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Observations - Annual Commentary 2006

Observations - Annual Commentary 2006

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ThinkingCap
 Annual Commentary
2006Hemant Sreeraman(hemant.sreeraman@gmail.com)
 
Hope…can’t substitute Reason.
As the curtains come down on yet another eventful year in the Indian equity market, I think the time is rightto put down my thoughts. In this commentary, I shall write on the broad factors that influenced marketdirection in 2006. I shall not use too many jargons, as I believe they kill the fun of reading.
(However, in placeswhere I cannot avoid some, explanations follow)
. In connection with this, I shall write on what fuelled the growth instock prices of companies and prices of real estate. I shall also write on the factors that I think keep foreigninvestor interest high on Indian equities.As usual, I shall refrain from making any prediction about market direction or market levels. I believe thatpredicting market direction is far less fruitful than predicting my behavior, simply because I have far morecontrol over the latter.
What happened to the Indian stockmarket in 2006?
1.1: Macro factors strong
The Bull Run that began in 2002-2003 showedno signs of abating in the year gone by. Themacro economic factors strengthened further,propelling India’s GDP (Gross Domestic Product)to an 8.4% growth over 2005.In the latest quarter (Jul-Sep 06) the economygrew a whopping 9.2% over the correspondingperiod last year. Significant contributors to thisgrowth were the Services sector, which grew14% followed by Manufacturing, which posted agrowth of 12%. Agriculture though proved to be alaggard, growing a meager 2% over last year.Some comments are worthy here. Theencouraging trend of the services andmanufacturing sectors showing strong growthindicates several things. The former capturesgrowth in trade, hotels, transport andcommunication. Companies that cater to theseindustries, not surprisingly, made their shareholders very happy.Before this section peters down to a numericalexercise, I shall introduce briefly on theimplications of a growing economy on individualsand companies. This, according to me, is of far more importance than dwelling on numbers. Solet’s dive right in.During an economy’s expansionary phase,interest rates tend to be low, thereby leading toan increase in what experts call, ‘credit offtake’ (a jargon that can be loosely replaced with ‘loans’).The low interest rates imply that individuals likeyou and me can borrow more than we previouslyimagined. This leads to growth in loans, which ispositive for banks and financial institutions. Lowinterest rates also mean that companies canaccess low cost capital for capacity expansion.A growing economy also increases demand for 
Economic Data: India (2005)
Population (Billion) 1.1GDP (PPP in $ Trillion) 3.8GDP (Per Capita in $) 3,508GDP Growth Rate (%) 8.4Inflation (Consumer Prices in %) 4.2Exchange Rate (Re/$; average) 44.1
Source: www.economist.com
 
ThinkingCap
 Annual Commentary
2006Hemant Sreeraman(hemant.sreeraman@gmail.com)
 
Hope…can’t substitute Reason.
goods and services. There are two major implications of this. The first, affects companiesand stock prices and the second, inflation. I shalladdress both.A growing economy benefits companies asdemand goes up for goods and services. Thisresults in companies using their capacities to thehilt to cater to the burgeoning demand. Thisvirtuous cycle reaches a stage where companiesfind that they have to add to existing capacities tocater to the ever-rising demand. Couple this witha low interest rate scenario (discussed above)and one sees why it’s a terrific time for companies to embark on capacity expansion.This is what’s happening in the Indian markets of late. The process, which began roughly in the2nd half of last financial year, has picked upmomentum now. One can expect this to continuethrough the next financial year as well.The second implication, inflation, is of a far moreserious nature and affects companies andindividuals to a great extent. We’ll look at theeffects of Inflation through an example.After an economy gets into a hellhole, Mr.Inflation goes off to sleep. Nobody wants him.Why? People are laid off; incomes are cut or greatly reduced, leading to a drop in demand for goods and services. As demand falls, companiesthat produce goods and services are forced tocut the prices they charge customers. Else theyare stuck with a lot of unsold items in their inventory. This leads to deteriorating corporateperformance. Seeing the slackeningperformance, investors cash out. They arediscouraged by the lull in the economy andrefrain from committing any more capital into thestock markets. This leads to a fall in the stockprices of companies. People start thinking moreabout the basic necessities than luxury…Whew…the bottom line of the exposition is that,demand falls, price falls and Mr. Inflation (whichcan be defined as the general price level) goesoff to sleep.Seeing an in-the-hellhole-economy the powersthat be decide to cut interest rates and pushreforms. The cut in Interest Rates sets off avirtuous cycle that I had written about in earlier paragraphs. With time, the economy picks upand eventually starts booming…and wakes upthe fast asleep Mr. Inflation. Mr. Inflation thengrows from strength to strength until a stagewhere the same powers that be – which were ina way responsible for waking him up – fall over one another to put him back to sleep! Theyrealize that if left unchecked, Mr. Inflation iscapable of bringing an economy to its knees.This causes Interest Rates to go up, whichgradually sets the stage up for the scenarioplayed out three paragraphs above.Mr. Inflation eats ‘up’ the purchasing power of your money. For instance - assuming an inflationof 5% - a thing that costs Rs.100 today wouldcost Rs.105 a year hence, due to Mr. Inflation.This is also one reason why investments are soimportant. They help one in keeping ahead of Mr.Inflation’s reach. A return of 10% before inflationis taken into account would turn into 5%, after giving Mr. Inflation his due (5%).Getting out of story mode, Inflation today is adefinite concern for the powers that be (we’ll callthem RBI). Recognizing the effects inflation canhave on the economy they decided to hike theInterest Rates.The implication of this is easy to see by now.Higher rates mean lesser borrowing byindividuals. Highly leveraged companies will feelthe pinch, as their interest costs will be higher.
 
ThinkingCap
 Annual Commentary
2006Hemant Sreeraman(hemant.sreeraman@gmail.com)
 
Hope…can’t substitute Reason.
This leads to a drop in net profits and EPS,assuming for an instant all other factors areconstant. Dropping EPS means lower stockprices on the same P/E (Price = P/E x EPS). Thenet effect of all this is that the economy isprevented from over-heating and imploding.While this is a good effect, the market reactionsto interest rate hikes is mostly knee-jerk innature. Among other factors, an interest rate hikein May-June 06 was enough to send the marketsouthwards by 25-30%.On balance the RBI, while being optimistic abouteconomic growth is also silently worried aboutthe negative effects of inflation. I believe thatthere is some more interest rate tightening downthe road, especially if inflation continuesunabated.After the super performance in the latest quarter,GDP forecasts for India have been raised to8.7% for 2006-2007. Put in superior corporategovernance and reporting standards (althoughone could do with a bit more here!) and highROE, and it is easy to see why FII are interestedin the Indian market.
1.2: Thoughts on the market
10k..11k..12k..9k..10k..11k..12k..13k..14k?
That is the sequence the BSE Sensex tracedbroadly during the last year. After beginning theyear at 9000 odd levels, the Sensex risecontinued rapidly, fuelled in no small part byeager FII. Suddenly everyone was lookingclosely at Indian markets. The good GDP figures,coupled with reasonable inflation, good generalcorporate governance standards, high Returnson Equity (ROE), were enough to make FIIembrace Indian equities. Companies werebeating analyst expectations pretty consistentlyand this led to stock upgrades. An illustration is inplace.
Figure pertains to Section 1.2
Companies beatexpectations AnalystsupgradeestimatesInstitutions loadup on equitiesMore FII followsuit. Very bullishon equities

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