The basic reason is simple -- a benchmark index does not represent anything other than the stocks in it. Krishna Kant explains what this means
Mention the stock market and the first thing that comes to mind is the BSE Sensex or its NSE cousin, the Nifty.
Their daily movements are so widely reported and tracked that for most, the retail equity market is equivalent to these two benchmark indices.
If these two are doing well, they take it as a signal to raise their exposure to equities or vice versa.
Investors often forget that the movements in indices such as the Sensex reflects the performance of its constituent stocks; nothing else.
An index rises or declines not because the entire market is moving but because of the movement in its specific stocks and their relative weightage in it.
At last count, around 4,200 companies were eligible for trading at the BSE, of which around 3,000 stocks are traded daily.
The Sensex, its benchmark index, constitutes the 30 top stocks. It’s perfectly possible that the Sensex moves in an opposite direction to the movement in non-index stocks.
Experts say the benchmark indices are, at best, a gauge of market sentiment, a lead indicator of economic activity.
The equity universe is much bigger and more diverse.
“The benchmark indices indicate the mood at any given time but tell very little about the money-making opportunity in the market. Investors need a stock-specific strategy to prosper in the longer term,” says Devang Mehta, head of equity sales at Anand Rathi Financial Services.
Real returns come only when investors follow a bottom-up approach and pick the right stocks.
“You should pick stocks with strong fundamentals that offer a strong case for growth in revenue or profit, either due to stock-specific development or industry dynamics,” Mehta adds.
This gets clear when we slice the Indian equity markets in its various components and compare their historical performance. In the past five years, the BSE Sensex has risen a cumulative 67 per cent.
The Nifty appreciated 66.4 per cent during the period (see table).
There was, however, a great divergence in the performance of various sectoral indices during the period, apart from individual stocks.
Pharmaceutical makers were the top performers, with the BSE Healthcare index more than tripling in the period, outperforming the broader market by over three times.
Consumer goods makers (both staples and durables) and information technology services companies also outperformed the Sensex by a big margin.
At the other end of the return spectrum were realty companies, metal producers, power companies and government-owned public sector undertakings (PSUs), which gave absolute negative returns.
In the middle were oil & gas companies, including some of India’s biggest companies such as Reliance Industries and Oil and Natural Gas Corporation.
Their valuations and stock prices remained static during the period. In short, the Sensex and Nifty represent only averages.
Too much of an emphasis on these would give a wrong picture of the market dynamics and churn that the economy and companies go through in a business cycle.
If we take a look at India’s top 200 companies, part of the BSE 200 index, 141 stocks provided positive returns to shareholders in the past five years.
A quarter (47 stocks) saw a decline in their share price.
The top five performers delivered 61 per cent to 112 per cent annualised returns during the period. The bottom five delivered 1.1-2 per cent annualised returns.
Among the losers (those whose share price fell), the top five saw a 25-30 per cent annualised decline in their share price in these five years.
Not surprisingly, most analysts take a stock approach in building their model portfolio.
“We largely follow a portfolio approach while advising clients and the portfolio is built one stock at a time.
We keep the market sentiments in mind but the factors affecting our target stock are always the biggest determinant,” says Dhananjay Sinha, head of institutional equity at Emkay Global Financial Services.
The argument in favour of a stock-specific approach becomes even stronger if we go deeper into the index management.
The way indices are constructed, they are disproportionately impacted by the volatility in sectors and stocks where they have the highest exposure. For instance, bank and financial firms are currently the biggest constituents of both the Sensex and Nifty, with nearly 30 per cent weightage.
This makes these indices susceptible to new flows and macro economic development that have a major impact on banks but might have only a small impact on real sectors of the economy.
Not surprisingly, among various sectoral indices, historical performance of the Sensex and Nifty are closest to those of the BSE Bankex and CNX Bank Nifty (see table).
The financial sector is, however, not the best value creator on Dalal Street.
It is a highly capital-intensive business, with regulatory mandates that link the permissible size of their business with their capital. Firms in other sectors face no such regulatory restriction.
The financial services sector is also pro-cyclical. Profits can rise and shrink quickly, in tune with the business cycle.
In good times, the profits would be large. If economic slowdown gets prolonged, losses in a bad year can wipe off years of profits, as is currently happening to government-owned banks.
Another problem with indices is that they capture market cap rather than changes in the stock price. But investors make money only when stock prices rise.
There could be a case where a company’s market cap rises but not its share price or that it rises less than the increase in the market cap.
The gap is common in capital-intensive and regulated businesses such as banking and financial services, power, construction & infrastructure, metals and utilities, where companies require constant infusion of fresh capital.
These companies regularly issue new shares to either new investors or existing shareholders, resulting in equity dilution and a cut in earnings per share, and a poor return on equity.
This weighs on their share price, besides making them vulnerable to the macro economic volatility.
For example, consider ICICI Bank. In these 10 years, its net profit grew at a compound annual growth rate of 19.6 per cent but growth in EPS was much lower, at 12.5 per cent in the period.
The gap accounted for equity dilution at a CAGR of 6.5 per cent in the period.
There is no such gap in companies such as Tata Consultancy Services, ITC, Dabur, Hero MotoCorp, Bajaj Auto, Maruti Suzuki and Hindustan Unilever.
Capital-intensive companies, however, always have higher weight in the indices.
This is because their capital base is larger and there is a greater number of shares to be traded. This ensures liquidity on the bourses, attracting high- volume traders that generate a fat trading fee and income for stock exchanges and brokerages.
It also makes them perfect candidates for creating derivatives products such as stock futures and options, that fuel even more trading in these stocks.
In comparison, there is no or little equity dilution in sectors such as consumer products, manufacturing, IT services and pharma.
This results in superior EPS growth and a high return on equity. The downside is their small equity base, lesser number of shares to trade and lower liquidity in these counters.
This reduces the chances of their inclusion in the benchmark indices, unless their size or influence makes it unavoidable.
It should be clear by now that benchmark indices are best for professional traders, who get a single instrument to bet on news flows that affect companies and the economy.
However, it is of little use to equity investors who wish to buy and hold. They make money when stocks in their portfolio rise in value, underpinned by a corresponding rise in their earnings and distributable surpluses (dividends).
Finally, companies enter the Sensex and Nifty when they emerge as sector leaders, not when they were growing the fastest. Inclusion in the benchmark index is recognition of a company’s past performance -- it doesn’t indicate their future potential.