The stock markets have seen extreme volatility led by a dramatic change in sentiment. At the heart of the crisis is the shift in global investment climate.

With interest rates across developed markets on the rise, investors are taking the flight to safety, thereby downgrading emerging market equities.

Even as the tide seems to be turning against the emerging markets, India - the most sought after market of them all in the past two years - seems to be getting bowled faster than one would have ever anticipated.

Since May 10, Indian equities have fallen over 25 per cent, leading the pack of losers among global markets. Experts cite the higher share of portfolio flows during the recent rally and high valuations relative to other emerging markets as the reason for the fall.

But Singapore-based hedge fund manager Samir Arora demolishes this argument. In a tete-a-tete with N Mahalakshmi, Arora explains why high multiples for Indian equities are justified. According to Savvy Manager (Arora's nick name since his Alliance Capital days), markets may be close to bottoming out.

India isn't expensive

One reason touted by regional analysts on India is that our valuations are higher than valuations of other comparable markets. India's price-earnings multiple is higher than other markets in the region, but so is the expected growth rate of Indian companies.

It does not appear in any way that the relatively higher P/E multiple for India is unjustified.

India has the best strength and breadth of companies among the emerging markets with companies in the sectors like software, engineering, consumer and pharmaceuticals including subsidiaries of MNCs listed on the local stock exchanges.

Most other emerging markets are dominated by companies in energy, materials, banking and technology (hardware) companies, which typically get lower valuations owing to their cyclicity and higher capital expenditure requirement etc.

For example, it is ridiculous to compare P/E of India with that of Russia and argue that the Russian market has lower P/E than India. The Russian Index is primarily weighted in energy and materials and, hence, the lower P/E for that market is logical and consistent.

In Indian indices, the P/E multiple is also inflated because of the presence of multinational consumer, pharmaceutical and engineering companies. Most of the branded consumer companies in the world are multinationals like Levers, P&G and Nestle [Get Quote].

Therefore, it is not possible to generally buy good consumer companies in most emerging markets. In India, investors can buy listed Indian subsidiaries of multinational companies.

Whether one likes it or not, these companies trade at valuations higher than domestic consumer companies (available in other emerging markets) with lower brand power. This increases the P/E of our market, but for entirely justifiable reasons.

Similarly, if investors want to play the theme of growing investments in the power sector in emerging markets, they can only buy utility companies. In India, the presence of listed companies such as Siemens, ABB and Ariva allow a more direct way of investing in the sector, though these companies trade at higher valuations.

Separately, it may be interesting to note that Bank of China, which is only one of many banks in China, has a market capitalisation higher than the entire Indian banking sector - private and state-owned banks put together.

India has got its due, not undue share

Year to date, India has received $940 million from foreign investors ($2.2 billion in cash market less $1.3 billion sold in the futures market). Foreign investors have invested a larger amount in Indonesia and more than double of this in Thailand year-to-date.

Last year, foreign investors infused more than $10 billion into the Indian markets. Many strategists argue that India got a disproportionate share of the inflows into the emerging markets in recent years. The country's share of inflows appears high when compared with its weightage in the global emerging market indices.

However, no one seems to ask a more basic question: Why is India's weightage in the index so low? This is because MSCI in its infinite wisdom chose to make 'free float' the key determinant for determining country and stock weights.

Three years ago, the weightage of Samsung Electronics in the global emerging markets index was higher than India's weightage in the same index. Now, is it not possible that investors around the world care for factors beyond 'free float' when choosing to invest in different countries?

Another factor that investors look at before investing in various countries is corporate governance. A March-2006 report on corporate governance in Asia and Australia - Beyond the Numbers - by Deutsche Bank ranks India second in Asia, on par with Singapore and next only to Australia.

Gold wealth effect ignored

At present, the two consensus trades of many strategists are long gold and short/ sell India. What these strategists do not appreciate, realise or even bother about is that Indians are the largest holders of gold in the world.

This is distributed more equitably than other forms of wealth, with the middle and weaker sections of society holding more gold relative to other assets.

The World Gold Council estimates that Indians own more than 15,000 tonne of the yellow metal. The value of this gold has appreciated by nearly $80 billion in the past six months. Considering the size of our GDP, this is a substantial number by any calculation and must be factored in by investment strategists.

Commodities can't be concern

In recent months, investors have been unnerved by the fall in commodity prices. What Indian investors do not appreciate is that commodity or material stocks are a very small part of the index.

Only 8 per cent of MSCI India Index is in materials stocks, but the same number is much higher for countries like Brazil and Russia. India is a developing country with huge infrastructure needs and investment.

Also, the country is a beneficiary of lower commodity prices for it is a net consumer and not a net producer of commodities.

Recent rally makes up for the past

Another reason touted by the bears is that the Indian market is up 300 per cent in the past three years, about 45 per cent of that can be explained by increase in earnings.

During the same period, trailing 12-month P/E increased from around 13 to 21. Since there was significant re-rating, that part of the gains must be evened out.

The logic of the bears is that markets should move in step with corporate earnings growth � although this is correct over the long term, there is no reason why this should happen over a three-year period.

Three years ago, it was an extraordinarily bearish period with the Indian market (excluding the violant moves due to the dotcom boom and securities scam) actually falling from some 3800 levels in May 1994 to 3000 in May 2003, despite steady earnings growth during the same period.

It is obvious that the year 2003 was a better time than any other time to buy Indian equities, but to benchmark the appreciation from that time and say that therefore the market has gone up too much is a weak argument.

Markets aren't really correlated

The business news channels everyday highlight the cues that they are getting from other markets. Investors look at overnight close of Dow Jones and NASDAQ in the morning along with how Asian markets are faring.

In the afternoon, everyone looks at how European markets are doing and we believe that we are faring in line with these global cues.

Although it may appear on a day-to-day basis that all markets are moving in tandem, looking at slightly longer data shows that various markets actually move quite differently from each other.

It is interesting to see that India has been the worst performing market among BRIC countries by a wide margin over all periods.

Markets may have bottomed out No one can exactly say whether the market has bottomed or not. A better way is to see whether the market will be higher than the current level six to 12 months hence. There are several vital signs which show that the market is somewhere close to bottoming out.

• All the good news is being ignored by the market - higher than expected GDP growth, the arrival of monsoons on time, growing FDI inflows (the $4 billion from IBM, for instance). The market cannot ignore these ground realities for too long.
• Since the market slump began, the open interest in the derivatives market has reduced significantly. This only suggests that the speculative positions in the market, especially the over-leveraged positions, are out. Plus the precipitious fall recently will make traders more cautious which itself will reduce overall risk in the market.
• The fall registered in May 2006 is the third-biggest monthly fall since 1994. Last month, the Sensex plunged 14 per cent, while May 2004 and March 2001 witnessed higher monthly declines at 15 per cent. The point to be noted is that after every big monthly fall, the market has invariably stabilised or recovered in the subsequent months.

Sensex Rise and Fall: Complete Coverage

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