Expert Zone

(Rajiv Deep Bajaj is the Vice Chairman and Managing Director of Bajaj Capital Ltd. The views expressed in this column are his own and do not represent those of Reuters)

With real interest rates starting to move from negative to neutral, cost of capital rising and stock markets trading in the fair value plus zone, it will be tough to rake in substantial gains from equities in the near term. Prudence suggests that investors diversify their portfolio across asset classes and stagger their equity investments over the next 12-18 months.

The recent FII money fuelled rally in Indian stock markets has taken everybody by surprise. As is the case with most liquidity fuelled rallies, it is tough to predict the top and anticipate the exact time when liquidity flows will start reversing. At the macro level, the significant differential in growth and interest rates between the developed world and the emerging economies such as India, coupled with an ultra-easy monetary policy in developed economies have ensured that cheap money continues to flow from developed world into emerging markets and other riskier asset classes.

The dilemma facing investors today is whether to participate in the rally or to wait on the sidelines. It is tough to arrive at a decision as on one hand the opportunity cost of sitting on the sidelines can be huge as has been seen of late, whilst on the other hand, a plunge into the markets at these levels can be damaging in case the tide turns, as has been seen in the latter half of 2007 and early 2008.

Looking at fundamentals, though they are robust both at a macro as well as micro level, they do not seem to justify the present valuation levels. At least given the valuations, it is tough to see significant gains from here on, in the near term. With the BSE Sensex trading at levels of more than 20,400 which translates into a Price Earnings multiple of more than 19 times based on estimated Sensex EPS for 2010-11, markets seem to be fully pricing in earnings even up to 2011-12, trading at 16 times the expected FY12 EPS.

It is then difficult to imagine what will drive further upside, particularly when inflation is high, interest rates are rising and global growth is expected to slow down in 2011 as compared to 2010.

Looking at the performance of India Inc in terms of earnings growth in the second quarter of the current fiscal, it has been either in line with or slightly better than estimates in most cases.

There have been occasional blips in certain cases such as in metals, but on the whole they can be said to be in line with estimates. Revenue growth has been solid but upward pressure on input costs and interest costs has affected margins. No wonder the top line has grown more than the bottom line.

The moot point however is, can a growth rate in corporate earnings, that justifies the present valuation levels, be generated and more importantly be sustained going ahead? With core infrastructure growth decelerating and remaining low, industrial output growth showing increased volatility, interest rates rising, liquidity conditions remaining tight, capacity utilisation levels peaking or looking likely to peak in the near term in many sectors, commodity prices firming and wage pressures building up, it is likely that there can be a moderation in growth in the short term.

A study on the changes in shareholding pattern between September 2010 quarter and June 2010 quarter reveals that there has been a considerable shift in holdings from the hands of domestic retail and institutional investors to foreign institutional investors. Might be that the FIIs have recognised the growth potential of the Indian economy better than us. But the worrying factor is that a considerable portion of these FIIs are either ETFs or are coming through the participatory notes (PN) route. This gives rise to doubts on their commitment and the longevity of their investments in India.

RBI has raised policy rates in its second quarter review of monetary policy. While the 0.25 percent hike in repo and reverse repo rates was widely expected, it is for the first time that RBI has allowed a peek into its mind by saying that the likelihood of further rate hikes is low in the immediate future.

Given the astute regulator the RBI is, it is not customary of RBI to give such forward looking statements. The fact that they have indeed given such statements underscores the central bank’s confidence in its ability to manage the situation.

Another pleasant surprise was the transparency in the RBI statement wherein it actually detailed the factors that determine its monetary policy stance. The analysis of industrial growth, WPI and CPI inflation and their various components, Current Account and Trade deficits, foreign capital flows, currency metrics and volumes on the LAF auction window, all show how the central bank looks at these different factors while formulating the monetary policy.

The cap on loan to value ratio for housing loans at 80 percent, increase in risk weights for housing loans worth 7.5 million rupees or more, to 125 percent and the increase in provisioning for housing loans distributed at ‘teaser rates’ to 2 percent, all reflect the proactive nature of the RBI. Clearly, the RBI policy has not been a dampener, as far as financial markets are concerned.

In the current market conditions, prudence suggests that investors should stagger their equity investments and should invest with an essentially long term horizon of 3-5 years. At these levels, this market is clearly not for those who are looking to make a quick buck in a short time. Actually it has never been so. Equities are essentially long-term investments and should be treated as such at all times.

As has been proved over the last decade or so, the best way to invest in equities is to invest through good quality diversified equity mutual fund schemes. However, for those who think they can do it on their own, they should look for fundamentally strong stocks that carry above average growth potential and are available at reasonable valuations.

We know that finding such stocks in the current environment will require extensive research, lots of hard work, perseverance and patience. But who ever said that making money was easy?