Momentum investing, i.e., buying stocks which are going up is generally recognised as one of the six investing 'styles' that work. A logical implication of momentum investing is that the larger stocks in a market-cap weighted index, such as the BSE 100, should do better than smaller stocks. In fact for most of the 1990s, this adage worked nicely. See Figure 1.
It shows returns of the bottom decile of the top 100 stocks in India minus the top decile.
Then for most of the noughties, the picture evened out, i.e., the bottom decile of the top 100 stocks gave more or less the same returns as the top decile. And then the picture inverted. Over the past six years, for the first time since the Indian economy was liberalised in 1991, we have seen the bottom decile of the top 100 stocks outperform the top decile in terms of investment returns. If every year from 1991, on March 31st, you had gone long on the bottom decile of the top 100 stocks ranked by market cap (with annual rebalancing and with an equally weighted portfolio), your compounded return over 26 years would be 15.1 per cent. A corresponding strategy for the top decile would have yielded only 10.6 per cent.
So, why, a generation after the 1991 reforms, have the smallest stocks in the top 100 started outperforming the largest stocks? More specifically, why has the trailing P/E multiple for the bottom decile re-rated at 3 per cent per annum between 1991 to 2017, whereas the trailing P/E for the top decile has de-rated at 0.5 per cent over the same period? (See Table 1.)
The answer I think lies in the increasing inability of the top 10 stocks in Indian companies to lock into India's overall economic growth. As Table 2 shows, in the early 1990s, the top decile of the top 100 stocks was clearly participating in India's overall GDP growth revival (just as the bottom decile was). However, in the FY12-17 period, the picture has changed considerably - the top decile's earnings growth is nowhere close to even nominal GDP (which was 10 per cent over FY12-17). In contrast, the bottom decile of the BSE 100 is comfortably keeping pace with the broader economy.
Changes in India's society, politics and its economy are going to lead to rapid churn in the Sensex and the Nifty. To quote from Ambit's September 2016 thematic, "Powerful transformations underway in the Indian economy are likely to manifest in the form of a high churn ratio in the Sensex. By calendar year 2025, we expect the Sensex to retain only 15 of the companies that currently comprise the 30-stock index."
To be specific, in a changing India, large conglomerates with crony capitalist antecedents and/or poorly incented management teams are sitting ducks for smaller, hungrier companies, which now have abundant access to cheap capital (public and private equity and debt).
From an investment standpoint, the logical market-neutral strategy against such a backdrop would be to go long the bottom decile of the top 100 stocks and short the top decile. In the seven years since FY11, this strategy has given positive returns in five years and a CAGR return of 8.1 per cent versus the BSE 100's CAGR of 7.1 per cent (an equally weighted bottom decile portfolio purchased on April 1, 2010, and annually rebalanced would give a compounded return over FY11-17 of 13.7 per cent)
The relative slide of the top ten stocks in India has one more troubling implication - most large-cap Indian equity funds tend to, by default, load up on these stocks. If these stocks are not delivering, then, by extension, large-cap equity fund managers in India will have a problem. This could explain why post-2010, large-cap equity mutual funds in India have stopped delivering alpha.
Saurabh Mukherjea is CEO - Institutional Equities at Ambit Capital and the author of The Unusual Billionaires and Gurus of Chaos.