ThinkingCap

Annual Commentary
2006

Hemant Sreeraman
(hemant.sreeraman@gmail.com)

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 Some comments are worthy here. The
market in 2006? encouraging trend of the services and
manufacturing sectors showing strong growth
indicates several things. The former captures
Economic Data: India (2005) growth in trade, hotels, transport and
communication. Companies that cater to these
Population (Billion) 1.1 industries, not surprisingly, made their
GDP (PPP in $ Trillion) 3.8 shareholders very happy.
GDP (Per Capita in $) 3,508
GDP Growth Rate (%) 8.4 Before this section peters down to a numerical
Inflation (Consumer Prices in %) 4.2
Exchange Rate (Re/$; average) 44.1
exercise, I shall introduce briefly on the
implications of a growing economy on individuals
Source: www.economist.com and companies. This, according to me, is of far
more importance than dwelling on numbers. So
let’s dive right in.
1.1: Macro factors strong
The Bull Run that began in 2002-2003 showed
no signs of abating in the year gone by. The During an economy’s expansionary phase,
macro economic factors strengthened further, interest rates tend to be low, thereby leading to
propelling India’s GDP (Gross Domestic Product) an increase in what experts call, ‘credit offtake’ (a
to an 8.4% growth over 2005. jargon that can be loosely replaced with ‘loans’).
The low interest rates imply that individuals like
In the latest quarter (Jul-Sep 06) the economy you and me can borrow more than we previously
grew a whopping 9.2% over the corresponding imagined. This leads to growth in loans, which is
period last year. Significant contributors to this positive for banks and financial institutions. Low
growth were the Services sector, which grew interest rates also mean that companies can
14% followed by Manufacturing, which posted a access low cost capital for capacity expansion.
growth of 12%. Agriculture though proved to be a
laggard, growing a meager 2% over last year. A growing economy also increases demand for

Hope…can’t substitute Reason.


Annual Commentary
2006
Hemant Sreeraman
(hemant.sreeraman@gmail.com)
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’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 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’ll 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…
Hope…can’t substitute Reason.
ThinkingCap
Whew…the 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…and wakes up
the fast asleep Mr. Inflation. Mr. Inflation then
grows from strength to strength until a stage
where the same powers that be – which were in
a way responsible for waking him up – 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 ‘up’ 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’s 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’ll 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)

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.

Analysts
upgrade
estimates

Companies beat Institutions load

expectations up on equities

More FII follow

suit. Very bullish
on equities

Figure pertains to Section 1.2

Hope…can’t substitute Reason.


Annual Commentary
2006
Hemant Sreeraman
(hemant.sreeraman@gmail.com)
This cycle, which began in 2003 continued and
lot of foreign money flowed into India. A we-will-
not-tinker-too-much stance from the Finance
Minister in the Union Budget didn’t upset the
applecart. One could hear the, “long-term growth
story is in place” almost everywhere.
It seemed little could go wrong…
And then the crash came…
In a matter of weeks the markets tanked 25-30%.
The reasons behind the fall in itself is an
interesting and vast topic best relegated to a
discourse elsewhere and at some other time.
Part of it came about from the rate hikes and part
from over-leveraged individuals and FII who
wanted to extract maximum bang for their buck
invested in Indian equities.
If you are wondering why there is the odd blue
shading in this section title, it is for good reason.
The fall was one of the best times in years to buy
into stocks of companies. Temporary stupidity
and over reactions presented a golden
opportunity to buy pieces of fantastic businesses
at attractive prices. This was the best time to go
stock shopping.
In a knee jerk reaction, the markets dumped
businesses, which had got better over time.
However, sanity prevailed and the markets
began its trot towards 14k with aplomb, turning
people bullish along the way. No sooner had it
touched 14k that ‘experts’ were predicting 15k
before March 07.
And then the crash came…once again…
The CRR (Cash Reserve Ratio) hike in
December gave the Sensex the shivers and it
crashed almost 1000 points in 3 days. This is
what transpired during the fall. A day by day walk
Hope…can’t substitute Reason.
ThinkingCap
through.
First day – Down 200 points
Everyone said it was a ‘technical’ correction and
there was nothing to worry about.
Second day – Down 400 points
About 30% of the people who opined on the first
day turned ‘mildly bearish’ and suddenly began
theorizing about how ‘hot’ Indian equities were.
Third day – Down another 400 points
This was enough to provide ‘proof’ for the Bear
Hypothesis. About 60% of the people from the
first day became bearish. They started predicting
a bigger fall in the days ahead and took money
out of the markets.
Fourth day – Up about 200 points
Ah! The long-term growth story was in place still,
wasn’t it? The fall was just FII ‘churning’ their
portfolios during year end. There was nothing to
worry about. Thinking about buying (and changing
opinions)
Fifth Day – Up (some 3 figure points)
The long-term India story is…let’s Buy!
Sixth Day – Up…well…
The lon…BUY BUY BUY!
It seems like I love taking a dig at directional
traders. That digresses from a larger issue.
I cannot fathom how quickly the ‘experts’ alter
their opinion about the markets based on how
markets move, not on how the underlying
businesses that represent the stocks they hold
move. A continuous fall gets them itching to sell,
even when the businesses are on sound footing.
It also reflects the ultra short term outlook most
people have when investing in equities.

