A complex game

Benchmark return tends to camouflage Changing sector composition

It’s one of the mysteries of investing: very few investors actually “buy” the Nifty or the Sensex, and yet, a common question I get is: “What’s your Sensex target?” This question is not only misleading but also harmful, as it understates the opportunities as well as the dangers of investing in stock markets. 

Let’s focus on that a bit. The Nifty first touched 6,000 on December 11, 2007, and it would seem that the “market” hasn’t moved a bit in almost six years. This attracts much commentary on how investing in equities has been value destructive, as investors have not been able to make any absolute returns, let alone beat inflation or the return on fixed deposits.

But the performance of broad indices can be misleading, as sector and stock weightings in the index are not constant. Given that Nifty levels only matter to a handful of investors buying Nifty exchange-traded funds or futures, let’s look at sector performances within the Nifty since it first touched 6,000 in 2007. The market capitalisation of consumer staples and healthcare stocks are both up 260% and that of information technology (IT) stocks is up 180%. On the other hand, the market capitalisation of metals, utilities, industrials and telecommunication stocks has dropped 30-60%.

Within sectors, too, there is a clear divergence between stocks. For example, the overall performance of financials has been disappointing. As a group, the market capitalisation has barely changed, but the performance of sub-groups within the sector and, in particular, specific stocks, has diverged significantly. Some private sector banks and non-banking financial companies (NBFCs) have done well, whereas public sector banks and real estate companies have seen sharp erosion in value. Similarly, in IT, stock prices of TCS and HCL Tech have increased 250-280%, whereas that of Infosys was up only about 70%. 

If six years is a long time, let’s look at the Nifty since the beginning of the year, when, too, it was at 6,000 levels. It would seem that the market has not moved since then. In fact, tech stocks soared 47%, healthcare 29%, and consumer staples 25%. But industrials and financials were down 33% and 15%, respectively.

Plotting sector weightings in the Nifty over a period of time also suggests that there is nothing short-term about these performances. The trends are remarkably consistent, as the companies that these stocks represent see strong business momentum or vice versa. Inclusions and exclusions further accentuate the changes in weightings: after all, companies are periodically removed from or added to the index following changes in their market capitalisation.

This also answers an oft-asked question: “the economy continues to weaken, but the stock market is holding up remarkably well: is a correction not due?” While most market participants and observers instinctively link the economy and the stock market, in reality, the correlation is very low. There is no denying that India’s GDP growth has slowed significantly, and that some parts of the economy are in particularly bad shape, such as large-scale infrastructure investments and middle-income consumption. But stocks that reflect these sectors in the index have mostly been beaten down. The sectors and stocks holding up the broader index are the ones that have strong prospects. 

In many ways, the constitution of the index reflects market expectations of the parts of the economy that will likely to do well in coming years. So, sectors exposed to large-scale infrastructure investment, such as industrials, steel and public sector banks (that have lent money to these projects), have already seen significant corrections, and their combined share in the Nifty has shrunk from 25% in 2007 to less than 10% at present. Thus, even sharp declines in these stocks do not affect the broader indices much.

But can we really construct a diversified portfolio of stocks where prospects still look good?

Let’s start with IT companies. After several years their dollar revenues are beginning to accelerate. As cash-rich corporates in the developed world start setting aside their fear of a cataclysmic crisis and begin to open their wallets, most IT companies are reporting an improvement in order books. At the same time, their raw material, that is, young entry-level engineers, continues to be cheap: salaries of entry-level engineers haven’t changed for six years now, and given the poor job environment currently, hikes are unlikely this year and next as well. Even if the rupee does settle below 60 to the dollar, this sector should continue to do well.

Second, Indian pharmaceutical companies in the generic space are globally competitive, and no other emerging market has the depth and width of skill-sets and companies that India has. Most of these companies started their global expansions 10-15 years back and, after initial hiccups and course corrections, are now on a steadier growth path.

Despite strong export volume growth thus far, India’s volume market share of global pharmaceutical production is low, and should continue to rise over time. This sector needs strong bottom-up analysis more than others, so not every stock/company will do well, but it now provides a much broader portfolio of companies to choose from. In 2007, there were only four companies that provided the market capitalisation and trading volumes required by institutional investors. Now, there are more than 10 such companies.

Third, there is unprecedented productivity growth at the bottom of the income pyramid, driving strong wage and consumption growth. While this part of the economy will also see a slowdown in wages, it should continue to outpace the others. Consumer goods companies targeting this market segment are also in the process of expanding distribution reach, and thus are capable of delivering volume growth in excess of market expansion. 

Fourth would be the sectors operating at the fringes of the formal and informal economies, and are the vehicles of increased formalisation: media players and NBFCs. In order to reach out to new customers with their brands, consumer companies need the access provided by both the print and broadcast media: stocks of some of these companies are also good bets over the medium term for investors. Similarly, given the large differences in borrowing costs between the formal and informal sectors, as also the stronger growth in the informal economy, asset growth for NBFCs should remain robust.

Then, after a prolonged period of hyper-competition, there is some stability in the telecommunications sector, which is allowing companies to reduce discounts and increase profitability. 

Thus, there is a broad range of sectors doing well even as the overall economy slows, and the combined weight of these sectors in the Nifty continues to rise. Investors can still drive healthy returns from equities through stock picking in these sectors.

There is a natural inclination to refer to the past and to link the travails of the economy to prospects of the broader market, and believe that healthy equity market returns are unlikely till the time that large-scale infrastructure projects pick up again, and the non-performing assets (NPAs) for the banks start to fall. But that may not happen for many years. 

One must not forget that the market is forward-looking: 33 of 50 companies in the Nifty in 1996 are no longer part of it. Few now link the prospects of the Nifty to the health of the fertiliser and textile industries, each of which had several stocks in the Nifty in 1996.