Over the past decade, Nifty’s earnings have not only grown at a much slower pace than the Indian economy, they have also trailed the S&P500’s earnings growth by a country mile (although the Indian economy is growing much faster than the US economy).
This disturbing phenomenon has far reaching implications for Indian investors.
The Nifty has fallen far behind the Indian economy
Over the last 10 years, India’s GDP growth (in nominal terms) has averaged 13 per cent per annum while the most popular benchmark index in India, Nifty, has seen its earnings grow at a mere 8 per cent per annum. In fact, in nine out of last 10 years, Nifty’s earnings growth has trailed nominal GDP growth by a country mile (the only exception being FY11).
In the US on the other hand, nominal GDP growth over the past decade has been barely 4 per cent and yet the S&P500’s earnings has grown at 12 per cent per annum, a full 400 bps faster than Nifty (even without converting the Nifty’s earnings to US dollars)! Why do the benchmark indices in India and the US display completely opposite trends (compared with the GDP growth of their respective economies) and what implications does that have for investors?
Why does Nifty lag Indian economy?
To understand why Nifty no longer captures the dynamism of the Indian economy, a good place to start is the index as it stood 10 years ago. On the face of it, the 10-year return from investing in Nifty is a very respectable 14 per cent but that is a deceptively flattering figure. A better way to understand the quality (or lack thereof) of Nifty is to look at the return from investing in the underlying 50 stocks, which were in the Nifty 10 years ago – such a portfolio (equal weighted) would give you a return of negative 1 per cent per annum (CAGR over 10 years). [Note: by starting the measurement in February 2009, when the market was close to its post-Lehman lows, we are giving the Nifty every chance to benefit from an unusually low base.]
If you assume that the cost of equity of a typical investor investing in Indian stocks is 15 per cent, only 18 out of the 50 stocks in the Nifty have given a return above the cost of equity over the past ten years. [This number too is flattered by the fact that our starting period in Feb 2009.]
These 18 outperformers – ranked in descending order of performance – are: HCL Tech, TCS, HDFC Bank, Maruti Suzuki, M&M, Zee, HUL, HDFC, Wipro, Tata Motors, BPCL, Infosys, ITC, Siemens, Hindalco, ICICI Bank, Grasim, L&T and Sun Pharma. As you can see from the list, barring four companies, all the other companies are from relatively capital light and/or B2C sectors like consumer, auto, pharma and banking.
The other 32 companies – whose 10-year return is below the cost of capital – are from balance sheet heavy sectors like power, construction, metals, telecom, real estate and oil & gas.
These sectors accounted for roughly 30-35 per cent of the Indian economy (as per the data by the Indian government’s statistical arm). And yet these companies account for two-thirds of the companies in Nifty leaving little room in the index for the more vibrant sectors of the economy.
The over-representation in Nifty of the capital-heavy sectors of the economy is, therefore, a key reason its sluggish performance. It is not obvious to us why the Nifty continues to have such a high proportion of companies from balance sheet heavy sectors.
Secondly, over the last five years, Nifty’s market has increasingly diverged from India’s nominal GDP (after faithfully tracking it for much of the preceding decade). This in turn is suggests that significant drivers of the Indian economy are no longer in the listed market.
For example, taxi aggregators (Ola, Uber), online retailers (Flipkart, Amazon), electronics goods manufacturers, car manufacturers other than Maruti, hotels other than Taj, Oberoi and Lemontree, etc are all unlisted. Basically most of the things that affluent India buys beyond FMCG and apparel is no longer in the listed market.
These companies are able to access capital at low cost without entering the stock marketand therefore their contribution to GDP is not reflected in the stock market. If, as the Indian economy matures, the unlisted world continues to provide capital at lower cost than the listed market then the gap between GDP and market cap will widen further.
Implications for investors
The sluggishness of Nifty makes its relatively easy for reasonably competent fund managers to outperform the index and unjustifiably claim the presence of skill. While this does pose a challenge for Nifty tracker/index funds (since they are tracking a moribund index), it also opens up enormous opportunities in India for smart beta funds.
For example, Nifty Junior (which represents the 50 most liquid stocks below the Nifty) almost always outperforms the Nifty.
Given that nearly two-thirds of the Nifty constituents have failed to give a return above the cost of capital, large cap Indian funds which draw their constituents largely from the Nifty are a difficult investment to justify. On the other hand, even a relatively simple method – like our Consistent Compounders algorithm which focuses on a select subset of Nifty stocks – is able to deliver returns which are consistently above the cost of capital.
The inability of the Indian stock market to provide lower cost funding than the Private Equity (PE) firms is depriving the Indian stock market of high quality companies which can dominate their sectors and help the stock market participate in India’s economic growth. The more important foreign companies and PE funded companies become in India, the bigger the questions mark around the relevance of the Indian stock market as a medium via which ordinary investors can benefit from India’s economic growth.
The fact that the S&P 500 can consistently grow earnings much faster than US economic growth suggests American companies can tap into Emerging Markets’ economic growth much better than Indian companies in the Nifty. This not only raises troubling questions about the quality of capital allocation and accounting in many large Indian companies that are in the Nifty, it also suggests that Indian investors should consider investing in a portfolio of global companies who dominate specific segments on a worldwide basis.
(Saurabh Mukherjea is the author of The Unusual Billionaires and Coffee Can Investing: the Low Risk Route to Stupendous Wealth. He’s the Founder of Marcellus Investment Managers, a SEBI regulated provider of Portfolio Management Services.)