In my previous columns I highlighted that the Indian market has the highest 'churn' ratio amongst the world's major stock markets. In particular, over a ten-year period the Sensex churns by around 50 per cent, i.e., of the 30 stocks in the Sensex at the beginning of a decade, only 15 are left by the end of the decade. Interestingly, churn in the Sensex tends to be higher in the wake of major economic reform; during the ten years from 1995-05 Sensex churn rose to 67 per cent. The churn tends to be lower during the periods in which little or no reform takes place (such as the period during which UPA-II was in power when the churn fell to 25 per cent).
This process of creative destruction should be of interest to investors because there are outsized returns to be made from buying into companies that will become Sensex constituents over the next decade. My colleagues Gaurav Mehta and Karan Khanna find that whilst the Sensex itself compounds at 17 per cent per annum over long periods of time, entrants into the Sensex - even large-cap entrants which are already in the BSE 100 - compound at 22 per cent per annum in the ten years prior to Sensex entry. Mid-cap entrants (Sensex entrants which emerge from the hundred stocks below the BSE 100) compound at an even more impressive 36 per cent per annum in the ten years prior to Sensex entry.
So, how can we predict which stocks will be in the Sensex ten years hence? Here is how my colleagues and I have gone about solving this puzzle.
Firstly, given the Sensex's history since 1991, we can see that Sensex churn will be at least 50 per cent over the next decade, given the reforms that Prime Minister Modi has kick-started (attacking black money, attacking subsidies and shifting the subsidy system to direct benefit transfer, and attacking crony capitalism). This implies that at least 15 new companies will enter into the Sensex over the next decade.
Secondly, analyzing 25 years worth of Indian stock market data shows us the entrants into the Sensex come from the following sources:
- Half of the entrants historically have come from the top 100 stocks based on the market-cap as of the beginning of the decade.
- About 16 per cent stocks come from the next 200 stocks (i.e., beginning-period market-cap rank between 101 and 300).
- The remaining third of the stocks entered the Sensex on account of fresh listings.
Thirdly, we can collect powerful clues from the fact that India's per capita income (PCI) today stands at $2,000 and should go to $4,000 over the next decade, provided we compound PCI over the next decade at the same rate as the last decade. Over the past 20 years, several other countries - Russia, China, Poland, Korea, Sri Lanka, Indonesia, Malaysia, Turkey, etc. - have made this transition from $2,000 to $4,000 PCI. By studying their stock markets we find that during these transitions:
- The weight of discretionary consumption stocks in the market rises sharply.
- The weight of financial-services stocks in the market rises sharply.
- The weight of consumer staples falls sharply.
- The weight of industrial stocks moves in a particular pattern.
Finally, having used history to give us clues regarding where Sensex entrants will come from (in terms of sectors and market-cap buckets), we then use our proprietary stock picking tool - the Ambit 'greatness' model, which uses the last six years of data to identify the companies, which, in specific sectors and market cap buckets, have allocated capital with greatest success.
So what comes out of the mix after we have applied these four layers of filters? History tells us that ten out of the 15 Sensex entrants are likely to come from currently listed companies (the rest being IPOs). Our ten entrants, segmented by sector, are:
- Consumer discretionary: Asian Paints, Nestle, Pidilite and Page Industries
- Financial services: Kotak Mahindra Bank and IndusInd Bank
- Pharma and chemicals: Torrent Pharmaceuticals and PI Industries
- Auto: Eicher Motors
- IT: HCL Tech
Predicting the IPO entrants is much harder because we don't really know which IPOs will come out of the woodwork over the next decade but on the basis of the names that are currently doing the rounds in the press, the five most likely Sensex entrants appear to be Flipkart, Paytm, Hindustan Aeronautics, Cafe Coffee Day and ICICI Prudential Life. Each one of these companies is a market leader in its segment, and barring Cafe Coffee Day and Paytm each of these companies is already big enough to occupy a place in the Sensex in the foreseeable future.
Saurabh Mukherjea is CEO - Institutional Equities at Ambit Capital and the author of Gurus of Chaos: Modern India's Money Masters.
This column appeared in the September 2015 Issue of Wealth Insight.