Should you only buy Sensex based companies?

Jun 24, 2015

In this issue:
» Auto sales volumes have not been encouraging
» Realty companies are looking for funds
» China prefers stocks over gold
» ...and more!

Is a churn in the Sensex constituents important when it comes to investing in equities? For instance, in recent developments, the pharma company Lupin replaced Tata Power in the BSE Sensex.

Does that mean that the stock of Lupin automatically becomes a Buy and that of Tata Power is a Sell?

For that one needs to understand the criteria that the BSE considers when it comes to including stocks in the Sensex. One such has been the company's free float or non-promoter holdings. Thus, stocks with higher liquidity have assumed bigger weights in the index and stocks with lower liquidity have fallen in the rankings. That is not all.

The BSE, in the last decade or more, has made quite a few changes to the Sensex. One such change has been to make it more diversified. Thus, no individual stock gets a very large weight in the Sensex. Plus, the dependence on a single business group has also reduced.

What this essentially means is that the BSE has its own set of criteria for adding or removing stocks from the Sensex. These are quite different from what an investor should look for while investing in stocks.

For instance, we recommend a more bottom up approach while investing in equities. So what an investor needs to focus on are factors such as the strength of the business model, competitive advantage that the company enjoys, good growth prospects, sound management and also whether valuations are reasonable.

These are hardly factors that the BSE takes into account.

Indeed, stocks such as Castrol, Colgate and Nestle India, which were once part of the Sensex, are no longer part of it. However, these stocks have amply rewarded investors in the last decade as compounded returns for each of these stocks has averaged at around 24% during this period.

So for the value investor, just as predicting the next Sensex level should be taken with a pinch of salt, so do stocks moving in and out of the Sensex hardly be given much importance.

What more, ultimately the BSE Sensex comprises 30 stocks, which can hardly be considered as the best representative of the overall Indian markets. There are many good quality companies in the midcap and smallcap space as well, which have gone on to do well when it comes to generating shareholder wealth.

Ultimately, it makes sense to have a selection of stocks from the largecap, midcap and smallcap spaces by following the principles of asset allocation.

If a stock is made part of the Sensex, do you automatically buy it? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Auto sales volumes in the year so far have not been very encouraging, thereby showing signs of a weakness. After a bad FY14, FY15 did not see a strong comeback as well. FY16 is expected to be an important year for the auto industry as such, considering the expectations from pent up demand. With half of the two-wheeler volumes and about a third of the passenger vehicles sales coming in from the rural parts of the country, managements of auto players are hoping for a good monsoon season to drive volumes this year.

Today's chart of the day shows the year on year change in sales volumes for the past two year and the first two months of the current fiscal across various segments.

Auto sales volumes: Not so encouraging...

If one was to look at the volumes of individual companies, the performance has been quite mixed with certain players completely outshining the industry. Well timed and successful product launches have been key reasons for the same. What is disappointing is that sales volumes of certain segments are still far behind their all time highs recorded a few years ago. For instance, in the passenger vehicles segment, sales volumes stood at 2.6 m in FY15; the highest annual sales volumes of 2.68 m units were clocked in FY13. In the CV space, the peak volumes were seen way back in FY12, with the same coming in at 348,000 units then. In FY15, the figure stood at 232,000 units.

As per us, notwithstanding the short term fluctuations, a good way to gauge the long term demand cycle of auto demand is by normalising the volume growth for each year (and each segment) and comparing the same to the actual volumes. If the latter shoots up way above the normalised line, then one could expect the volume factor to slowdown. The same would hold true in the vice versa situation as well.

When it comes to gold, China and India are its biggest buyers. As per an article in the Wall Street Journal, China and India account for around 32% and 22.5% of the global demand for gold respectively. Typically, when gold prices fall, the demand from both these countries rises. But this time it has been a bit different.

Indeed, there have not been too many takers for the precious metal from China atleast. Chinese appear to be favouring stocks and the rise in the Chinese stock market is testimony to that. No such scenario in India though as demand continues to remain healthy while the appetite for stocks may have waned a bit.

The Modi government would have been happy had Indians also followed the Chinese. Indeed, gold imports in recent times have put immense pressure on the country's trade deficit. The government, in the meanwhile, has been looking at various means to bring down import demand by looking to monetize idle gold lying with households or issuing bonds against gold.

The fact that realty companies are sitting on inventory which is enough to service demand for many years is itself is a statement that can provide a good indication of how bad things are in the sector. To meet their financing needs, realty companies are resorting to various measures such as equity dilution or various forms of structured financing options as the scope of raising more capital through debt is limited. As reported by the Mint, the net debt of the BSE-Realty index companies stands at Rs 403 bn at the end of FY15 as compared to Rs 276 bn two years ago. It will be interesting to see whether such activities will suffice the funding needs of the realty players as they themselves are expecting recovery only a year from now. With the high number of unsold properties across the country, the possibility of the oversupply situation leading to a much needed correction in the real estate market cannot be ruled out. If one were looking to participate in the real estate market through buying listed players, it would not be very difficult to pick out the companies run by good honest managements. The only thing to consider here is to not overpay for such businesses.

At the time of writing, the Indian markets were trading well above the dotted line with the BSE-Sensex up by about 100 points or 0.3%. Stocks from the FMCG and pharmaceuticals spaces were in favour today while those from the metal and auto sectors were trading in the red. Mid and smallcap stocks were in favour too with their respective indices up by about 0.3% and 0.12% respectively.

 Today's investing mantra
"Investing is simple but it's not easy. Because emotions get in people's way or greed and that sort of thing. They get all excited about stocks when they've gone up recently, and they get depressed when they've gone down." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Devanshu Sampat (Research Analyst).

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1 Responses to "Should you only buy Sensex based companies?"


Jun 24, 2015

I always feel there is no single failureproof formula(incl. EM recommendations or for that matter following Buffet's principles or Graham's formula or Peter Lynch formula) that will give excellent result for every investment made. It is simply not possible for the simple reason that we are making some futuristic assumptions --may be very logical also --but market movements are unpredictable or rather follow some other logic.But as I have earlier also pointed out, you can consider mentioning in your recommendation/analysis note whether the stock is constituent of Sensex ,Nifty, MSCI Index(last one I am stating because FIIs are more inclined towards MSCI Index stocks and hence better chance of appreciation). It is also a fact that it is very difficult to beat the Index in a consistent manner in the long run.

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