FC Research Bureau

On August 18, the National Stock Exchange (NSE) announced the replacement of ABB, Idea Cellular and Unitech from S&P CNX Nifty with Bajaj Auto, Dr Reddy’s Lab and Sesa Goa, respectively, with effect from October 1.

It is not easy for a stock to become part of the benchmark indices — S&P CNX Nifty and BSE Sensex. The 50 stocks of Nifty, or the 30 of Sensex, together indicate the broad state of the Indian equity market. NSE, through its joint venture company with Crisil, India Index Services, carries out regular reviews of Nifty’s composition while the Bombay Stock Exchange does it for Sensex.

A sudden drop in liquidity is the most dominating reason for the replacement of stocks in the indices. NSE looks at the impact cost while BSE looks at trading turnover to judge changing liquidity patterns.

But should an investor offload stocks when they are excluded from the indices or buy the ones that make an entry to the benchmarks? Do more liquid stocks necessarily give more returns than less liquid stocks? An analysis of the stocks that have either entered or exited Nifty over the past three years reveals that new entrants have performed relatively better than the ones that were chucked out.

In six out of 10 cases, the excluded scrips gave lesser returns compared with the stocks that replaced them in the index. (see table).

“Index funds are generally major buyers of Nifty stocks. Retail investors play little role in impacting movements of such large-cap stocks. When a scrip is excluded from the index, index funds have to make similar adjustments and offload that particular stock to have exposure in the new stock. This helps the new entrant gain momentum,” said DD Sharma, vice-president of research at Anand Rathi Financial Services.

If the new entrants see compulsory buying by index funds, should retail investors also buy these stocks? “Fundamentally, scrips that enter an index like Nifty are sounder than the ones which have been excluded. Retail investors can invest in them looking at the sectoral performance and comparing them with the fundamentals of peer companies,” said Anita Gandhi, whole-time director at Mumbai-based Arihant Capital Markets.

In three out of nine cases in this analysis, incoming stocks performed worse than the outgoing ones. For instance, DLF came into Nifty on March 14, 2008, replacing Glaxo. The scrip has lost 67.52 per cent since then (see table) while Glaxo’s share price has doubled. Sometimes a stock is excluded when there are compulsory changes like delisting, mergers or other corporate actions. For instance, on June 17, 2009, Jindal Steel replaced Reliance Petroleum (RPL) as the RPL board of directors decided to merge it with Reliance Industries.

“It is true that index funds’ participation helps such stocks gain some momentum over a period of time. These stocks see buying from large buyers, particularly institutional investors,” said Pankaj Pandey, head of research at ICICI Direct.

However, changes in shareholding patterns before and after an index rejig do not reflect any clear preference for incoming or outgoing stocks.