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Observations - Annual Commentary 2006

Observations - Annual Commentary 2006

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Published by api-3799124
As Year 2006 draws to a close, I put my thoughts down on the Indian equity market.
As Year 2006 draws to a close, I put my thoughts down on the Indian equity market.

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Published by: api-3799124 on Oct 17, 2008
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03/18/2014

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ThinkingCap
Annual Commentary
2006
Hemant Sreeraman
(hemant.sreeraman@gmail.com)
Hope\u2026can\u2019t substitute Reason.

As the curtains come down on yet another eventful year in the Indian equity market, I think the time is right to put down my thoughts. In this commentary, I shall write on the broad factors that influenced market direction in 2006. I shall not use too many jargons, as I believe they kill the fun of reading. (However, in places

where I cannot avoid some, explanations follow). In connection with this, I shall write on what fuelled the growth in
stock prices of companies and prices of real estate. I shall also write on the factors that I think keep foreign
investor interest high on Indian equities.

As usual, I shall refrain from making any prediction about market direction or market levels. I believe that predicting market direction is far less fruitful than predicting my behavior, simply because I have far more control over the latter.

What happened to the Indian stock
market in 2006?
1.1: Macro factors strong

The Bull Run that began in 2002-2003 showed no signs of abating in the year gone by. The macro economic factors strengthened further, propelling India\u2019s GDP (Gross Domestic Product) to an 8.4% growth over 2005.

In the latest quarter (Jul-Sep 06) the economy grew a whopping 9.2% over the corresponding period last year. Significant contributors to this growth were the Services sector, which grew 14% followed by Manufacturing, which posted a growth of 12%. Agriculture though proved to be a laggard, growing a meager 2% over last year.

Some comments are worthy here. The encouraging trend of the services and manufacturing sectors showing strong growth indicates several things. The former captures growth in trade, hotels, transport and communication. Companies that cater to these industries, not surprisingly, made their shareholders very happy.

Before this section peters down to a numerical exercise, I shall introduce briefly on the implications of a growing economy on individuals and companies. This, according to me, is of far more importance than dwelling on numbers. So let\u2019s dive right in.

During an economy\u2019s expansionary phase, interest rates tend to be low, thereby leading to an increase in what experts call, \u2018credit offtake\u2019 (a jargon that can be loosely replaced with \u2018loans\u2019). The low interest rates imply that individuals like you and me can borrow more than we previously imagined. This leads to growth in loans, which is positive for banks and financial institutions. Low interest rates also mean that companies can access low cost capital for capacity expansion.

A growing economy also increases demand for
Economic Data: India (2005)
Population (Billion)
1.1
GDP (PPP in $ Trillion)
3.8
GDP (Per Capita in $)
3,508
GDP Growth Rate (%)
8.4
Inflation (Consumer Prices in %)
4.2
Exchange Rate (Re/$; average)
44.1
Source: www.economist.com
ThinkingCap
Annual Commentary
2006
Hemant Sreeraman
(hemant.sreeraman@gmail.com)
Hope\u2026can\u2019t substitute Reason.

goods and services. There are two major implications of this. The first, affects companies and stock prices and the second, inflation. I shall address both.

A growing economy benefits companies as demand goes up for goods and services. This results in companies using their capacities to the hilt to cater to the burgeoning demand. This virtuous cycle reaches a stage where companies find that they have to add to existing capacities to cater to the ever-rising demand. Couple this with a low interest rate scenario (discussed above) and one sees why it\u2019s a terrific time for companies to embark on capacity expansion. This is what\u2019s happening in the Indian markets of late. The process, which began roughly in the 2nd half of last financial year, has picked up momentum now. One can expect this to continue through the next financial year as well.

The second implication, inflation, is of a far more serious nature and affects companies and individuals to a great extent. We\u2019ll look at the effects 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, companies that produce goods and services are forced to cut the prices they charge customers. Else they are stuck with a lot of unsold items in their inventory. This leads to deteriorating corporate performance.

Seeing
the

slackening performance, investors cash out. They are discouraged by the lull in the economy and refrain from committing any more capital into the stock markets. This leads to a fall in the stock prices of companies. People start thinking more about the basic necessities than luxury\u2026

Whew\u2026the bottom line of the exposition is that, demand falls, price falls and Mr. Inflation (which can be defined as the general price level) goes off to sleep.

Seeing an in-the-hellhole-economy the powers that be decide to cut interest rates and push reforms. The cut in Interest Rates sets off a virtuous cycle that I had written about in earlier paragraphs. With time, the economy picks up and eventually starts booming\u2026and wakes up the fast asleep Mr. Inflation. Mr. Inflation then grows from strength to strength until a stage where the same powers that be \u2013 which were in a way responsible for waking him up \u2013 fall over one another to put him back to sleep! They realize that if left unchecked, Mr. Inflation is capable of bringing an economy to its knees.

This causes Interest Rates to go up, which gradually sets the stage up for the scenario played out three paragraphs above.

Mr. Inflation eats \u2018up\u2019 the purchasing power of your money. For instance - assuming an inflation of 5% - a thing that costs Rs.100 today would cost Rs.105 a year hence, due to Mr. Inflation. This is also one reason why investments are so important. They help one in keeping ahead of Mr. Inflation\u2019s reach. A return of 10% before inflation is taken into account would turn into 5%, after giving Mr. Inflation his due (5%).

Getting out of story mode, Inflation today is a definite concern for the powers that be (we\u2019ll call them RBI). Recognizing the effects inflation can have on the economy they decided to hike the Interest Rates.

The implication of this is easy to see by now. Higher rates mean lesser borrowing by individuals. Highly leveraged companies will feel the pinch, as their interest costs will be higher.

ThinkingCap
Annual Commentary
2006
Hemant Sreeraman
(hemant.sreeraman@gmail.com)
Hope\u2026can\u2019t substitute Reason.

This leads to a drop in net profits and EPS, assuming for an instant all other factors are constant. Dropping EPS means lower stock prices on the same P/E (Price = P/E x EPS). The net effect of all this is that the economy is prevented from over-heating and imploding. While this is a good effect, the market reactions to interest rate hikes is mostly knee-jerk in nature. Among other factors, an interest rate hike in May-June 06 was enough to send the market southwards by 25-30%.

On balance the RBI, while being optimistic about economic growth is also silently worried about the negative effects of inflation. I believe that there is some more interest rate tightening down the road, especially if inflation continues unabated.

After the super performance in the latest quarter, GDP forecasts for India have been raised to 8.7% for 2006-2007. Put in superior corporate

governance and reporting standards (although one could do with a bit more here!) and high ROE, and it is easy to see why FII are interested in 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 traced broadly during the last year. After beginning the year at 9000 odd levels, the Sensex rise continued rapidly, fuelled in no small part by eager FII. Suddenly everyone was looking closely at Indian markets. The good GDP figures, coupled with reasonable inflation, good general corporate governance standards, high Returns on Equity (ROE), were enough to make FII embrace Indian equities. Companies were beating analyst expectations pretty consistently and this led to stock upgrades. An illustration is in place.

Figure pertains to Section 1.2
Companies beat
expectations
Analysts
upgrade
estimates
Institutions load
up on equities
More FII follow
suit. Very bullish
on equities

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