GMO Emerging Markets Fund's Arjun: India is the central theme

It was 1992. The abbreviation, FII, wasn't yet commonplace and, being phonetically stilted as it is, hardly rolled off the tongue smoothly. True, the then Finance Minister Manmohan Singh's historic 1992 Budget had just opened up the stockmarket to foreign investors, but foreign institutional investor trades were still few and far between on the Indian stock exchanges. Some of the early movers, like Hong Kong brokerage Jardine Fleming (now part of J.P. Morgan), had set up shop in India but were still testing the waters. Jardine, for instance, made more news when its first India chief, Mark Bullough, a colourful Scotsman, commuted to office (in a rented Nariman Point business centre!) on a 500-cc Bullet mobike than for the firm's deals on Dalal Street.

In the first full year after foreign investment was allowed in the Indian stockmarket (1993-94), net foreign portfolio fund flows aggregated just $1.6 billion (Rs 5,126 crore) or a paltry 0.9 per cent of the total market capitalisation. That was then. Ten years on, FIIs are arguably the biggest drivers of the stockmarket boom. The current bull run-the Sensex's dizzying climb from April's 2,900 to December's 5,200 plus-is fuelled largely by foreign portfolio funds. During this period, net FII inflows added up to $5.4 billion (Rs 24,648.4 crore) or 4 per cent of the total market cap (Rs 10,00,494 crore). In 2003, fiis have so far invested around Rs 31,747.9 crore ($6.8 billion), nearly 135 per cent higher than the Rs 13,445 crore ($2.84 billion) they invested in 2001, which previously was the year with the largest net inflow since FIIs were allowed to invest in India in 1993. That means FIIs have invested $28.21 million (Rs 131.33 crore) on each of the 241 odd trading days so far.

Charge Of The FII Brigade

It's not difficult to see why. The Indian market is roaring. Thus far in 2003, emerging Asian markets have gone up by 39.7 per cent (in dollar terms), while India has spurted 56.9 per cent. A robust India story, especially when its stockmarket promises more than other emerging markets, obviously attracts foreign funds. But this time they're out here in droves. While the older India hands, like Capital International, Government of Singapore, Janus Investment, Fidelity, UBS Global and Morgan Stanley, have increased their exposure to Indian stocks, they've been followed by a host of newbies. Even global or developed market funds, who'd earlier give an emerging market like India the miss, are now headed for Dalal Street. Recent entrants include Swiss Re, William Blair & Co., AB Funds trust, GAM International Growth Fund, and ING Partners. In 2003, 61 new FIIs have registered with SEBI (statutory requirement), taking the total number of registered foreign investors to 515.

Others, not exactly newbies, like the US-based GMO Emerging Markets Fund, Australia's Platinum Asset Management, France's Carmignac Gestion and Netherlands' Nordea Value Management, have moved from being bit players to big investors. "Today, the FIIs breed in India has widened. A lot of global money as well as general hedge funds are looking at India," says Mihir Doshi, CEO, J.M. Morgan Stanley Securities. Indeed, they come in different hues. The plain vanilla emerging market funds are ubiquitous and, as their name suggests, are clearly focused on 30 emerging markets like India. But there are others. Like developed market funds, which have zeroed in on India despite being focused on markets like Germany and Hong Kong.

The simple reason for their deviance: the high returns that the Indian market promises and the strong rupee. Since January this year, NASDAQ has moved 37 per cent, Dow Jones 15 per cent, London's FTSE 8 per cent, while the Indian stockmarket has charged ahead by 56.5 per cent. High absolute returns in India have attracted hedge funds-essentially funds comprising closed groups of very high net worth individuals or organisations-like Kingdom Capital and Traxis Partners that, even though are not registered in India, are buying through participatory notes (derivative instruments issued to foreign investors who want to trade in Indian markets). "There is an increasing realisation of the true potential of India as a consumer market,'' explains Mark Mobius, President, Templeton Emerging Markets Fund.

