The role that the composition of Nifty must play

With the Indian stock market hitting new highs every month, market practitioners who follow fundamental analysis before investing are confused. In this calendar year, 46 trading days were marked by new market highs, but there was no significant market correction (over 5%) despite high sliding price / earnings multiples and poor returns on equity.

However, fundamental valuation is only one piece of the market puzzle followed by smart money. What are the other parts that solve the valuation conundrum for market participants? To begin with, the composition of the index is a key matrix that is keenly observed by market participants.

In India, there are two stock indexes, the Nifty and the Sensex. The Nifty Index is made up of 50 stocks, while the Sensex has 30. To understand the performance of the stock market, a look at the index itself can be helpful.

Over the past 15 years, the composition of Nifty has changed dramatically and this has a significant impact on the valuation of the index. In 2005-06, most of the index’s value came from older, capital-intensive, highly leveraged economy companies. Today, tangible assets have taken a back seat, and data-driven, consumer-centric financial and information technology companies with intangibles such as human resources and patented technologies are in the foreground. foreground of the index.

In 2005, the energy sector (with a weighting of 25.1%) was the main component of Nifty, while financials (with a weighting of 14.7%) were the third. In 2021, the two sectors exchanged positions. Financials (with a 37.7% weighting) are now the largest component, while energy (11.9%) is the third largest component of Nifty.

The valuation of the same index produced with different compositions during two different periods is not comparable. Each sector behaves differently as fundamental valuation metrics, such as return on equity (RoE), debt-to-equity ratio, earnings multiples and cash flow, vary wildly from sector to sector. . So any historical comparison of Nifty on PE, RoE and other fundamental valuation metrics would not explain the reasons for its phenomenal growth.

Talk with Outlook MoneyAshutosh Bhargava, fund manager and head of equity research, Nippon India Mutual Fund, says the performance of the index could not be properly explained if you ignore the composition.

“For a better understanding of the market valuation and the resulting index performance, you need to take into account the composition effect of Nifty, as the sector mix can significantly alter the valuations of the index”, adds Bhargava.

Bhargava is right because sectors such as energy, capital goods and infrastructure which had a high weight in the index in 2005 were all cyclical companies. Even financial institutions, predominantly public sector banks and to some extent private banks like ICICI Bank and Axis Bank, mostly derived value from corporate loans.

But now, most of the market value of financial services comes not from cyclical lending activity, but from non-lending activities such as insurance, mutual funds and credit cards. Even the asset profile (loan book) of banks is now more oriented towards retail, which is less cyclical in nature. So the financials, which are a big part of Nifty, get higher earnings multiples, increasing the index in return.

Reliance Industries is another example where cyclical petrochemicals have taken a back seat and consumer-focused telecommunications and retail operations derive significant share price value. The share has almost quadrupled over the past five years.

So, are stocks about to fall after such a stunning rally? Maybe not, because stocks aren’t as expensive as bond yields. In the United States, 10-year bonds yield 1.5 to 1.55% per annum, while in India, 10-year G-sec (government securities) yield 6.3%. . On the other hand, the Nifty has grown over 51 percent in the past year and over 11 percent in the past three months (one quarter). Thus, the low return provided by fixed income instruments also maintains the dynamism of stock markets globally.

But how long will the party last? Naturally, until the moment when other asset classes begin to offer significant returns to investors. “The opportunity cost of investing money in stocks is favorable with a low risk-free rate in developed economies, but once the risk-free rate or the discount rate starts to rise, both based on fundamentals and flows, stocks may become less attractive, ”Bhargava mentioned.

About Myra R.

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