Rerating of Indian equity?

The historical weights of industries in major indices offer some clues about economic evolution. Twenty years ago (1999), the fast moving consumer goods (FMCG) sector had the largest representation by free-float market cap in the Nifty/ Sensex. Automobiles & Ancillaries was at number 2 with information technology, oil and gas, and pharma-healthcare holding higher weights than banking, financial services & insurance (BFSI) at number 5.

By 2009, BFSI was the largest sector. In 2019, BFSI is by far, the largest. IT is the second-largest, with FMCG third, and Auto & Ancillaries in fourth place. Healthcare, Power, Telecom have all shrunk in relative importance.

The Nifty holds over 50 per cent of total market cap. It would be foolish to assume that these relative positions would hold through the next decade. New sectors would gain importance and pole positions would change.

It is an open question if the Nifty/ Sensex weights reflect the actual economic importance of specific industries. The indices are weighted via free-float, which makes shareholdings of non-promoters important. Free float underplays the role of closely-held companies and especially affects the weights of PSUs negatively, since these are all closely-held.

This is one reason why the weights of private banks in the indices far exceeds the weights of PSU banks, even though PSU banks hold about 70 per cent banking market share. Of course, private banks are also valued at far higher PE multiples for other reasons.

The dominance of BFSI is unsurprising and it’s likely to increase. Financial inclusion is still in its early stages in India with low levels of banking usage, and very low levels of insurance penetration. However, the low representation of Healthcare/ Pharma and Telecom is deceptive.

Healthcare is among the fastest growing industries. But it’s fragmented. There are no big listed groups that have achieved the mega-cap status required for Nifty inclusion.  The Pharma industry is big and export-oriented. But it has suffered a series of scandals, and endured strict inspections from the US Food & Drug Administration. The underweighting may be temporary. In telecom, Reliance Jio is a subsidiary of RIL and hence, the market value of India’s largest telecom service provider is not counted as a separate sector.

The IT industry is now quite a mature sector, unlike 1999 when it was just taking off. It remains export-oriented. Future growth prospects could depend on the sector exploiting the Digital India initiative. Indian IT also needs more traction in AI, IoT and cloud-based services, as growth in the old areas like low-end call-centre work has tapered off.

Given the emphasis on real estate development, the exclusion of realty is an anomaly. The sector had its first listings in 2007 and DLF was part of the indices for a while. Now there’s no direct representation although many BFSIs depend on mortgages for core income.

Power saw a surge in the early 21st century when PSUs like Powergrid and NTPC were listed. But it has since suffered a sequence of poor years and generated large NPAs. As a result, valuations are down. Private players like Adani Power and Tata Power have been removed from the indices but equipment makers are very much there.

It’s interesting to look at the performance of exclusions. A study by Value Research compared capital gains in stocks pulled out of the Sensex, to Sensex returns after the respective pullouts. The Sensex has returned 11.6 per cent CAGR since August 1996. There have been 55 replacements of companies between 1996 and 2018. This includes Reliance Petroleum, which re-merged into RIL. Just 17 excluded companies have beaten Sensex returns after they were removed from the index. As many as 13 companies have nominally negative CAGR since being removed. The rest, 25 companies in all,  have underperformed the index since exclusion.

Valuations are another key variable. The BSE releases the daily price-to-earnings (PE) of the Sensex, calculated according to the standalone earnings per share (EPS) of the last four quarters weighted by free float.  The Sensex bounced between PE 14 and PE 20 in the long period, 1999-2014.

Since May 2014, the valuation has never fallen below PE 20. This cannot be explained by earnings growth acceleration. EPS growth rates dipped during 2014-2019. The higher valuations can only be partly explained by lower interest rates. Presumably, it is due to a rerating of Indian equity. Will that positive rerating last with the economy now clearly in slowdown?

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