Download the latest issue of Business Today Magazine just for Rs.49
Should you follow investment pattern of FII inflows in India?

Should you follow investment pattern of FII inflows in India?

Investments by FIIs in Indian markets have always influenced Sensex, but should you follow their investment pattern?

We hear a lot about sales and purchases made by foreign institutional investors (FIIs) in Indian equity markets, with these numbers often making headlines. Why are we so obsessed with FIIs?

The answer, as Ajay Parmar, head of institutional research, Emkay Global Financial Services, puts it, is simple, "Indian markets are primarily driven by FII fund flows."

Parmar says the current market slide can be attributed to lower FII inflows in 2011. A look at stock indices since 2006 shows that the markets peak when FII inflows are the highest and fall when FIIs are missing in action. For instance, in 2008, the BSE Sensex fell almost 50% due to the global financial meltdown, wiping out the gains of 2007.

SPECIAL: How to balance your equity portfolio

"What hurt in 2008 was not the performance of companies but rapid outflow of $13 billion (Rs 55,000 crore) as investors fled risky assets," says Nick Paulson-Ellis, India head, Espirito Santo Securities.

The markets were flat during the first three months of 2009 as FIIs stayed away. After that, governments across the globe implemented plans to boost their economies. India, helped by robust economic growth, became a preferred destination for investors.

85% was the surge in the Sensex in 2009 with FIIs investing a net Rs 84,000 cr, crossing the 2007 level.

With FIIs investing a net $19 billion (Rs 93,100 crore) in 2009, crossing the 2007 level, the Sensex surged 85%. In 2010, the trend continued and FIIs pumped in $30 billion(Rs 1.3 lakh crore) into Indian equities, helping the Sensex gain 25%. Between December 2006 and July 2011, the number of FIIs registered in India rose from 1,024 to 1,730.

Investing in stocks with high FII interest can give good returns. For instance, the FII holding in HDFC has been 58-60% since 2008. Similarly, the FII holding in ICICI Bank has been 38-40% for years. Between March 2008 and 29 September 2011, HDFC Bank and ICICI Bank have risen 35% and 20%, respectively.

FII Inflow vs Sensex: There is a definite correlation between Sensex movement and foreign investment.
"Most banks have hit the FII investment limit, in which case there is always a buyer and a seller FII for the stock," says Parmar. At present, FIIs can hold up to 24% paid-up capital of an Indian company and 20% of a public sector bank. This can be raised after approval from the company's board.

The stocks-out of top 20 in BSE 500 on the basis of FII holding -that have seen a rise in FII interest since March 2008 include Yes Bank, Shriram Transport Finance, agriculture stocks such as Jain Irrigation and REI Agro, and United Spirits. Yes Bank and Shriram Transport Finance stocks have doubled in this period.

While you can gain by investing on the basis of what FIIs are doing, FII inflows can reverse any time and work against you. Out of the top 20 stocks with the highest FII holding in September 2011, real estate stocks such as Indiabulls Real Estate and IVRCL Infrastructure have seen a huge drop in FII interest. The FII holding in the former has fallen from 69% in December 2009 to 49%. The fall in case of IVRCL has been from 58% to 48%. IVRCL has lost 90% of its value since December 2009 while Indiabulls Real Estate is down 75%.

FIIs have invested just $200 million until September 2011 compared with $30 billion in 2010. This has affected the performance of the Sensex, which has fallen 11% this year. "While the outflow this year has been 1% of that in 2008 ($12 billion), India funds have seen redemptions in 20 of the past 21 weeks," says Paulson.

There are a number of factors that influence FII investment. Generally, the most important are valuations and earning expectations. It's natural that relative valuations and earning growth expectations come into play when somebody has an option of investing across countries.

"The other factors that have influenced FII investment are high inflation, aggressive tightening by RBI and escalation of corruption as an issue," says Paulson. Corporate governance has of late become very important.

"What hurt in 2008 was not the performance of firms but the rapid outflow of Rs 55,000 crore as investors fled risky assets."
Nick Paulson-Ellis | India head, Espirito Santo Securities

Unless there's a clear signal of inflation moderating and growth staying afloat, India may not see significant inflows. In fact, emerging markets, as a group, have been hit by the global uncertainty.

"Further, the debt crisis in the Euro zone and faltering US economy have pushed investors towards safe assets," says Kavita Chacko, manager economist, CARE Ratings. Investors around the world are moving out of emerging economies and putting money in safe assets, such as US Treasuries and the dollar.

High Correlation: Over the years, higher FII inflows have helped the Sensex generate higher returns.
This, in fact, has weakened the rupee against the dollar, making FIIs nervous and jittery as the value of their rupee income has fallen. The rupee fell 6% in September 2011, coinciding with a 6% fall in the Sensex, a double blow for foreign institutional investors.

"In the coming weeks, once the market stabilises, we could see money entering India as the rupee would be weak, making it attractive for FIIs," says Parmar. This is because a strong dollar will help FIIs buy more in rupee terms. We saw this happen in May 2008 when the rupee fell 4.5% in a fortnight and FIIs pumped in a little over Rs 700 crore. The Sensex rose 600 points to 17,350 on May 19, 2008. However, there's a risk of funds flowing out if the European debt crisis escalates.

"Retail investors should not be swayed by daily stock movements, regardless of whether they are caused by large FII inflows or outflows," says Manish Kumar, executive VP and head (investments), ICICI Prudential Life Insurance.

FIIs are known to take stock prices up or down more rapidly than local institutions. "FIIs do not look at stock prices very minutely while buying or selling. If they have decided to buy a stock, they buy it at the current price, and if they have decided to sell, they do so at the current price," says Parmar.

"Further, their impact is more in a market like India, which has thin liquidity and limited retail participation," says Paulson.

Most analysts say India is equally or better placed than other emerging markets for attracting foreign funds. "We have a large number of companies with capitalisation of over $1 billion (Rs 4,900 crore)," says Parmar. India also has a strong central bank, which has managed to keep the economy out of global financial troubles.

Espirito's Paulson says that given the extent of the current global uncertainties, India's domestic exposure will come back into focus. "Right now, the rest of the world makes India look good. The US and EU issues are well known, while China is more globally exposed and has to adjust to an erosion in wage competitiveness," says Paulson.

The problems India faces are by no means trivial-with the global crisis adding to inflation, slowing growth and corruption.

"Although these issues won't disappear overnight, with a 20% fall in the market along with earning multiples that are below the long-term average, India offers compelling opportunities," says Paulson. So, while FIIs' moves can be a good indicator of favourite sectors, do not follow them blindly as you may not be as nimble-footed as them.