Domestic themes may help investors ride out the global volatility

What view should you, as investor, take on the intense volatility in Indian stocks? Well, there are two equally convincing answers.
Strong fundamentals

On one hand, the recent rout in Indian stocks has little do with the fundamentals of the economy or companies, triggered as it is by global factors (mainly fears relating to the US housing market). India Inc. continued to deliver strong earnings growth even in the just-concluded June quarter and growth drivers such as consumption and infrastructure spending appear to be strongly poised.

Companies in the Indian investment universe, except technology majors, also do not have a significant exposure to the US economy or its consumption trends and thus, their earnings may not be directly vulnerable to any US-related slowdown. This view suggests that the recent corrective phase could be a temporary one triggered by panic and that India’s strong fundamentals will eventually win over investors (both local and global). If this is indeed the case, any further declines in the coming weeks should actually be used to ferret out buying opportunities in Indian stocks.
Liquidity matters

However, the opposite view can also be argued with equal conviction. Yes, corporate India’s fundamentals are quite strong and may even be more resilient than those of other emerging economies. But a deluge of foreign investment in Indian stocks over the past four years has meant this fact is already well-known and is reflected in current stock prices. The recent correction notwithstanding, the stock market continues to trade at a premium valuation to other emerging markets.

What is more, while India’s companies do not depend heavily on the rest of the world for growth, its stock market certainly does. With a relatively low domestic participation in equities, it is the steadily increasing FII investments that have contributed in a major way to steadily spiralling stock prices over the past four years. For Indian stocks to resume their upward journey a continued flow of liquidity will be a pre-requisite. And recent global events definitely do have the potential to interrupt these liquidity flows.

In the past week, several non-US banks, financial firms and hedge funds have reported troubles from indirect exposures to mortgages/mortgage securities in the US markets. While debt funded M&A may be the first casualty, a ripple effect could draw in players such as hedge funds, international investment funds, global investment banks and private equity players, all active participants in the equity markets; this is bound to have liquidity implications for equities, especially in emerging markets such as India. This suggests that despite their fundamental attractions, Indian stocks could settle into a prolonged phase of listless or even downward moves.
Caution warranted

These factors suggest that, even if corporate fundamentals do seem positive, caution may be warranted in making fresh equity investments at this juncture. To start with, the decision on whether to indulge in a buying spree, or to simply remain on the sidelines now, should probably be based on the shape of the individual’s portfolio.

An investor who has a small or negligible equity exposure, but an appetite for risk, can use the corrective phase as a buying opportunity to peg up this exposure. But one who already has a significant equity allocation in his portfolio (relative to his preferred debt-equity mix) should probably consider staying on the sidelines. Replacing some poor portfolio choices with fundamentally sound stock ideas would also be a good move at this juncture, as it could help reduce the downside risk you carry.

Greater selectivity in stock and sector choices may also be called for while rejigging your portfolio. For instance, despite signs of recovery in this sector last week, it appears wise to limit exposures to technology stocks at present. Though the cap on external borrowings by Indian companies is widely expected to support the rupee, the jury is still out on whether this will be offset, over the medium term, by a falling US dollar or stronger domestic portfolio flows.

The significant exposure that large IT companies have to the global banking and financial services space, by way of clients/business, also suggests that it may be better to wait to gauge the impact of unfolding global events on IT company earnings. On the other hand, the earnings outlook for the domestic banking sector has certainly improved in recent times as the RBI cap on external borrowings last week may lead to stronger credit offtake for domestic banks, lending strength to earnings. However, bank stocks may still be vulnerable to a decline in valuations, arising from any global meltdown in financial stocks.

Given the uncertainties relating to the external environment, investment opportunities in companies with a strong domestic focus may deliver superior risk-adjusted returns for investors.

Domestic themes may pay

Companies focused on lifestyle or consumption driven sectors such as FMCGs, consumer goods or media offer one set of options.

For investors with a higher risk appetite, frontline stocks from the infrastructure and capital goods space (consensus is building that interest costs will not materially impede growth in these sectors), may present good investment opportunities. Phasing out any stock purchases over the next few weeks/months, to take advantage of stock price volatility, may be the best course to follow.

Defensive portfolio: Marico Industries, Glaxo Smithkline Consumer Healthcare, Indian Hotels, Monsanto India and 3M India — stocks that combine a low beta (tendency to move with the markets) with strong earnings growth prospec ts appear good options for conservative investors with a long investment horizon.

Aggressive portfolio: Bharat Electronics, L&T, Maruti Udyog, Idea Cellular and Sun TV — stocks which combine strong growth prospects with a high beta may be candidates for investors with a high risk appetite looking to build a long-term portfolio.