FII’s Outflow from Indian Stock Market

Investor’s Query: Please refer to the article in the latest issue of ‘The Economist’

http://www.economist.com/node/21562227

"In April alone, foreigners sold almost $1 billion of portfolio investments in listed shares and debt. Such outflows are scary. India runs a current-account deficit, which it aims to plug with portfolio inflows and foreign direct investment. After a record deficit relative to GDP of 4.2% in the year to March 2012, the deficit this fiscal year is expected to be 3-3.5% of GDP, or $50 billion-60 billion. To fund that kind of gap safely, India needs the world to be bullish about it most of the time"

With this kind of deficit, what is your thought on the potential mid-long term impact on Indian Stock Market?

Mr. Gerard Colaco: I do not know what the potential mid- to long-term impact on Indian stocks of foreign investments being withdrawn from India will be, as mentioned in the excerpt from 'The Economist' referred to by Mr. ABC.  Personally, I hope it has a seriously negative impact because I always like lower prices since we have a huge number of investing clients eager to make investments in 'margin of safety' situations.

As Warren Buffett states: "The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism, but because we like the prices it produces. Its optimism that is the enemy of the rational buyer."

The sad truth is that neither Mr. ABC nor 'The Economist' nor I nor anyone  can predict what is going to happen either in the short, medium or long term to stocks in India. In the long term, history teaches us that the probability of good returns on stocks in general is high.

There have been far greater scare stories than mere uncontrolled fiscal deficits in the more than 33 years that the BSE Sensex has been calculated. Despite this the Sensex has risen from 100 points in April 1979 to 18,000 points as of yesterday giving a compounded annual return of close to 17 percent. As for the acrobatics of foreign fund inflows and outflows, they do not worry me in the least. They may happen for reasons we cannot figure out. For example, if there is a desperate liquidity crisis in the US and FIIs need money there, they will liquidate their Indian investments even if the Indian economy is in the pink of health.

I agree that 'The Economist' is probably the best news magazine in the world. In fact it is the only magazine that I read cover to cover. That does not mean their analysts can calculate the potential mid to long term impact on Indian stocks that the budget deficit may cause. Foreigners may have sold $1 billion of portfolio investments in April 2012. But today’s Business Line states that the markets have hit 18,000 because of foreign investment inflows.

Between April and now, the Indian fiscal deficit has worsened, if anything. Would 'The Economist' care to explain the U-turn in foreign capital flows? There are things that cannot be explained by 'The Economist' about the movement of stock prices. My favourite example to prove this is of the stock Mangalore Chemicals & Fertilizers Limited (MCF).

When I joined the stock market in 1985, the Rs 10/- paid share of this company was quoted at around Rs 64/- even though the company had a carried forward loss in its balance sheet of Rs 187 crores or so, a huge amount for those days. The company had not paid a dividend for since inception. No one could explain why the Rs 10/- share was quoted at Rs 65/-. But this is only the beginning of the story.

Fast forward, to 2012. The company is still in existence. Over the years it has returned to profits. It is now paying dividends pretty consistently. It has a book value of Rs 45.18 per equity share of Rs 10/- face value. The dividends paid during the last 5 years are 6%, 7%, 10%, 12% & 12%. Yet the stock price is approximately Rs 43/- per share.

I hope the irony is not lost on anyone. If you had purchased the stock at Rs 65/- in 1985 when the main achievement of the company was a remarkably consistent track record of losses and held on for a period of approximately 27 years, taking delight in the sterling performance of the company as it returned to profits, wiped out its carried forward losses and declared consistent dividends, your delight would be sadly diluted by the fact that you would suffer a long term capital loss if you now sold your shares at Rs 43/-!

The day someone can explain this, I will start worrying about fiscal deficits and their stock market impacts. Until then, I will continue with my advice for lump sum investments in the stock market only when there is a margin of safety and systematic investments into well diversified equity portfolios at any time. There are things we can control and things we cannot control. We cannot control the fiscal deficit. We can control diversification and systematic investment. I would focus on the things we can control.

The final word on the impact of economic dangers such as uncontrolled fiscal deficits should come from John Bogle: "In investment terms, risk is to reward, what breadth is to length in spatial terms: the lesser of the two sides of the plane. That is not to say that risk is unimportant. It is crucial. But I simply do not accept its being counted equally with reward. Faith in the future, an essential element in investment, entails the implicit assumption that return will exceed risk. If potential return does not exceed the potential risk, why invest at all?"