Should you go for the Sensex’s latest?

The composition of market bellwether Sensex does not stay constant — it is altered regularly to represent the dominant stocks in the listed stock universe. The constituents of the Sensex were last changed on December 23; UltraTech Cement, Titan and Nestle India were added to the index to replace Tata Motors (and its DVR), YES Bank and Vedanta.

Do changes in the constituents of an index guarantee an upside in the stocks that have been included in it? Should you consider adding such stocks to your portfolio, too?

Not quite, suggests our analysis based on historical data from 1992 till date. Not all stocks gain after their inclusion in the index. Also, short-term gainers need not be long-term winners, while short-term losers could gain in the long run. A stock’s long-term prospects eventually depend on its fundamentals and valuation.

Price performance

The Sensex comprises 30 stocks (31, until recently, including the Tata Motors DVR). From 1992 until November 2019, the periodic changes in the Sensex have seen 65 stocks replacing older ones. We checked how these stocks fared over one year, three years and till date, from the time they formed part of the index. It’s a mixed bag.

Of these 65 stocks, 39 gained in the first year after being included in the index — a 60 per cent positive strike rate (39/65). Three years after listing, the positive strike rate is about 61 per cent and this further improves to 70 per cent if we consider the returns from index inclusion till date. HDFC and HDFC Bank have been the top multi-baggers (about 40 times) since their inclusion in the index until date.

But these aggregates hide the churn in the winners and losers over the years. Not all the stocks that gained in the first year remained winners later on. Of the 39 gainers in the first year, nearly a fifth (eight stocks) lost value until the third year, and more than a fourth (10 stocks) ended up in the negative when we consider returns till date.

The list of short-term-winners-turned-long-term losers include stocks such as Reliance Communication, MTNL, Jindal Steel and Power, Tata Power and Arvind.

While 39 of the 65 stocks (60 per cent) gained over a year after their inclusion in the Sensex, it is pertinent that as many as 26 stocks (40 per cent) lost value and posted negative returns in the first year. Over three years, about 38 per cent of the 65 stocks were losers and, until date, 30 per cent of the stocks were in the red.

This indicates that there is no guarantee that a stock will rally merely because it is part of an index.

Considering their performance till date, Jaiprakash Associates and Reliance Communications top the list of worst performers, with nearly 100 per cent value erosion since their inclusion in the Sensex. While the bankruptcy of a subsidiary dragged down the former, the latter was felled by debt woes and competitive pressures.

Not all the short-term losers stayed subdued, though. Of the 26 stocks that lost in the first year after inclusion in the Sensex, half (13 stocks) have posted positive returns till date, with 10 stocks doubling or more till date. Prominent names among short-term losers-turned-long-term multibaggers include market leaders such as Bharat Forge, ICICI Bank, Maruti Suzuki, HCL Technologies and Hero MetoCorp. Proof that fundamentals play a key role in the price movement of stocks in the long run.

Volume jump

Despite varying returns posted by the 65 stocks over one year from their inclusion in the index, one thing that runs common to all these stocks is an increase in their traded volumes.

Take, for instance, the additions in 2018. In June 2018, Vedanta was added to the Sensex, while Bajaj Finance and HCL Technologies were added in December 2018.

While the stocks of Bajaj Finance and HCL Technologies have rallied 62 and 22 per cent, respectively, till date, Vedanta has been a bummer with a 36 per cent erosion in its stock price. But, in terms of traded volumes, all the three stocks saw a jump. In 2019, their average daily turnover saw an increase of 47, 27 and 12 per cent, respectively, from their 2017 levels.

This is because index funds and exchange traded funds, which mimic the indices, have to invest in the index constituents. If a stock is added to the Sensex, the index funds based on the Sensex also need to add the stock to their portfolios.

This increased demand from fund houses for these stocks contributes to the jump in their traded volumes.

However, despite higher volumes, a price jump after a stock’s inclusion in the Sensex is not a given.

This is due to the BSE’s selection criteria that picks from large-cap, widely traded stocks for inclusion in the Sensex; the positives in such stocks may already have been factored in.

Selection criteria

For inclusion in the Sensex, the BSE picks stocks from the top 100 listed companies based on their full market capitalisation. That apart, the quantitative criteria also mandate 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 last one year.

The emphasis on large-cap stocks with high trading volumes (quantitative criteria), coupled with the BSE’s qualitative criterion in terms of an acceptable track record, means that the stock is already widely tracked and traded.

So, the positives in the stock may already have been factored in its price; this could limit price upsides after the stock’s inclusion in the index.

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