Spot the leader

Tags: Stock Market

Want to ride the index stocks? You must catch them before they even come into reckoning to represent the broader market. For, they tend to grow too big by the time they make it to the index, leaving very little for the late riser

Spot the leader
Investors and fund managers track the equity benchmarks closely and even allocate sizeable portions of their funds to stocks in the bellwether indices, especially those who manage large-cap or diversified portfolios. This is to ensure that their fund performance does not go completely out of tune with the way the benchmark indices move.

This is the main reason behind most funds’ exposure to Reliance Industries, the most weighted stock in the bellwether Sensex.

Similarly, investors also have a tendency to quickly add stocks that are included in the indices, when stock exchanges make such a change. This explains the sudden spurt in the prices of those stocks immediately after such a change is announced.

But the biggest challenge for investors and fund managers is to identify stocks that will come into the index before they are actually included. Simply put, identifying stocks before they catch the attention of the investing public as and when they become big enough to get represented in the bellwether index is one way to beat the market.

The constitution of the benchmark stock indices is done based on the weight of their market capitalisation. This means stocks that are not in the index have to run up significantly in the previous months (or years) to get included in the indices. For instance, Infosys Technologies was inducted into the benchmark index in 1998, though smart fund managers and investors identified it at least two years back in 1996 and benefitted from the rally.

The opposite happens too. Stock prices fall consecutively over several months before they get removed from the index.

When Reliance Communications was removed from Nifty on April 27, the stock price eroded massively and it proved too late for investors to exit the stock based on the NSE announcement.

A study by Ambit Capital, the Mumbai-based broking firm, which analysed Nifty inclusions and exclusions since September 1996, found that one year before their entry into Nifty, the stocks had given a median CAGR of 28 per cent, which goes up to as high as 38 per cent if three-year performance is taken into consideration. Stocks that got excluded also showed a similar pattern. They have fallen as much as 26 per cent in a year prior to their exit, and 19 per cent on a three-year basis.

The performance of a stock after its entry in Nifty was also revealing. After its entry, a stock gave just three per cent return in the first year while over a three-year period, the median CAGR was actually negative 9 per cent. Stocks that got excluded, fell a further 8 per cent in the first year, but actually gave 6 per cent positive return over three years.

As is clear from the analysis, by the time they were included, Nifty stocks had already outperformed significantly. While the outperformance persisted for another year, it was too small and was eventually followed by a far more meaningful underperformance over the subsequent two years, shows the Ambit analysis.

Similarly, stocks that got excluded from Nifty had already underperformed significantly by the time they got left out. While the underperformance persisted for another year, it was eventually followed by a significant outperformance over the two subsequent years.

“Overall, the exclusions outperformed inclusions by a median CAGR of 15 per cent over a three-year period from the point of their exclusion/inclusion,” the Ambit analysts said.

Rajiv Anand, managing director and CEO of Axis Mutual Fund, says the way the indices are constituted, which is based on market-cap weight, is flawed.

By the time a stock is fit enough to get inducted into the index, investors have missed out on most of the run-up in prices. “It is always a challenge for fund managers to identify stocks before they get into the index,” he told Financial Chronicle.

What makes life difficult for fund mangers is the frequent changes in the benchmark stock indices, meaning they are forced to churn their portfolios to reflect this within short time frames.

Sunil Singhania, head of equity investments at Reliance Mutual Fund, said there are positives and negatives in the methods used to constitute an index. However, he pointed out that the frequency of changes in the Indian benchmark stock indices is very high compared with, say, the US market.

Sample this. Of the initial 50 constituents of Nifty in November 1995, 44 per cent were out by April 2002. This ‘churn’ ratio was 48 per cent for the 10-year period beginning April 2002. The churn in the Indian market is almost twice as high as it is in the US market; it also appears to be higher in India compared with other large emerging markets, according to Ambit Capital.

“Of the 50 stocks in Nifty in 1995, 22 were out by 2002. Out of these 22, four belonged to the BFSI sector and three each to the automobiles, refineries and metals/steel sectors. Of the 22 firms entering Nifty by 2002, five belonged to the FMCG sector while four each belonged to the pharma and IT sectors,” says the Ambit report authored by analysts Gaurav Mehta and Saurabh Mukherjea.

What is clear from these trends is the replacement of economy-linked cyclical plays with defensive (or less cyclical) names, they pointed out.

Of the 50 firms in Nifty in 2002, 24 were out by 2012. Of the 24 firms exiting Nifty by 2012, barring FMCG (six firms) stocks, there was no obvious sector concentration. Among the entrants, four belonged to the BFSI, power and capital goods, while three belonged to the metals/steel sector.

The trend is a complete mirror image of the previous decade with economic cycle-linked names replacing defensives.

As many as 15 of the 24 stocks that exited Nifty during 2002-2012 were firms that had entered Nifty in the previous decade, underscoring just how hard it is to stay at the top of the Indian market for a sustained period.

Ambit analysts have stuck their neck out to predict the likely exits and entrants in Nifty over the next 10 years. The likely exits are HDFC, State Bank of India, ONGC, Axis Bank, Tata Steel, NTPC, IDFC, BHEL, Tata Power, GAIL (India), Jindal Steel, Hindalco Industries, Cairn India, Punjab National Bank, JP Associates, BPCL, DLF, Sesa Goa, Reliance Infra and Siemens.

More importantly from an investors’ point of view are the likely entrants over the next 10 years. According to the Ambit forecast, they would be Nestle India, Titan Industries, IndusInd Bank, Colgate-Palmolive, Glaxo Pharma, Bosch, Federal Bank, Dabur India, GlaxoSmith CHL, NMDC, Cummins India, Exide Industries, United Breweries, Cadila Healthcare, Oracle Financial Services, Castrol India, M&M Financial, Crisil, Torrent Power and Bata India.

Investors looking at these stocks need to first see if they have already run up significantly, in which case they can avoid them as a matter of caution and look at those which may not have seen a major rally by now. zz

rajeshabraham@mydigitalfc.com

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