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The stock market has become more volatile and it’s quite difficult for retail investors to take a smart investment decision. During such times, switching to scrips of companies with smaller FII exposure could be a smart move for investors, say Krishna Kant and Ramkrishna Kashelkar

RETAIL investors should have learned their lessons from the market crash of 2008-09 as they gear up to face the economic turmoil in the European countries. While we prescribed a list of companies expected to help investors weather the storm last week, we highlight another investing pitfall, that investors should do well to avoid. It is a common mentality of retail investors to ‘follow the biggies’. Invest in shares that foreign investors are buying. After all, with all their financial acumen, research prowess and ability to catch long-term trends, following their trail in investment decisions should bring good returns, right? The strategy might be useful when the going is good, but not so in a volatile market. Empirical evidence suggests that the scrips with higher FII exposure tend to underperform in a falling market. This is logical. Most FIIs follow strict exposure limits to emerging markets and have to liquidate their holdings in India if the value of their global portfolio starts shrinking. As a result, we see the Indian markets tanking in response to a fall in European or American markets. It is for this reason that investments in companies where FIIs hold a large stake becomes risky during the uncertain times. We had witnessed all this during the period of January 2008 – March 2009 when over Rs 60,000 crore of FII money flew out of the country on the back of the sub-prime crisis in the US. One can legitimately suspect if a similar thing is going to happen in the coming months, particularly after FIIs took out more than Rs 9,000 crore in May 2010 alone. Investing along with FIIs can be beneficial when the going is good. Firstly because FIIs mostly invest in financially and operationally sound companies, Second, their exposure is mostly in liquid counters where entry and is easy and cost-efficient. A high FII holding brings visibility to the company and valuations tend to go up. But when it comes to the current volatile times, the opposite stands true. A sudden exit by FIIs can bring down the valuation of such companies faster than the overall market.

An analysis of the stock performance and FII activity in the Nifty and the Nifty Junior companies during the January 2008 – March 2009 period supports our assumptions. The companies with higher FII stakes indeed underperformed grossly.

METHODOLOGY
We skimmed through the FII holding patterns from the December 2007 quarter, which was the peak of the bull-run, to March 2009 when the markets hit the bottom and a turn around began. To understand the real impact of FII moves on the stock prices, we calculated the FII’s stake as a proportion to the floating stock of the companies. Thus, a 5% FII holding in a company where promoters hold 80% equity gives it control over 25% of the floating stock. Here the FII’s moves are likely to have more impact on the stock price than in a company with a 50% promoter holding. Since insurance companies, including LIC, also invest with a long time horizon, we also excluded them while calculating the floating stock.
Then we checked the stock market performance of these companies during the December 2007 to March 2009 period, juxtaposing it with the FII activity. The findings clearly highlight the risk associated with high FII holdings in a downturn. Where the FIIs controlled more than half of a company’s floating stock, there was 87% chance that it would underperform the market in the downturn. Just four companies — Bharti Airtel, Container Corporation, Hero Honda and NTPC — could beat the market between December 2007 and March 2009 despite FIIs controlling the majority of floating stock.
If FIIs controlled more than 40% of floating stock of a company in December 2007, there was a 62% chance that the scrip would have underperformed in the downturn. Where the FIIs sold more than half of their holding in any company during this period, the crash in market capitalisation was over 70% as against around 55% fall in the BSE Sensex.
In 46 companies, where FIIs sold less than one-fifth of their initial stake or increased their stake during the December 2007-March 2009 period, the average fall was muted at around 42%.
All these findings point towards one important thing. While a retail investor looks at the financial and valuation parameters apart from the industry outlook etc in making an investment decision, a closer look at the shareholding pattern is also necessary. It will be a smart move in the present volatile times to shift investments to companies where FIIs outflows cannot affect the valuations.
To provide a point of reference, we have given lists of companies where the FII holdings as a proportion of the floating stock was highest and the lowest as on March 31, 2010. While the companies, such as Indiabulls Real Estate, DLF, HCL Tech and PNB, figure in the first list, Syndicate Bank, ITC, NTPC and L&T are in the second list. The average performance of the companies with higher FII exposure is already below that of the Sensex in FY11 so far. While those with less FII exposure are doing well.
While it will be audacious to claim that such shares won’t fall in a weak market, one can surely conclude that the likelihood of them outperforming the downturn is quite high.