Markets

Does Sensex really mirror the economy?

Keerthi Sanagasetti BL Research Bureau | Updated on January 31, 2020 Published on January 31, 2020

Change in index constituents also influenced by trading volume, market capitalisation

The Economic Survey has made an attempt to use the changes in the constituents of the Sensex to show that the inherent framework of the Indian economy became more dynamic and new technologies became more dominant after 1991.

While the findings, to a large part, are correct, the analysis does not take into account other factors that influence the churn in Sensex constituents, such as the business cycles in the sector to which a stock belongs, the trading interest in the stock and its free-float market capitalisation.

Changing economy

The survey highlights that “the firms that displaced the incumbents on the Sensex brought with them new ideas, technologies and processes.”

This is evident from the increasing dominance of the service sector in the Sensex, compared with the manufacturing sector. From about 4 per cent in 1991, the service sector formed about 55 per cent of the market capitalisation of the Sensex in 2019. This 55 per cent is made up of stocks from the information technology and financials sectors which grew at a faster pace post-liberalisation and were virtually non-existent in the Sensex in 1991.

The Economic Survey also believes that through continuously challenging the competitive advantage of entrenched firms, creative destruction can be achieved. The analysis threw light on the displacement of the sectors that were once considered mainstays of the Indian economy, by new sectors that brought with them new technologies and products.

Stocks such as Indian Organic, Premiere Auto and Century Textiles were replaced by ICICI, SBI and Colgate in the Sensex churn.

The analysis also highlights that the monopoly in the economy was declining, making way for a more competitive market. This was evident from the fact that in 1991, the largest firm on the index was roughly 100 times the smallest in terms of market capitalisation. Ten years later, the ratio declined to roughly 75. In 2018, the ratio was only 12.

Faster churn

The survey also says that “we can expect today’s dominant firms to remain dominant for only one-fifth of the time that their pre-liberalisation counterparts did.”

This indicates that the constituents of the index are experiencing a faster churn, given the dynamic changes to business environments.

Since inception, the constituents in the Sensex haave seen a churn of about 2-5 companies in every five years, till 1995. In 1996 alone, nearly half of the constituents of the index were replaced. In the five years from 2006 to 2010, 10 firms were churned out. In 2011-15 and 2016-19, it was eight and 10 firms, respectively. In other words, every five years, roughly one-third of the firms in the index were replaced, post the 2000s.

Analysis incomplete

While the above numbers are correct, the stock market in the 1990s was much different from what it is now, with greater foreign investor and domestic institutional participation. Research on the listed stocks is also exhaustive now; therefore, stocks that do not perform well or show any governance issues are punished strongly. That could also be the reason behind the faster churn in the Sensex constituents, besides a dynamic economy.

The analysis alsos takes note of the fact that the churn is also due to the selection criteria of Sensex constituents.

For inclusion in the Sensex, BSE picks stocks from the top 100 listed companies based on their full market capitalisation. That apart, the quantitative criteria also mandates that the stock should be among the top 150 companies, based on daily average trades — both number of trades and the traded value — in the past one year.

So, stocks that do not put up good financial performance, see a consequential decline in stock price and have dwindling volumes, exit from the index. Also stocks from sectors that witness more news flow and are, hence, more volatile, also find a place in the Sensex, due to higher volumes clocked.

So the trading patterns also tend to play a defining part in the selection of index constituents, besides changing business environment.

Published on January 31, 2020
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