A logical implication of momentum investing is that larger stocks in a market cap weighted index such as the BSE100 should do better than smaller stocks.
The bottom decile of the top 100 comes to the fore.
Momentum investing i.e. buying stocks which are going up is generally recognized as one of the six investing “styles” that work. A logical implication of momentum investing is that larger stocks in a market cap weighted index such as the BSE100 should do better than smaller stocks.
In fact for most of the 1990s this adage worked nicely – see chart below which shows returns of the “bottom decile of the top 100 stocks in India minus the top decile”.
Then for most of the noughties (the decade from 2000-2009), the picture evened out i.e. the bottom decile of the top 100 stocks gave more or less the same returns as the top decile.
And, then picture inverted - over the past six years, for the first time since the Indian economy was liberalized in 1991, we have seen the bottom decile of the top 100 stocks outperform the top decile in terms of investment returns.
Exhibit 1: Over the last 6 years the bottom decile of the top 100 stocks has outperformed top decile across horizons.
Just to emphasise how much better the bottom decile has done relative to the top decile, if every year from 1991 on March 31, you had gone long on the bottom decile of top 100 stocks ranked by market cap (with annual rebalancing and with an equally weighted portfolio), your compounded return over 26 years would be 15.1 percent.
A corresponding strategy for the top decile would have yielded only 10.6 percent.
So, why, a generation after the 1991 reforms, have the smallest stocks in the top 100 started outperforming the largest stocks?
More specifically, why has the trailing P/E multiple for the bottom decile re-rated at 3 percent per annum between 1991 and 2017 whereas the trailing P/E for the top decile has de-rated at 0.5 percent over the same period?
Exhibit 2: The bottom decile of the top 100 stocks saw P/E re-rating whereas the top decile de-rated
Why is the bottom decile outperforming?
The answer, I think, lies in the increasing inability of the top 10 stocks in India companies to lock into India’s overall economic growth. As the table below shows, in the early 1990s, the top decile of the top 100 stocks was clearly participating in India’s overall GDP growth revival (just as the bottom decile was).
However, in the FY12-17 period, the picture has changed considerably – the top decile’s earnings growth is nowhere close to even nominal GDP (which was 10 percent over FY12-17).
In contrast, the bottom decile of the BSE100 is comfortably keeping pace with the broader economy.
Changes in India’s society, politics and its economy are going to lead to rapid churn in the Sensex and the Nifty. To quote from Ambit’s September 2016 thematic: “Powerful transformations underway in the Indian economy are likely to manifest in the form of a high churn ratio in the Sensex.
By CY25, we expect the Sensex to retain only 15 of the companies that currently comprise the 30-stock index.”
To be specific, in a changing India, large conglomerates with crony capitalist antecedents and/or poorly incented management teams are sitting ducks for smaller, hungrier companies who now have abundant access to cheap capital (public & private equity and debt).
From an investment standpoint, the logical market neutral strategy against such a backdrop would be to go long the bottom decile of the top 100 stocks and short the top decile.
In the seven years since FY11, this strategy has given positive returns in five years and a CAGR return of 8.1 percent versus the BSE100’s CAGR of 7.1 percent (An equally weighted bottom decile portfolio purchased on 1 April 2010 and annual rebalanced would give a compounded return over FY11-17 of 13.7 percent.)
The relative slide of the top ten stocks in India has one more troubling implication – most large cap Indian equity funds tend to, by default, load up on these stocks.
If these stocks are not delivering then, by extension, large-cap equity fund managers in India will have a problem. This could explain why post-2010, large cap equity mutual funds in India have stopped delivering alpha.(Disclaimer: Saurabh Mukherjea is the CEO of Ambit Capital and the author of “The Unusual Billionaires”. The views expressed are personal. The views and investment tips expressed by the expert on moneycontrol.com are his own, and not that of the website or its management.)