Equity Investing: Weapons of mass inclusion

It’s human nature to demonise things, which one can’t understand. There are examples galore of ideas that were scorned at first, but embraced later. Equities suffer from the same malaise. Those who have not understood equities and investing in equities condemn them as gambling and write-off any contribution that they could play in the country’s development.

Financial inclusion is a much-talked about concept these days, but I think people have not understood it well. First, we should understand financial inclusion in the right perspective. There are many people who say that half of India is unbanked and they don’t have a bank account. Will it be financial inclusion if we are to open a bank account and put some small deposit in it? Most likely, the account will be defunct soon, and this helps no one.

I believe that meaningful financial inclusion can be done by participating in equities. Let’s understand how and why it is important. The Indian economy, as most of us agree, is likely to grow by 8.5-9% in real terms, which is 13-14% in nominal terms.

As has been the pattern over the past three decades, agriculture will grow at a slower pace of 2.5-3% p.a. (as land is the limiting factor) and the industrial and services sectors grow at a faster pace of 10-11% p.a. in real terms of over 15% in nominal terms. This reflects in the corporate earnings that have average growth of 18% per annum. At that rate, equity investments double in about four years time, whereas bank deposits earnings at around 6-7% per annum will take almost 12 years to double. In these 12 years, investments in equities would have grown 8-fold.

Also, returns on equities by way of dividend and capital gains are either tax-free or attract lower tax rate compared with interest income. Sadly, a dominant part of this prosperity and wealth creation, fuelled by a booming Indian economy, is being enjoyed only by large foreign investors or a handful of high net worth individuals (HNIs).

If a small saver can multiply thousand rupees eight times vis-a-vis two times, we can imagine the kind of difference it can make to his post-retirement life, standard of living and also to that of his future generations. It is a pity that today, only 4% of the savings of Indian households get invested in equities.

No doubt, there exists the risk of reckless investments. But this is where a professional investment manager would help. He is someone who understands that it’s incorrect to paint ‘equities’ in general as ‘very risky’. There are different grades of risk within equities.

While investments in small- and mid-cap companies have a higher risk-return payoff, investments in blue-chips and large-cap liquid scrips are considerably ‘safe’ while providing decent returns. A professional investment manager can understand people’s risk appetite and help channel investments to the right kind of companies for an acceptable rate of returns.

Long term investors can invest now in Indian equities

While the GDP growth of 4Q has been a pleasant relief for investors, the question still lurking in their mind would be, is it sustainable? The good news in the 4Q GDP report is the strength in private consumption at 14% growth in 4Q in nominal terms despite the drought and the revival in the investment cycle with 25% growth in nominal terms in 4Q. I think this momentum will continue into FY11, and barring unforeseen circumstances, one can expect FY11 GDP growth of 8.5%. Private consumption and the revival in the investment cycle will be bigger contributors to growth in FY11, more than offsetting the deceleration in government expenditure, monsoons being the big wild card. On the flip side, however, such strong growth numbers would imply continued policy tightening from the RBI, in response to the inflationary pressures. I expect another 100bps hike in policy rates through the rest of FY11.

The sudden spike in the price of risk in early May has resulted in huge swings in currencies, commodities, equities and bond prices, with some key commodities declining 10-25% MoM. Perversely however, the fall in commodity prices will have beneficial impact on inflation and the current account. At current oil prices, FY11 current account deficit will be under US$30bn (<2% of GDP) and will be lower than that in FY10. This is a fairly modest quantum of deficit for a country of India’s size and I think it will be easily funded by even modest capital flows.

The worries over fiscal deficit have also abated with the highly successful 3G and BWA auctions. The extra revenue from these auctions will lower government’s fiscal deficit (and borrowings) by ~1ppt easing the pressure on long bond yields. This, coupled with prospects for normal monsoon and consequent easing of inflation will ease the upward pressure on interest rates – RBI will tighten rates gradually (~25bps hikes) rather than have to raise interest rates sharply in my view.

