In my previous columns I have highlighted that the Indian market has the highest "churn" ratio amongst the world's major stock markets. In particular, over a 10-year period the Sensex churns by around 50 per cent i.e. of the 30 stocks in the Sensex at the beginning of a decade, only 15 are left by the end of the decade. Interestingly, churn in the Sensex tends to be higher in the wake of major economic reform â€“ during the 10 years from 1995-05 Sensex churn rose to 67 per cent - and churn tends to be lower during periods in which little or no reform takes place (such as the period during which UPA-II was in power when churn fell to 25 per cent).
This process of creative destructive should be of interest to investors because there are outsized returns to be made from buying into companies that will over the next decade become Sensex constituents. My colleagues, Gaurav Mehta and Karan Khanna, find that whilst the Sensex itself compounds at 17 per cent per annum over long periods of time, entrants into the Sensex â€“ even large cap entrants who are already in the BSE-100 â€“ compound at 22per cent per annum in the 10 years prior to Sensex entry. Midcap entrants (i.e. Sensex entrants who emerge from the hundred stocks below the BSE-100) compound at an even more impressive 36 per cent per annum in the 10 years prior to Sensex entry.
So, how can we predict which stocks will be in the Sensex 10 years hence? Here is how my colleagues and I have gone about solving this puzzle.
Firstly, given the Sensex's history since 1991, we can see that Sensex churn will be at least 50 per cent over the next decade given the reforms that Prime Minister Modi has kick-started (attacking black money, attacking subsidies and shifting the subsidy system to Direct Benefit Transfer and attacking crony capitalism). This implies that at least 15 new companies will enter the Sensex over the next decade.
Secondly, analysing 25 years worth of Indian stock market data shows us the entrants into the Sensex come from the following sources:
- The weight of discretionary consumption stocks in the market rises sharply;
- The weight of financial services stocks in the market rises sharply;
- The weight of consumer staples falls sharply; and
- The weight of industrial stocks moves in particular pattern.
Finally, having used history to give us clues regarding where Sensex entrants will come from (in terms of sectors and market cap buckets), we then use our proprietary stock picking tool "the Ambit "greatness" model which uses the last six years of data to identify the companies which in specific sectors and market cap buckets have allocated capital with greatest success.
So what comes out of the mix after we have applied these four layers filters? History tells us that 10 out of the 15 Sensex entrants are likely to come from currently listed companies (the rest being IPOs). Our 10 entrants, segmented by sector, are:
- Consumer discretionary: Asian Paints, Nestle, Pidilite and Page Industries;
- Financial Services: Kotak Mahindra Bank and IndusInd Bank;
- Pharma and Chemicals: Torrent Pharmaceuticals and PI Industries;
- Auto: Eicher Motors; and
- IT: HCL Tech.
Predicting the IPO entrants is much harder because we don't really know which IPOs will come out of the woodwork over the next decade but basis the names that are currently doing the rounds in the press, the five most likely Sensex entrants appear to be Flipkart, Paytm, Hindustan Aeronautics, CafÃ© Coffee Day and ICICI Prudential Life. Each one of these companies is a market leader in its segment and barring CafÃ© Coffee Day and Paytm, each of these companies is already big enough to occupy a place in the Sensex in the foreseeable future.
Saurabh Mukherjea is CEO - Institutional Equities, at Ambit Capital and the author of "Gurus of Chaos: Modern India's Money Masters". He writes here in his personal capacity.