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Has India's stock market hit its top?

While the runup in shares has been good for investors so far, some market veterans are feeling uneasy, CAROLYN LEITCH writes

They shouldn't have sent the nagarawalas home.

As stock exchange officials in Mumbai waited last month for the sizzling Bombay Stock Exchange's Sensitive Index to hit the 10,000 mark, they hired a group of local drummers, called nagarawalas, to celebrate the milestone in rhythm.

But dejected officials dismissed the drummers when the index stalled, local reports say.

Last week the nagarawalas were nowhere to be seen when the Sensex 30 climbed above 10,000 to a record with a little less commotion than originally planned. Still, for investors who bought in early to the country's rapacious growth story, the market's 39-per-cent total return in U.S. dollar terms in 2005 is likely fanfare enough.

But while the runup in the stocks has been good for investors so far, some market veterans are feeling an uneasy sense of déjà vu. Money floods into a hot market, only to push stock valuations past the most optimistic growth projections.

New York-based Pablo Salas of Trilogy Advisers LLC points out that India now has the highest valuation in the emerging markets universe.

Even compared with well-heeled New York and London, stock prices look rich, says Mr. Salas, who manages the $163-million CI Emerging Markets fund.

"Now when you look at valuations of some of these companies in India relative to other markets -- not only emerging markets but really even developed markets like Europe or Canada or the U.S. -- valuations are not as attractive."

The price-to-earnings ratio for the Sensex is about 18 times forward earnings, he notes.

The multiple for the U.S. benchmark, the Standard & Poor's 500-stock index, is about 15.

"So it tells you that investors are expecting a lot out of companies in India. If for some reason those companies deliver slightly below what people are expecting, you could see a correction in those stocks," Mr. Salas says.

That downturn could come even while fundamentals remain strong if expectations get a little too lofty, he says.

"I think the risk to investors could come more from the expectations built into stock prices. . . . I think you've seen that in many markets in different parts of the world in history."

Christian Deseglise, project manager, global emerging markets at HSBC Halbis Partners (USA), says he is taking a "cautious" view of India's markets now that international money flowing into India has pushed valuations so high.

"They have been collecting a lot of money," Mr. Deseglise says.

He figures about three years worth of corporate earnings growth has already been priced into the market. Meanwhile, stocks could be vulnerable.

"Negative news could create a correction."

HSBC offers a "BRIC" fund that buys into the high-octane markets of Brazil, Russia, India and China. While HSBC believes all four emerging powerhouses have tremendous long-term potential, they expect leadership to shift around from time to time.

"We can vary that exposure very aggressively," Mr. Deseglise says.

At the moment, he says, the fund has its lowest exposure to India since inception about 18 months ago. The weighting now stands at about 16 per cent, compared with 23 or 24 per cent in the past.

Meanwhile, the fund's weightings have jumped to 30 per cent for China and 28 per cent for Russia.

"Our country bets are in China and Russia," he says of the shorter-term outlook.

Mr. Salas of Trilogy also still likes the long-term prospects for India -- the country's swelling middle class, market reforms and robust economic growth will attract investors for years to come.

It's just that he's finding better stock bargains elsewhere. He points to South Korea, for example, where he places the fund's heaviest weighting of 14 per cent.

"As an investor or portfolio manager looking at the region, you're having to become increasingly selective when you're looking at the Indian market."

Over all, Mr. Salas has actually been trimming his holdings in India. The country's stocks now account for about 5 per cent of the CI Emerging Markets fund, which is down from as much as 8 per cent last year.

One area where he has been taking profits is the financial services sector.

Mr. Salas believes it's one of the most attractive sectors around for potential growth: Consumer credit penetration is only about 20 per cent of gross domestic product. In some developed countries, that figure is more than 100 per cent.

"You're very early into the development of the credit culture -- particularly at the consumer level," Mr. Salas says.

By contrast, in South Korea, bank stocks are once again a good deal after that country's credit cycle bottomed out.

In India, HDFC Bank is one of the best-run private banks in India, the manager says. But after a strong runup in the stock, Mr. Salas sold HDFC and other bank shares. Now his only position is in State Bank of India.

The government-controlled bank is improving its disclosure, governance and efficiency, Mr. Salas says, with a return on equity of about 19 per cent. For many banks, an ROE of 16 per cent is considered healthy.