The Third Wave

You could call the recent rush of FIIs the 'third wave' of FIIs in the Indian market. The first wave was in 1993-94, when India's first steps towards liberalisation and economic reforms attracted attention of global investors. This saw the emergence of India-specific funds by firms like Morgan Stanley and Alliance Captal. The second wave of FIIs came in 2000-01, when, lured by the tech boom, another swathe of foreign investors zeroed in on India, lapping up Indian paper, particularly tech stocks, so much so that the market got overvalued. Now, it's the third wave. India's economy is poised for higher growth and buoyant demand has perked up businesses across a larger spectrum of industries, not just in a few like infotech and pharma.

Expectedly, this has seen a change in the appetite of FIIs-both in terms of how much of Indian paper they are buying but also what they're buying. Till last year, FII interest may have seemed to be limited to the big cap (typically $2 billion plus) stocks like Reliance, Infosys, Ranbaxy, SBI and HDFC-all staple FII favourites. But this year, brokers and analysts are hawking a welter of other smaller cap stocks. And finding takers. FII interest has gone beyond infotech, banking and pharma to auto and auto components, and steel. Explains Sanjiv Duggal, CIO, HSBC Asset Management: ''Indian companies are exporting quality products at globally competitive prices.''

The new breed of FIIs is willing to delve deeper. Says Andrew Holland, Vice President, DSP Merrill Lynch: "A year ago, an analyst would look at the mid caps more as a channel check, but now they are meeting the companies and seeing immense potential." That they're seeing a lot of potential in India seems quite obvious. As much as 34.4 per cent of the $81.7 million Platinum Asia Fund is invested in India; 8 per cent of GMO Emerging Markets Fund 's $5 billion corpus is vested in Indian paper. Says Timothy Julien, Regional Director, ING Investment Management (Asia-Pacific): "We are overweight on India because we believe that earnings growth for India is strong and there could be upward revisions and also the economic policies are becoming more favourable."

Party Poopers?

It's the lure of the lucre that attracts investors to any market. The Indian stockmarket offers the highest return on equity and, in terms of average price earning multiple, it is at the middle of the pack compared to the Asian emerging markets-India has an average PE of 13 times 2004 earnings, while Taiwan and Thailand are at 15 times and 11 times respectively and Indonesia is at eight times. Return on equity (which measures the return on money invested) in India averages 21 per cent as compared with 11 per cent in Taiwan and 14 per cent in both Korea and China. As growth in the US and Europe slows and the dollar depreciates, investors are looking at markets which are not dependent on the world economy and have a large domestic base. Says U.R. Bhat, director and head of equity at J.P. Morgan India: ''With investors in the US diversifying their investment baskets, big time investments are coming to India.'' Adds Duggal of HSBC Asset Management: "The US investors looking for growth are scanning for non-dollar assets and India offers a wide variety in terms of sectors and companies."

But the party could come to an end. Even as Mumbai's tony hotel lobbies are filled with itinerant foreign investment bankers and ever-growing teams of analysts from Singapore and Hong Kong routinely make the rounds of companies across the country, it would pay to be cautious about the current hype about FIIs. For one, portfolio funds seek returns and, once other markets recover or the Indian markets get overvalued, they are bound to flow out. Developed market funds are unlikely to increase their exposure to India once their focus markets recover. And emerging market funds that are active in the Indian stockmarket could decide to move to other emerging markets once those offer them relatively better growth prospects. Besides, hedge funds are notoriously mercurious in seeking out new growth stocks in different markets. Says Arjun Divecha, Portfolio Manager, GMO Emerging Markets Fund: "The Indian market is attractive, but I believe you make more money when things go from truly awful to merely bad rather than from good to better." That may explain why Indonesia and Argentina appear more attractive than India to some investors.

For the moment, though, the revelry is on. Despite the $6.8 billion inflow from FIIs, the Indian market is under-owned by foreigners, who according to CLSA Asia-Pacific Markets estimates have just a 9 per cent share of the total market cap. Compare that to, say, Taiwan, where 39 per cent is owned by FIIs. Partly that's because of poor supply of floating stock in the Indian market, something that many foreign investors expect will improve once the government is more decisive on disinvesting its stake in large and profitable PSUs like the oil companies. If economic initiatives like that happen, the FII party could get another boost.

-with inputs from Dipayan Baishya