Annual Commentary
2006
Hemant Sreeraman
(hemant.sreeraman@gmail.com)
The general feeling I get from my interactions
with people is that most hold the view that trading
is counter productive. But they just can’t seem to
hold off the urge to trade. The verbal volleys
around them entice them to do something that
they shouldn’t be doing. And trading is a zero
sum game. The broker and another lucky trader
Most sell because the technical indicators
scream a sell and they buy later for the same
reason, after some ‘direction’ has been
established. What they fail to take into account is
the charges that are involved in the trades. Sure
they aren’t very large but they exist. And more
often than not, the subsequent buy is higher than
the sell, and if unfortunately, the market reverses
direction to move down, the losses magnify.
Nobody can predict tops or bottoms in the
market. But a ‘businessesque’, as opposed to a
‘traderesque’, thought process would have
Hope…can’t substitute Reason.
ThinkingCap
on the other side of the trade get richer as the
individual gets poorer.
An illustration is appropriate here…
indicated buying more of the stock during the fall.
The costs are less and if indeed the markets
moves up the investor makes a lot more money.
The losses mount if the markets continue their
southward journey, but a staggered buying takes
care of this problem to a large extent. The crux
here is…conviction.
The common retort that people give to this is,
“how does one know what a business is worth?”
Sure that is a difficult question to answer. But if
one cannot answer that then, in my opinion, it
doesn’t make any more sense to trade, again
 ThinkingCap
Annual Commentary
2006

Hemant Sreeraman
(hemant.sreeraman@gmail.com)

based on some indicators which the investor people to ‘lock in’ to their real estate investments
knows as much about as he knows about at current levels.
businesses! I think caution is the buzzword here. (I may have to
eat my words next year!)

1.3: Thoughts on Real Estate

The year saw maddening investor interest in real
estate. Suddenly from nowhere, stocks of real
estate companies soared to the heavens. It
seems the rising stock prices lead to a rise in the
estimates of land banks owned by real estate
companies! DLF’s mega IPO was scrapped due
to adverse market conditions and is slated to hit
the markets soon as conditions are better. Some
other IPOs got phenomenal responses and, not
surprisingly, saw their listing prices soar, making
promoters and investors very rich.
Looking at this scenario, I think investor
expectations have run ahead of reality. The
prices have been bid up so high that it will take a
superlative performance from the real estate
companies to justify the valuations. A big
question mark hangs over my head on this issue.
I hope investor expectations do not encourage
companies to resort to creative accounting to
meet expectations.
1.4: Conclusion
I think a combination of concerns over
inflation and optimistic outlook towards
Indian equities will usher in a new year. The
nearing elections will probably see the
government trying to juggle political and
economic considerations. Petrol and diesel
prices have already been slashed. While this
is good from a political standpoint, it’s a
disservice to economics. The sooner the
government realizes it the better it is for the
economy.
Apparently the Indian market has an 80%
correlation to the S&P 500 index. Almost
everyone is portending gloom and doom for
the US economy. It will be interesting to see
how the Indian market will react, should a
slowdown really occur in the US.

I have paid dearly for keeping out of this space Whatever the outlook, the markets will
during the last year. But I hold my view and will provide opportunities to buy chunks of great
not enter this space in the near future. I don’t businesses at attractive prices.
want to get caught waiting for a greater fool to
bail me out. I prefer to wait till then (and indulge in investing
astrology if the markets are unkind enough not to provide
However, my feeling is that investor interest will me with any opportunities!).
continue to remain high in the coming years and
prices might go up further. A plethora of real
estate funds slated to hit the markets may only
exacerbate the situation.

As a sidekick, I feel real estate prices have also

moved up far too quickly in certain areas. A
combination of over optimism and fear is forcing

Hope…can’t substitute Reason.