Similarly, Mr. Salas has lightened up in the software sector. Infosys Technologies Ltd., which also trades on the New York Stock Exchange through American depositary receipts, is something of a bellwether for India's information technology stocks. In New York, the ADR has soared to about $75 (U.S.) from the $20 level in 2003.

"It's hard to see much upside."

Mr. Salas has also sold stocks in the pharmaceutical and mobile telecommunications industries.

In Canada, Rohit Sehgal, chief investment strategist for Dynamic Mutual Funds Ltd., sees investing opportunities in India that he can't find anywhere else.

The manager of the $1.4-billion Dynamic Power Canadian Growth fund has about 5.7 per cent of the fund's holdings in India.

Mr. Sehgal is not so worried about valuations.

"I don't think that's a big concern because the earnings growth has been better than expected so we're seeing more positive surprises."

Mr. Sehgal points to India's sugar industry, for example, where he has had good success. India and Brazil are about the only two places in the world where investors can buy into publicly listed sugar producers, he says.

He has also recently purchased shares of Ashok Leyland, which is seeing sales of its trucks grow at a fast clip along with the country's burgeoning infrastructure.

The central bank's move to edge up a key lending rate last month doesn't worry him because that only proves economic growth is accelerating, he says. The bank also slightly raised its target for economic growth this fiscal year to between 7.5 and 8 per cent.

Meanwhile, inflation is under control.

Ajay Argal and Jayesh Gandhi of Birla Sun Life AMC Ltd., portfolio managers for the $128-million Excel India Fund, are also optimistic about India's economic and market prospects.

The managers have increased their exposure to capital goods, banks and automobiles.

As one sign of growing prosperity, Indian consumers have started buying more cars and the managers have made a similar move in their portfolio.

"We have shifted to four-wheelers from two-wheelers."

They point out that the historical average forward price-to-earnings ratio has ranged from about 9.5 at rock bottom to about 22. Currently the market's valuation is in the middle of that range.

"The valuations don't look cheap here but the growth rate is also stupendous."

Mumbai express

India's benchmark index has many investors cheering, but others fretting: A flood of foreign money into one of the world's best performing markets may have pushed some stock prices higher than is warranted by the outlook for earnings.

CI Emerging Markets Fund

CATEGORYEmerging markets equity
TOTAL ASSETS$163-million
MANAGEMENT EXPENSE RATIO2.81%
GLOBEFUND 5-STAR RATING SYSTEM****

Returns to Jan. 31, 2006

1-year simple rate of return38.0%
3-year compound annual23
5-year compound annual7.4
10-year compound annual7.3

Top 10 holdings As of Dec. 30,2005

1Taiwan Semiconductor3.60%
2OAO Gazprom ADR3.3
3Samsung Electronics3.1
4Petroleo Bras Sa Petro2.8
5Kookmin Bank2.5
6Hon Hai Precision Industry Com2.4
7Massmart Holding2.2
8Shinsegae2.1
9Far East Energy2.0
10Old Mutual PLC1.9

Excel India Fund

CATEGORYEmerging markets equity
TOTAL ASSETS$127.9-million
MANAGEMENT EXPENSE RATIO3.51%
GLOBEFUND 5-STAR RATING SYSTEMHHHH

Returns to Jan. 31, 2006

6-month compound annual17.60%
1-year simple rate of return32.5
3-year compound annual49.5
5-year compound annual16.4

Top 10 holdings As of Dec. 30,2005

1Bharti Tele-Ventures 5.30%
2Hero Honda Motors4.3
3State Bank of India4
4Tata Consultancy Service3.5
5ITC3.4
6McDowell & Co.3.3
7Larsen & Toubro3.3
8Pfizer3.1
9Satyam Computer Services2.8
10United Phosphorus2.7

Mumbai Sensitive 30

Yesterday's close: 10,110.97, up 66.15

Best and worst performing stocks

TOP FIVE

12-MONTHS

Larsen & Toubro133.27%
Bharat Heavy Ele.124.53
Cipla103.66
Bajaj Auto103.55
Satyam Computer84.40

BOTTOM FIVE

12-MONTHS

Tata Consultancy20.81%
Grasim Inds.16.36
Reliance Energy6.59
Tata Steel- 2.53
Ranbaxy Labs.- 17.18

SOURCES: GLOBEFUND.COM AND BLOOMBERG FINANCIAL SERVICES

© 2007 The Globe and Mail. All rights reserved.

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