Want to beat the Sensex? Just buy stocks the index discards

The experience with India’s flagship indices is somewhat different from global trends.

If BSE’s Sensex and the National Stock Exchange’s (NSE’s) Nifty were viewed as investment portfolios, then their fund managers would be a strange lot. That’s because the stocks they discard deliver far greater returns compared to the stocks they add to the index. The data shows that such a contrarian strategy pays off handsomely for investors.

At least that’s what Mint’s study of index changes of the past 10 years shows. A portfolio made up of all Sensex discards since November 2007 generated an annualized return of 13.8%, while in the case of Nifty, the discards together generated returns of 11.5% annually.

In contrast, a portfolio of stocks added to the Sensex in the past 10 years returned a much lower 6.2%. Ditto with the Nifty, where a portfolio of stocks that were included generated annualized returns of 8%. For the methodology, see below.

So what’s behind this phenomenon? Whether it happens consciously or not, managers of the Sensex and Nifty follow a so-called momentum style of investing, where stocks that have done well in the recent past are included in the index, while laggards are dropped. As a result, the additions are coming in at relatively higher valuations, while the discards may well be good value picks.

Ritesh Jain, chief investment officer at BNP Paribas Asset Management India Pvt. Ltd, says, “Sometimes, it so happens that the stocks that are dropped off are caught at the bottom of their business cycle. This is also a reason that when the business cycle picks up, these stocks tend to do well.” A case in point is Hindalco Industries Ltd, which was dropped from the Sensex at the bottom of the aluminium cycle in end-2015. With aluminium prices rising sharply since, Hindalco shares have risen by more than three times in less than two years.

Kalpen Parekh, president at DSP Blackrock Investment Managers Pvt. Ltd, says, “Once a stock gets out of the index, we see many funds being underweight in that stock. This automatically results in relatively low ownership, which when used as a signal, can be a good investment strategy. After all, stocks exiting the index are becoming cheaper on the valuation front.”

Of course, investors should be warned that by buying index discards they can end up with duds such as Unitech Ltd, Reliance Communications Ltd, Suzlon Energy Ltd and Jaiprakash Associates Ltd, which have fallen between 62% and 93% since the time they were excluded from either of the indices.

But the fact that the overall discards portfolio still generates relatively higher returns shows that the value picks Parekh and Jain are referring to more than make up for the laggards.

The Sensex and Nifty returned around 10.7% annually using a strategy where an equal amount is invested in these indices on the date the inclusions and exclusions are effective. This suggests there is a silver lining when it comes to the stock selection process followed by the index managers—while they get it mostly wrong when it comes to dropping stocks and picking up new ones, the stocks they retain tend to do fairly well. Still, a moot question is if these indices are good benchmarks to start with, given the somewhat warped manner of stock selection.

The experience with India’s flagship indices is somewhat different from global trends. Studies on changes in the S&P 500 Index suggest there is a positive correlation when it comes to additions to the index. Among other factors that lead to an increase in the stock price after it’s added to a flagship index is increased awareness among investors. Besides, in developed markets, there is a far greater proportion of index-linked funds that chase additions, driving up prices as well.

However, at the same time, studies show there isn’t a commensurate decline when it comes to deletions. Researchers Honghui Chen, Gregory Noronha and Vijay Singal say in a paper published in the August 2004 edition of The Journal of Finance, “Investor awareness can increase following a stock’s addition to the index, but awareness does not easily diminish when a stock is deleted from the index... A similar argument can be made that while added firms have improved access to capital, deleted firms do not necessarily experience a significant change in that access.”

As Parekh of DSP Blackrock sums up in the Indian context, “The stocks that are excluded are going out after a big round of underperformance.” The experience in the past 10 years shows many of these stocks may be down, but not out.

Methodology: The study considers index changes in the past 10 years, i.e. since November 2007. An equal amount is invested in each stock that is discarded at prevailing prices on the date of exclusion from the index. If the index managers reverse their decision, i.e. they re-include a stock that had previously been dropped, then the position is liquidated and proceeds are reinvested in the remaining portfolio. This portfolio of discarded stocks performs better than the corresponding portfolio of newly-added stocks, constructed in a similar manner. Sensex/Nifty returns assume investments on the same date as the date of inclusions/exclusions.