Take your cues carefully from FII trends

Want to pick up some of the stocks that FIIs fancy? Don't do it blindly for the risks may be high.

Do you continue to hold yester-year education player Aptech and or wind equipment maker Suzlon Energy, which had a field day until 2007 but were battered in 2008? If you are fondly hoping they will go back to their 2007 levels, your hopes may well be dashed. Four years hence, these stocks are still trading at half their March 2007 prices, thanks to unceremonious dumping by FIIs. This is typically the kind of fall mid- and small-cap stocks are vulnerable to when FIIs lose interest in them. It is one key reason why retail investors have to be wary of blindly following FIIs in selecting stocks for their portfolio.

It has to be said, though, that stocks such as Shriram Transport Finance Company or City Union Bank, in which FIIs meaningfully hiked stakes (over 10 percentage points) in the 2007-11 period, have delivered phenomenal returns that less fancied stocks could not have matched. So, if you are a retail investor wishing to follow FII footsteps, what precautions should you take? Read on to know how to decipher the FII ownership trends.

FII stronghold

A look at the BSE-500 ownership pattern suggests that FIIs held as much as 15 per cent of the full-market capitalisation of the BSE-500 and a whopping 35 per cent of the free-float market cap as of March 2011, thus providing them considerable influence over stock markets. Domestic institutions (mutual funds and insurance companies), on the other hand, held a more modest 21 per cent of the free-float market cap. It is for this reason that FII trends cannot be ignored in the Indian context.

Sector trends

Let's first look at the long-term FII trends (in sectors within the BSE-500) to know sectors that have moved off the FII radar and those that are gaining ground. If we were to take the total allocation of the FIIs in BSE-500, and sift through the holding between the last four years from March 2007-2011, the most striking feature is the FIIs' heightened interest in non-banking finance companies and investment holding companies.

Their overall stakes in this sector were hiked from 5.5 per cent in March 2007 to 10.5 per cent in March 2011, making it the third most preferred sector of FIIs in the BSE-500 universe. The increase though was substantial only post March 2009. Aside of NBFCs, refineries and, more recently, steel and non-ferrous metals (following the commodity rally) as well as trading companies (such as 3M India, Adani Enterprises) are sectors in which FIIs have upped stakes within their overall portfolio allocation.

Among those that lost FII favour, the most conspicuous was telecom. From 9.5 per cent allocation in March 2007, this number dwindled to 3.2 per cent, thanks to both fundamental and governance issues in the sector. Brokerages and realty, too, dwindled to insignificant levels dragging the share prices of stocks in this segment to new lows. Interestingly, infrastructure developers continue to attract FII interest despite slack financial and stock performance. If these are the trends, what should a retail investor make of it?

Take the case of NBFCs. The sector has been re-rated rather swiftly, rather like the brokerage and realty stocks in 2007. And the fate of realty or brokerage stocks in the 2008 meltdown is well known. With demanding valuations prevailing in some of the NBFC stocks, investors would do well to be cautious in such sectors and book profits on rallies.

Similarly, sectors such as auto and cement and capital goods have been the more volatile FII fancies, with holdings being constantly churned. IT too, is one of the first sectors to be dumped in a downturn and also among the first in which FII picked stakes. In the FII's BSE 500 portfolio, the IT holding was anywhere between 8 to 15 per cent in the last four years; much of the churning pertaining to mid-cap IT. It is noteworthy that IT receives only 10.4 per cent sector weight in the BSE 500. Clearly, the FIIs tend to go overweight on the sector, thus having a higher influence on stock movements.

So are there any sectors where the FIIs have held reasonably steady? FMCG and pharma appear to be the most dependable on this count. With FII portfolio allocation varying within a safe 2-4 per cent in each of these sectors, they appear to be less under the influence of FII buying and selling. In both these sectors the FIIs have lower allocation compared with the BSE-500 weights.

The infrastructure sector, on the other hand, appears to be among the more promising space from the FIIs' perspective. The quiet accumulation of select stocks such as L&T and GMR Infrastructure and Engineers India at relatively low valuations appears to suggest that the sector may be turning ripe to deliver returns.

Mind the mid-caps

Sector trends apart, investors also need to be mindful of the market cap bias of the stocks they own. Even in FII overweight sectors/stocks, large-cap stocks are less affected by FII selling compared with mid-cap stocks. Take the case of large-caps Voltas or HDFC. FIIs reduced their stake by 10 percentage points in these stocks over the last four years. The stocks nevertheless went on to deliver over 20 per cent returns compounded annually.

The same though was not true of another capital goods company Jyoti Structures, in which FIIs reduced stakes by over 14 percentage points in the above period. The stock is still trading at half its March 2007 price despite sound financial performance. Stocks such as IVRCL or Gammon India, which, despite heavy selling, continue to have high FII stakes, have seen sharp volatility in their stock movements since the 2008 downturn and their stock price has declined over the years. Constant FII churning, also affected these stocks.

Apply this rule to stocks where FIIs are now upping their stakes. Large caps IDFC or Hindalco, for instance, may well bear the pain of any FII selling, given that FIIs have not jumped in to these stocks; the accumulation instead has been steady with the stock climb being gradual, backed by earnings growth. The same may not be entirely true of mid-caps such as Manappuram General Finance & Leasing or LIC Housing Finance that have caught the FII fancy in recent times, delivering astronomical returns of 135 per cent and 69 per cent compounded annually! Any steep hikes in FII ownership in mid-caps would, therefore, require caution, especially when the valuations appear stretched; while you may rest easy in the case of large-caps as long as they are fundamentally sound even if it means enduring a short correction.

Is there domestic support?

If you have still gone ahead and bought the mid-caps fancied by FIIs, be sure that there is some domestic institutional holding to support the stock as well. In other words, do the FIIs' domestic peers — mutual funds and domestic insurance companies (DIIs) — hold sufficient stakes in the stock and can they provide some buying support in the event of FII selling?

This was not the case with SKS Finance. With DIIs holding 5 per cent at the time of listing (and later reducing stakes further), this stock had a free fall ever since allegations of mismanagement broke.

Jain Irrigation Systems, Ansal Properties & Infrastructure, Anant Raj Industries or NDTV are some of the stocks where the domestic institutional holding is really low compared with the high FII ownership.

Source: http://www.thehindubusinessline.com/features/investment-world/article2077024.ece?homepage=true