If you take either one of our two frontline equity indices-the Sensex or the Nifty-you will find that they churn by over 50 per cent over a ten year period. That is to say, if we begin a decade with 30 stocks in the Sensex, by the end of the ten year period, less than 15 of those stocks are in the Sensex. This churn ratio was below 15 per cent in the 1980s but has steadily risen over the last 20 years. Moreover, compared to other large Emerging Markets or compared to the Western markets, the Indian market churns much more. Although other markets do churn, the degree of churn pales compared to India. For instance, the Dow Jones (USA) has 23 per cent churn, the Hang Seng (Hong Kong) has 30 per cent churn and the Bovespa (Brazil) has 39 per cent churn). So why has the Sensex's churn gone up so sharply in the last 30 years? And why does the Sensex (or for that matter the Nifty) churn so much more than any other large stock market in the world?
Let's begin with why the Sensex's churn has gone up over the last 30 years. Back in the 1980s, when the License Raj prevailed, the Indian economy was fairly ossified. Unless you turned up in New Delhi with truckload full of goodies for the powers that be, your company did not go anywhere. As a result, in that era hardly any companies exited the Sensex (and hence hardly any companies entered the Sensex). You could say inertia was the only constant in the 1980s resulting in the Sensex constituents to be fairly consistent for a long time.
Then 1991 came and Manmohan Singh's “New Economy Policy” was unleashed on India. Over the next ten years the Sensex churned by 63 per cent as a host of stalwarts from the License Raj tumbled out of the Sensex. So out went Hindustan Motors and Premier with their cars from a bygone era. Along with them a slew of textile companies-Bombay Dyeing, Century Textiles, Futura Polyester,-also found themselves ejected from the Sensex. Amongst the 20-odd entrants into the Sensex were several representatives of the “brave new post-liberalisation India” including the tech majors like Infosys, HCL Tech and Satyam Computer. There were also new era companies like Zee Entertainment, Cipla, Dr Reddy's, Ranbaxy and ICICI Bank. In effect, the intense churn in the Sensex reflected the revolution that the Indian economy underwent in the decade post-1991.
However, what's intriguing is that after the intense churn of the 1990s, the Sensex churned again by 50 per cent in the ten years leading up to the current day. Over the last ten years, the Sensex has ejected cement companies (ACC, Ambuja, Grasim), IT companies (HCL Tech, Satyam), Pharma companies (GSK Pharma, Ranbaxy), FMCG companies (Nestle, Colgate) and public sector companies (MTNL, HPCL). Interestingly, no banking or NBFCs are on the “exit list”.
Amongst the 25 companies that the Sensex has welcomed are lenders (HDFC, HDFC Bank), IT companies (TCS, Wipro), auto companies (M&M, Maruti) and a raft of public sector companies (NTPC, GAIL, ONGC, Coal India). Overall, the last ten years of rapid churn in the Sensex present a picture of a confused country which does not quite know whether to consume or to invest. This tension becomes even more apparent when one looks at the composition of India's GDP over the last decade-in none of the last ten years have we seen consumption and investment (expressed as a per cent of GDP) move in the same direction. So when consumption is rising, investment is falling and vice versa.
Whilst the 1991 liberalisation followed by the disjointed economic policies of the past decade can explain why churn in the Sensex has risen compared to the sedate pre-liberalisation era, what explains the high level of the Sensex's churn compared to other large markets?
The answer I believe lies in the incredibly aggressive expansion plans of large Indian companies. Last summer, my colleague, Gaurav Mehta and I looked at how India Inc allocates capital compared to corporates in other large economies. We found that over the last ten years, large Indian corporates have allocated far more of their operating cash flow to acquisitions and capex than their peers in other large economies. As a result, large Indian corporates has returned less cash to their shareholders (through dividends and buybacks) than their peers in other large economies. This aggressive pending and reluctance to return cash to shareholders automatically makes large Indian companies highly vulnerable to a de-rating, which in the next stage eventuallly leads to their exit from the Sensex.
What does all of this mean for investors? I read the Sensex and Nifty's high degree of churn to mean that investing heavily in the index or in large cap companies is bad for the health of my portfolio. Better managed companies which consistently produce better returns can be found in the lower reaches of the index where fewer institutional investors are hunting and where fewer corporates have delusions of grandeur.
Saurabh Mukherjea is CEO of Institutional Equities at Ambit Capital. The views expressed here are personal.
This column appeared in the April 2014 issue of Wealth Insight
This article was originally published on May 23, 2014.
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