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Why this bull market is for real

November 14, 2003

In a recent television interview, Reliance Industries chairman Mukesh Ambani categorically stated that his company is unlikely to raise fresh capital from the equity markets. On the face of it, this might seem like an innocuous assertion.

If, however, it reflects the sentiment of corporate India as a whole, there could be something to cheer about. I would argue that the fact that Indian companies are unlikely to make large cash calls on the stock market augurs well for the current bull run.

Here's why.

Let's start with a bit of simple economic theory. Stocks are no different from onions (or any other product for that matter) when it comes to the mechanics of their price determination.

Flood the mandi with a large supply and prices of onions crash.

Push up the demand for onions and prices move up. Substitute stocks for onions and you get a bull run when investors increase demand. Prices crash when there is an excess supply of stocks.

Given this basic mechanism, I argue that one of the reasons why stock market booms went bust in the past was essentially due to a huge rise in stock supply that came in their wake. The initial rise in demand was fuelled either by post- liberalisation euphoria (in the mid-nineties) or optimism about a specific sector like software in 1998-99.

The supply response usually took the form of IPOs (initial public offers) that hit the markets and absorbed investor savings.

Thus the initial rise in the demand for equity paper was completely swamped by fresh supply.

To take an example, when markets boomed in the mid-nineties, fresh equity supply of as much as Rs 30,000 crore (Rs 300 billion) came into the markets in just the two years of 1994-95 and 1995-96.

Although the rally in 1998 and 1999 was very narrow and fuelled almost exclusively by demand for Indian software shares , it nevertheless led to more than Rs 5,000 crore (Rs 50 billion) of new equity issues. As supply outstripped demand, prices naturally softened.

There is a sequel to this story. A good bit of the fresh capital that was raised during boom times either created large excess capacity or funded dubious projects. Thus, the fresh supply of paper not only suppressed stock prices, it funded activities that depressed prices and revenues.

As the business cycle wore out, profits declined dramatically. Some companies went bust in the process, leading to 'capital destruction.'

This found its analogue in the stock market and prices of stocks nosedived.

Investors, particularly on the retail side, burnt their fingers, became somewhat irrationally suspicious of stocks and perpetuated a bear phase.

Are things different this time around and if so, how are they different?

I would argue that ironically enough, the really positive thing going for the Indian stock market today is the absence of an IPO boom.

Despite the sharp recovery in the equity indices, Indian companies are clearly not making a beeline to raise money from the equity markets. This is likely to keep paper supply in check. There is a clear reason for this apparent apathy towards new issues.

Indian industry has just been through a phase of consolidation -- small unviable entities have shut shop or have been gobbled up by larger companies. In a scenario like this, fresh investments are likely to come from incumbent firms who have survived the shakeout. New firms, 'entrants', are unlikely to enter this market in a hurry.

Thus, the usual flurry of new companies that usually launch operations on the back of stock-price booms is unlikely to be there. This might worry some analysts but is actually a good thing. It means that investors might not have a larger menu of stocks to choose from but prices of existing stocks will have an upward momentum.

What about the possibility of equity issues by the 'incumbents' that can potentially have the same price lowering effect?

This is where Mr Ambani's assertion becomes important. Most large Indian companies like Reliance do not need to make a trip to the IPO market at this stage simply because they don't need to.

Almost all of them are sitting on large piles of cash that will take a while to exhaust. The accompanying table gives a sector-wise breakdown of cash profits, or the trove available to companies to fund investments.

These cash piles have resulted from a combination of improved top lines, a dramatic reduction in interest costs and improved treasury operations.

Is there a possibility of incumbent firms going on a huge capacity creation binge, creating an overhang of supply in the medium term that is likely to depress profits in the long-term.

The answer, fortunately is again in the negative.

The Indian corporate sector is just emerging from a phase of consolidation where the emphasis has been on raising output through the better use of assets.

Anecdotal evidence on investment plans of Indian companies suggests that there are hardly any plans for the creation of greenfield capacity.

The emphasis seems to be on working purely at the margin, de-bottlenecking existing capacity to make assets sweat harder rather than add to their stock.

This however does not mean that stocks will climb continuously. There will be episodes of correction when investors sell their stocks and book profits.

This will essentially be driven by perceptions of what constitutes a fair value for Indian equities and if prices cross this limit, investors are likely to sell some of their holdings.

Over the last few months, Indian stocks have run up more than most other emerging markets (The MSCI India index has risen 44 per cent compared to a rise of 39 per cent in the aggregate index) and it is quite likely that towards the end of this year, there will be some decline in prices.

However, as prices come down, investors will start buying again and in the absence of large fresh supply, prices will move to another peak and the bull market will sustain.

When will the bull run come to an end?

Clearly if excess supply is unlikely to depress prices, price appreciation will peter out when demand slackens.

Demand for Indian equity, both from foreign and retail investors depends on the health of the Indian corporate sector and there the prognosis is encouraging.

Broadly, two sets of things are happening.

Investors are beginning to appreciate the fact that Indian companies have seen huge gains in productivity over the last three or four years, driven by factors such as workforce rationalisation and inventory management.

This has led to better operating margins and profitability. Interest costs have also come down dramatically as a result of lower borrowing and falling rates.

The economy is in the middle of a cyclical rebound and the consensus is that this will last at least for another year-and-a-half. This is going to keep demand for Indian stocks stable.

In the absence of a huge overhang of supply, the bull-run is here to stay.

The writer is senior economist at the Crisil Centre for Economic Research.

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