estate and gold.

Influence of FIIs

Indian companies tend to have high promoter holding and I have read somewhere that when you take the entire index, the promoter holding comes close to 50%. That means the rest 50% is the free float shares available for domestic and  foreign investors. FIIs hold roughly half of these free float shares. So in short even though FIIs own only 25% of the market they drive the markets since they own 50% of the free float shares that could get traded in the bourses. So the Indian market is under the whims and fancy of the foreign investors which makes things very complicated for Indian investors. Even if you are a value investor looking for companies that are at bargain prices, you will face headwinds due to the mood of FIIs. Over the last ten years there have not been a boring period for the Indian share markets and value investors earn their keep by spotting opportunities even when the market is generally flat and boring. We don't tend to get that in India since the markets fluctuate widely but it should be seen as an opportunity because the whole theory behind value investing is the market irrationality which is beautifully summed up in Benjamin Franklin's 'Intelligent Investor' which cites the moody Mr. Market with whom we can deal. The trouble is that when you invest in a market like India even if you are a value investor you depend very much on market momentum to realize your returns which again comes with a further lag. So it is good to understand what drives this foreign money.

What Drives FII Money Flows?

Developed World Monetary Policy

Indian markets and Rupee exchange rate went into a free fall when Ben Bernanke did his QE (Quantitative Easing) taper talk last year. Yesterday also market suffered because of the fear about an 'ahead of  schedule' monetary tightening  by US Fed. The old adage that 'When US sneezes the whole world catches cold' rings very true. The post 2008 developed world monetary policy is characterized by loose monetary policy as they have been trying to kick start their economies with varying degrees of success. Both US and Japan have followed a policy of Quantitative Easing and Mario Draghi is also contemplating the same for ECB. For ECB it is kind of complicated because the process by which they determine the proportion at which they buy various Euro zone countries' bonds will invite criticism.

QE refers to the policy by central bank to buy up long term government bonds from the market using what is essentially for all intends and purposes out of thin air money (It is largely a balance sheet exercise between the central banks and normal banks which own these assets). Apart from government bonds, the central bank can also target to buy asset classes such as mortgage bonds like the Fed did in US. QE is supposed to help the recovery in the following ways: 

1) The demand from the central bank will drive down interest rates for these long term bonds and this in turn drives the rates down for other bonds like Corporate bonds. This will help companies to refinance their debts and prompt some to use the low interest rates to do capital investments which will boost up GDP. This is applicable for ordinary people also in terms of refinancing and boosting consumer demand.

2) The Central Bank buying up assets will transfer money to those who were originally holding these assets. This money might end up getting invested in riskier assets like equity markets propping up their prices. This in turn might lead to wealth effect and money trickling down to the real world economy through increased spending.

3) A portion of the money that is transferred gets out of the country searching for foreign assets and better rates which will have a depreciative effect on the domestic currency. This depreciation will boost the relative export competitiveness of the country that is undertaking the QE.

The third channel one is the money which ends up in Indian markets through FIIs. That is why their flow is dependent heavily on developed world monetary policy.

Relative Prospects of Indian Economy & Relative Valuation of Indian Markets

For the FIIs, they have a variety of countries that they can invest in and where the money goes depends very much on the relative prospects of these target economies and their relative valuations. They are also exposed very much to currency movements since their performance will be evaluated on USD returns. This very much increases the complexity in their decision making and since we are also exposed to their money flows, we are also exposed to this kind of complexity. We cannot think in isolation about the prospects of our economy and not give a damn about the World economy and the larger macro-economic trends. Many of the emerging economies are either following an export driven manufacturing model or are resource rich nations. We are not either of these and it makes us a good defensive play for foreign investors. Oil prices going down is good for us as long as the fall is not prompted by a big financial crisis.  

Individual Stocks in Indian Market

Once the FIIs decide an allocation for our market, it generally flows to the usual suspects which tend to be in the large cap and mid cap segments. They don't have many options in the market because the companies have  to be sufficiently big for it to make enough of an impact in their portfolio. Once the valuation of these companies get stretched money will trickle into the broader market and only then the value investor will get his/her reward. It will be very tempting to try to time the market but in my opinion it is an impossible task considering all the variables involved. 

Conclusion

Even though value investors are agnostic about market momentum, in Indian markets we are very much dependent on it when it comes to stock picking as well as profit booking. Wild fluctuations in Indian markets give value investors great opportunities but at the same time it will be nerve-wracking and many people will succumb to temptations. The momentum in market is driven to a large extent by the FIIs who are also a moody bunch with plenty of variables to consider in deciding where the money flow to. In my opinion it is futile to second guess all these factors and try to time the market. Have strength in your convictions and be patient to play things out in the market. You don't get plenty of markets where you can spot stocks that go ten times. The stock might languish below your buying price for 3-4 years and the ten times journey might get played out within the next six months.