While the European Union is an important market for India’s merchandise exports (with a share of 15-20%, though it is declining), the share of the severely affected PIIGS countries is just 4%. The share of India’s services exports to these countries is even lower, in my view. Thus, I do not see a negative impact of the current European crisis unless the crisis spreads to the bigger European countries like UK, Germany etc. However, with the euro weakening significantly (it’s down ~15% against the rupee since the start of FY10), imports from EU into India (primarily capital goods and transport equipment) will likely increase.

Market valuations are currently trading broadly in-line with or a shade lower than historic average, leaving room for appreciation for long term investors. With macro fundamentals improving significantly and prospects for over 20% earnings CAGR over next two years likely, equity markets look attractive for investors with patience to ride out the intermittent bouts of volatility.

The Challenges of Regulating Financial Markets in India

Global recession and Indian regulations – what did we do right and what went wrong:

The Global recession that we have experienced and which was triggered by the subprime mortgage crisis has been a ‘one in a life time’ event, hopefully. I personally think that a regulator neither caused nor could have averted this kind of a crisis and the ensuing recession. This was not a scam or something illegal which could have been averted by a stronger regulatory framework. It was more a result of monetary and fiscal policies. However, a sound regulatory framework helps us to quickly understand such a crisis, develop appropriate regulatory response so that the impact of crisis is contained. It also helps improving the effectiveness of such policy measures such as stimulus packages etc and our ability to monitor the same.

Fortunately we have had a very sound regulatory framework in India which has helped us in mitigating the impact on our economic financial system. Having said that, I must say that our banking and financial systems are not as large or as complex as those of developed countries like USA and Europe and therefore a possibility of crisis of that magnitude does not exist. To give a very crude analogy, a bullock cart will be far less accident prone as compared to an automobile. While I agree with most commentators that the Indian regulatory framework has done a commendable job in managing this crisis however, we should be careful and not draw lessons which are not relevant for us. We do not need remedy for elements that have not impacted us, of course we need prevention.

There is another caveat in the tone that many speakers have adopted, that would suggest that US has failed in something we have been successful. Step aside for a moment and think about the kind of growth and continuous rise in standard of living that a US citizen has enjoyed for the last 50 years. If you ask them to go back in time by 50 years and have a restrictive framework which will not allow them to enjoy growth and increased standard of living but will enable them to avoid one crisis that will happen after 50 years, I am sure that they will choose to embrace the crisis but not give up on the pleasures of growth and consumption.

I remember about some 10-15 years back, Mr. Chidambaram had once stated that we do not need Comptroller of Imports & Exports but Developer of Imports and Exports. Similarly India needs today is developer of the capital market and I will discuss how important it is keeping in mind the agenda of financial inclusion.

Financial Inclusion

First, we should understand financial inclusion in the right perspective. There are many people who say that half of India is unbanked and they do not have bank account. Will it be financial inclusion if we are to open a bank account and put some small deposit in it. Most likely, the account will be defunct soon, and this helps no one.

I believe that meaningful financial inclusion can be done by participating in equities, let us understand how and why it is important. The Indian economy, as most of us agree, is likely to increase by 8.5% to 9% in real terms which is 13% to 14% in nominal terms. We all know that agriculture can grow at a slower pace and therefore industrial and services sector growth rate is expected to be higher, anywhere between 15% to 20%, which will also be reflective of corporate earnings expected to grow at say around 18% per annum. In such a case, equity investments can double in say four years time, whereas bank deposits will earn around 6% per annum which will take 12 years for the money to double. In these 12 years, investments in equities would have grown 8 fold. Now imagine that this share in prosperity and wealth creation because of booming Indian economy is only limited to foreign investors or a handful of high networth individuals. If a small saver can multiply thousand rupees 8 times vis-a-vis two times we can imagine the kind of difference it can make to his standard of living and also to that of his future generations. It is a pity that today only 4% of the savings by Indian households get invested in equities. No doubt there exists the risk of reckless investments but as described earlier so is the risk with an automobile. It should be made a part of public policy to drive higher penetration of equity investment and larger share of equity assets in a common households portfolio. And that’s where the regulator can play a very important role. Unfortunately in today’s environment, the scams hit the headlines and the commendable work by a regulator leading to growth in equity penetration and wealth creation at the lower stratum of the pyramid, goes unnoticed. Indeed, in the last 15 years, screen-based trading, removal of counter-party risk by settlement to NSCCL and dematerialization to depositories have played an immense role in driving up equity penetration in India and this has been aided by free flow of information and leveling of prices for retail investors through technology.

