Four laws of stock market investing

4 years ago

The mean reverting tendencies of stock markets and economies is well known and now, thanks to behavioural finance specialists, the human mind’s inability to factor in mean reversion is also well understood. For example, all of us know that one day even the deepest of economic downturns will turn into an economic recovery and then climax in an economic boom. In spite of that, most of us find it very hard to factor such well established cycles into our investment decisions.

Recognising this frailty of the human mind, my colleague, Gaurav Mehta, and I looked at the Indian market’s behaviour since 1995 (the year the Nifty was created) and sought to understand the key ‘mean reverting’ features of our market. What we found was at one level deeply intuitive and at another level very helpful in framing our ‘thumb rules’ regarding investment decisions in large cap stocks. Presented below are our four ‘laws’ of investing in large cap Indian cap stocks.

1a) Almost all the outperformance in a stock (vis-a-vis the Nifty) comes in the years preceding its entry into the Nifty. Typically, the outperformance in the three years running up to Nifty entry is 30% on a CAGR basis. Once a stock enters the Nifty, its outperformance almost disappears in the first year post-entry. Furthermore, by the second year, entrants usually start underperforming the Nifty.

1b) Almost all the underperformance in a stock which is a Nifty constituent comes in the years preceding its Nifty exit. Typically, the underperformance in the three years running up to the Nifty exit is 20 per cent on a CAGR basis. Once a stock exits the Nifty, its underperformance tails off in the first year post exit. By the second year, the stock actually starts outperforming the Nifty.

2) Every ten years the Nifty churns by around 45 per cent i.e. of the 50 stocks that make up the Nifty at the beginning of the decade, only 28 are still in the Nifty a decade hence (with 22 having exited over the course of the decade). Interestingly, such churn is comparable to other emerging markets like Brazil and Hong Kong but much higher than that prevailing in a developed market such as the US (which has churn of around 30 per cent).

Note that since around 22 stocks exit the Nifty every ten years, by definition the same number has to enter the Nifty. Note further that law 1 tells us that we need to focus our time and effort disproportionately in identifying these Nifty entrants and exits because that is where the heavy out/underperformance lies. So how does one identify these critical stocks?

3a) Almost 65 per cent of the stocks exiting the Nifty over a ten-year period come from the bottom 20 stocks in the Nifty. So, of the 22 exits that take place every decade or so, 14 come from the bottom 20 stocks in the Nifty (suggesting a 70 per cent attrition rate for the bottom 20 stocks in the Nifty).

3b) Of the top 10 stocks in the Nifty at the beginning of a decade, one stock is thrown out of the Nifty by the end of the decade. Obviously this stock underperforms the Nifty in a major way over the course of the decade (usually with a CAGR of 15-20 per cent).

4a) Almost 80 per cent of the stocks entering the Nifty over a ten-year period come from the 50 stocks just below the Nifty at the beginning of the decade. The NSE calls these 50 stocks the “Nifty junior”. So, of the 22 entries that take place every decade or so, 18 come from the 50 stocks in the Nifty junior. As mentioned in law 1a, typically, the underperformance in the three years running up to Nifty exit is 20 per cent on a CAGR basis.

4b) Around 20 per cent of the stocks entering the Nifty over a ten-year period comes from the world below the Nifty junior. Since these are midcap stocks making a giant leap to “large cap” status over a ten year period, they are superstar performers usually generating outperformance relative to the Nifty of 50 per cent CAGR (over a ten-year period).

As I said at the beginning of the mail, much of this is intuitive, but what is really helpful is that a framework like this really focuses your mind on identifying the big drivers of portfolio performance such as the midcaps, which have it in them to become a Nifty constituent a decade hence and, conversely, the “top 10” Nifty constituents which will get knocked out of the Nifty a decade hence.

As an aside, these findings also point to the futility of putting your money in “index tracking” funds which necessarily have to buy stocks after they have entered the Nifty (i.e. just as they are about to begin underperforming) and sell stocks after they have exited the Nifty (i.e. just as they are about to begin outperforming). It’s the popular hold of insane ideas like this which allow people like me to earn a living.

The growing prevalence of index trackers also suggests that the following simple but counterintuitive pair trade should generate alpha: SELL entrants into the Nifty and BUY exits from the Nifty!

(Saurabh Mukherjea is the Head of Equities at Ambit Capital. The views expressed here are his own and not Ambit Capital’s.)


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1 Comment
Anand Andhalkar . 5 years ago

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Four laws of stock market investing

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