Winners change as cycles change

When it comes to investing, there is no one-size-fits-all approach. Every portfolio manager, big or small, has a unique strategy and there will always be hits and misses.

A seasoned portfolio manager knows that there will always be storms in the weather. Economic cycles will change and so will the winners. Thus, while the past is full of learnings for an investor, looking ahead is the only way to go.

We tend to look at indicators to lead us and that’s how the word index or indices came into existence. That is one reason why investors focus so much on the index and stocks that are found on it.

Being a part of important indices has become a status indicator for companies. However, as history tells us, it reveals very little about the future of companies.

As change continues to accelerate at a steady pace, the composition of the index has also gone through a significant shift over the past decades.

As the Indian economy transitions from $2.75 trillion to $5 trillion, this composition will go through even greater churn.

As a result of this, many companies that aren’t even listed today will become a part of the index, while many established companies might fall away.

Hence, as change accelerates, indices might hide more than what they reveal about the future. What one needs to realise is the fact that globally, most indices are built on the free float which means that the company’s stock is readily available for trading in the market.

The larger the free float, the more weight a company will have on the index. This holds true for India’s main indices including the Nifty50 and the BSE Sensex.

In a market like India where there is a high promoter and founder ownership of stocks, this may cause aberrations as it reduces the free float affecting the weight of the company in the Index.

Being a part of the index does not in any way vindicate or prove otherwise about the future of the business or its leadership. Typically, index inclusion is a post-facto truth.

When a stock entered an index, such as the Nifty or the Sensex, its price moved up relative to its peers.

In a market like India, large swathes of the economy like textiles, and retail among several other sectors are underrepresented on the index as they are largely unorganised or fragmented.

Indices used as benchmarks for passive investing have, ironically, made indices powerful performance arbitrators.

Passive investing is extremely beneficial to investors who want to participate in the markets while lowering the overall costs for such funds.

If a company is included in a well-known index that is used as a benchmark by funds for passive investing, it attracts a lot of incremental flows initially which continue on an ongoing basis as the money keeps flowing in and out of such funds.

Hence, passive indexing, at times, makes heroes out of companies that are merely included in the index. This creates a virtuous upcycle for stocks included in the index, irrespective of their underlying financial performance, and the other way around for those excluded from the Index.

Interestingly, if the stocks start underperforming, it generally gets replaced in the index at the time of the next reset. Hence, while passive investing does allow investors to participate in the markets at a low cost, it has its own set of challenges.

In light of the above realities, we present a few facts on index composition and how it has changed over decades and might look very different over the next 5-10 years.

The composition of major indices has shifted consistently over time. 23 of the index companies of BSE Sensex 30 stocks in 1986 are no longer part of the index. Similarly, 24 out of 30 stocks in 1996 also are no longer part of the index.

Even compared to 2016, one-third of the index components no longer exist in 2022. These are significant shifts in the index composition and the weightage of those companies that survived has changed substantially.

This phenomenon is common, not just in India, but even globally. The current heavyweights of NASDAQ didn’t exist two decades back. Companies with the largest market capitalisation over decades have changed not just sectors but also geographies.

The complexion of the Indian economy might look very different as it evolves from $2,000 per capita to $5,000 over the next decade.

The shift in consumption patterns and lifestyles brought about this increase in per capita might mean that many sectors like healthcare, retail, technology telecom, media & entertainment, etc., will get much bigger in the next phase of the economy’s growth which might not be represented that well in the index currently.

Hence, when Investors look at equity markets in India they will have to ensure that they not only have companies that are doing well today and are market leaders, but those that will become much bigger as the economy changes complexion.

Everything goes through cycles and new winners will emerge with the next growth cycle, and spotting the same will require a robust process and a lot of patience.

(The author of this article is the Co-Founder and Co-CIO of Karma Capital)

Disclaimer: The views and recommendations given in this article are those of the author. These do not represent the views of MintGenie.