Micro vs Macro Regulations

It is important that regulators ensure fair play from both sides. I agree that brokers and intermediaries should have open relations with clients and ensure that they understand the product and the risk in trading. But there has been no protection from people who have malafide intentions, who willfully dupe or defraud investors, particularly the small investor. Today, there is no differentiation between small and large investors when it comes to practice.

While the panwala, my maid, my driver all of them understand that there are risks when it comes to investing in the stock markets, there are people who have spare money to give, say by way of Rs10lac or a higher amount, to a stock broker to speculate and leverage. But when things go wrong, these very people claim that they did not understand how market functions or provide other such excuses. I fully agree and appreciate that there should be protection to small investors and maybe rules can be made even more stringent in favour of small investors but there is no logic or justification for extending the same to all kinds of investors. A cash limit of one lac to five lac can be kept and there should be kept two separate tracks for investors and two separate levels of protections and rules.

Is incentivisation of financial products good or bad?

For any business which is not a monopoly, the regulator should have a limited rule in fixing the price. All advisors add value and therefore they have a fee. They need to build skills-sets and obtain a good training. There is a cost for that. All investors, including say some engineers or some pharmacists or some shopkeepers, cannot be expected to understand the financial products nor will have the time or inclination to know the same. If somebody else has to do that he needs to be reimbursed for his efforts. It is similar to a doctor getting paid for giving medical advice. There can be a doctor who can do a wrong caesarean or an unwanted kidney transplant and there are regulations to penalize him. But it does not mean that we take away the fee structure for the entire medical profession which is serving a very important purpose. However there is justification for unbundling, for transparency and disclosure of services. Therefore I think it has been a very welcome move to allow mutual fund transactions online and to separately disclose brokerage cost or commission paid. To continue the earlier analogy, it is like the doctors fee, which is not included in the cost of the medicines but paid separately.

Is speculation really bad?

Finally about speculation. There are many people who say that this should be regulated to control speculation risks and losses. At first we must understand that equity markets will have volatility and are prone to risk. Anybody who goes to play football should not say that I should not be pushed or I should not get hurt. People play knowing very well that there is a risk involved in this game and similarly a higher return can never be had without higher risk. Also speculation serves an important purpose. Speculation ensures healthy liquidity in the market and without speculation stock markets will be more like real estate markets and in that case, they would not have required an association like ANMI, nor brokers like us, nor a regulator like SEBI. But the fact of the matter is that this is an important vehicle for using capital for the country’s growth and that would work and sustain only if there is adequate liquidity in the market so that any person willing to buy or sell can do it with the least impact cost and in a hassle free way. I am sure that people consume alcohol or eat junk food know that it is not good for our health, but there are certain things that are required by human instincts and if you suppress them unnaturally then illegal means are adopted. For instance, wherever there is a prohibition we see illegal liquor trading erupts and that causes more damage than the good that is intended from the prohibition. Curbing speculation may result in a similar effect in the markets. I recall a small anecdote of my student days at IIM Ahmedabad. We had a project for a trader-cum-speculator to analyze his 20 years data. In a long presentation we proved to him that he usually loses money when he speculates. At the end of it we thought that we had convinced him to give-up speculation but he concluded that he would not give up the same because he enjoys it.