Sensex Churn

The Sensex churns by over 50% over a 10-year period. That is to say, if we begin a decade with 30 stocks in the Sensex, by the end of the 10-year period, less than 15 of those stocks are in the Sensex. This churn ratio was below 15% in the 1980s, but has steadily risen over the last 20 years.

Moreover, compared to other large emerging markets or the West, the Indian market churns much more (eg. the Dow Jones index (US) has 23% churn, the Hang Seng (Hong Kong) 30% and the Bovespa (Brazil) 39%). So, why has the Sensex’s churn gone up so sharply in the past 30 years? And why does the Sensex (or the Nifty) churn so much more than any other large stock market in the world? Back in the days when the Licence Raj prevailed, the Indian economy was fairly ossified. Unless you turned up in New Delhi with truckload of goodies for the powers that be, your company did not go anywhere. As a result, hardly any companies entered or exited the Sensex during that era.

Then, 1991 came and Manmohan Singh unveiled his ‘New Economy Policy’. Over the next 10 years, the Sensex churned 63% as a host of stalwarts from the Licence Raj tumbled out. So out went Hindustan Motors and Premier with their vintage cars. Along with them a slew of textile companies – Bombay Dyeing, Century Textiles, Futura Polyster – also found themselves ejected from the Sensex. Among the 20-odd entrants into the Sensex were several representatives of the post-liberalisation India, including Infosys, HCL Tech, Satyam Computer, Zee Entertainment, Cipla, Dr Reddy’s, Ranbaxy and ICICI Bank. In effect, the intense churn in the Sensex reflected the revolution that the Indian economy underwent in the decade post-1991. 

Even after the rapid churn of the 1990s, the Sensex churned again by 50% in the 10 years leading up to the current day. Over the last 10 years, the Sensex has ejected cement companies (ACC, Ambuja, Grasim), IT firms (HCL Tech, Satyam), pharma companies (GSK Pharma, Ranbaxy), FMCG majors (Nestle, Colgate) and public sector companies (MTNL, HPCL). Interestingly, no banking or NBFCs are on the “exit list”.

Among the 25 companies that the Sensex has welcomed are lenders (HDFC, HDFC Bank), IT vendors (TCS, Wipro), auto makers (M&M, Maruti) and a raft of public sector companies (NTPC, GAIL, ONGC, Coal India). Overall, the last 10 years of churn in the Sensex presents a picture of a confused country that does not know whether to consume or invest. This tension becomes even more apparent when one looks at the composition of India’s GDP over the last decade – in each of the last 10 years, we have seen consumption and investment (expressed as a percentage of GDP) move in opposite directions.

In between FY04 to FY11, consumption (as a % of GDP) fell to 52% from 60% while investment rose to a staggering 44% from 16%. Then, between FY12 and FY14, the pattern reversed as consumption went up to 60% from 52% and investment slumped to 23% from 44%. In effect, now, at the end of FY14, in terms of the structure of the Indian economy, we are back to exactly where we were 10 years ago. This yo-yoing between consumption and investment explains not just the high degree of churn in the Sensex over the past decade but why as a nation, we feel so uncertain about our economic future.

What explains the high level of the Sensex’s churn compared to other large markets? The answer I believe lies in the incredibly aggressive expansion plans of Corporate India.Over the past 10 years, large Indian corporates have allocated far more of their operating cash flow to acquisitions and capex than their peers in other large economies. In fact, over the past decade, BSE100 companies have actually spent more cash on acquisitions and capex than they have generated.

As a result, large Indian corporates have returned less cash to their shareholders than their peers in other large economies. This ultra-aggressive spending and reluctance to return cash to shareholders is extraordinary in a country where the cost of capital is the highest outside sub-Saharan Africa. It automatically makes large Indian companies highly vulnerable to an eventual exit from the Sensex.

What does all of this mean for investors? The Sensex’s and Nifty’s high degree of churn means that investing heavily in the index or in large cap companies is bad for the health of your portfolio. Better managed companies which consistently produce better returns can be found in the lower reaches of the index where fewer institutional investors are hunting and where fewer corporates have delusions of grandeur