Column: Fewer shares mean higher valuations, too

(DNA 20/04/2006) Mumbai - The Indian stock market's stellar run up since the start of 2006 by some 20% (even after falling 3.6% in the last week) raises the question: Are we in a bubble or is there more left in the fuel tank to propel the market higher?

While there are many factors that influence the value of individual stocks and the market as a whole, liquidity is the most powerful. Brokers estimate that the BSE Sensex trades at a financial year 2007 earnings multiple of 17 times (current price divided by forecast earnings). This places India in pole position as the most expensive market in Asia followed closely by Hong Kong at 15.5 times the forward earnings, even though the corporate growth levels expected from Hong Kong are higher than India for the same period. Indian stocks are clearly expensive, but are they likely to get cheaper?

The Indian growth story is well known and certainly helps to underpin the growth of the Indian stock market, which is up some 200% over the past five years, compared with 65% in China and 11% in the US. But it is important to consider the structural issues that may create an environment in which Indian valuations are always likely to remain high when compared with its Asian peers.

A legacy of Indian stock markets is that the publicly traded shares continue to have substantial promoter (founding family and possibly management) shareholdings, which severely restrict the pool of freely traded shares (free float) available in the market. On an average, only 60% of the shares available from the constituents of the BSE Sensex are freely traded. As investment funds chase these stocks, share prices get squeezed, causing overvaluation of the scrips. This concern has already promoted some mutual fund managers to cap the investment they can accept.

Does this mean that an Indian stock which is in demand and has a limited free float is likely to be considered expensive? Or, should investors accept they have to pay a premium valuation for access in a small marketplace.

By way of example, Wipro has consistently traded at a PE (price-earnings ratio, which is the share price divided by earnings) premium versus Infosys whose free float is five times larger. The limited free float here ensures that larger institutional investors who are seeking to invest their ever growing pool of funds have to pay up to be able to acquire a stock holding which would be able to make a meaningful impact on their portfolio.

Recent estimates put the flow of international funds alone into emerging markets at more than Rs 108,252 crore, year to date ($24 billion) as compared with Rs 91,563 crore ($20.3 billion) for 2005, which itself was a record. Most of these funds went into Brazil, Russia, India and China.

It's not surprising that these markets are up significantly in 2006. India's risk is that these funds could be withdrawn just as quickly, as better opportunities are found elsewhere. Fortunately, the increased volume of Indian IPO's will help absorb some of these flows but even today promoters tend to offer small percentages of their companies to the public.

However, corporate India's strength remains the significant promoter ownership of companies. What better barometer of a company's health and prospects than the level of investment held by those responsible for building the business? Furthermore, where promoters continue to acquire their own shares even at current valuations, as was the case with Crompton Greaves recently, investors should regard this as the optimum sign of confidence.

In the West, investors in the stock market are finding it increasingly challenging to motivate their management teams who typically have little skin in the game. Managers manage but do not share the risk of financial pain if they fail to perform. Surely, the substantial ownership of Indian corporates by promoters aligns their interests with the investors and justifies a premium valuation for the stock.

Looking at India as a standalone investment opportunity, the bedrock of promoter shareholdings actually gives India an edge over other emerging and many Western markets. The smaller free float is likely to keep the share price high during periods of excess liquidity but in turn, these higher valuations may be justified by the comfort factor new investors should take from the fact that the promoter has as much to lose, if not more, should the share price fall. Corporate governance may be poor in situations where promoters still command a majority vote but this can be protected by regulation rather than actual ownership.

By Nish Kotecha, founder of Sphere Partners (www.spherepartners.com) and president of TiE, UK (www.tie.org)