Reconstituting the Sensex

In my previous column, I had outlined, how I believed, Prime Minister Narendra Modi is likely to engineer three critical resets over the next four years, namely: (1) Shift India's savings landscape away from physical assets towards the formal financial system, (2) disrupt the model of crony capitalism and (3) redefine India's subsidy mechanism. Whilst in the long run these resets are likely to lower the cost of land, labour and capital, in the immediate term these changes are likely to limit GDP growth.

I had gone on to point out that Indian history shows that the initiation of powerful resets renders redundant the traditional constructs used by investors. This in turn spawns a new generation of winners and losers in the Indian stock market. For instance, 1992-2002 saw the era of the 'licence raj' coming to an end and also saw the Sensex's churn ratio rise to 60 per cent (i.e., 18 of the 30 companies in the Sensex in 1992 were out of the Sensex by 2002). In this column I will delve what the most likely companies are to be ejected from the Sensex over the next decade as the new PM's resets gain traction.

The churn in the Sensex peaked in the four years following the momentous reforms launched by P V Narsimha Rao (as PM) and Manmohan Singh (as finance minister). A whole host of businesses which had flourished behind the protectionist barriers created by the licence raj in industries were ejected from the Sensex. These industries include: (1) textiles (Aditya Birla Nuvo, Bombay Dyeing, Century Textiles and Future Polyester), (2) automobiles (Hindustan Motors and Premier), (3) steel (Mukand Limited), (4) paper (Ballarpur Industries) and (5) heavy engineering (Bharat Forge, Cummins India, Siemens and Voltas).

Post 1995 Sensex churn has fallen remarkably relative to the volatile era of the early 1990s - only eight replacements were made in the Sensex from 2004 to 2014 vs 20 from 1995 to 2005. Sensex incumbents grew rapidly in size and I attribute this to the following reasons:

• Large business groups ramped up domestic capacities in a licence-free era and followed them up by large acquisitions in the noughties (Reliance, Tata Steel and Hindalco).
• Export-led companies like software (Infosys and TCS) and pharmaceuticals expanded.
• The noughties also saw the rise of infrastructure companies (L&T) and banks/financial institutions which funded their expansion (ICICI Bank) and also benefitted (HDFC and HDFC Bank) due to the rise in overall GDP growth (from 3.9 per cent in FY03 to 8 per cent in FY04, 7.1 per cent in FY05, 9.5 per cent in FY05 and 9.6 per cent in FY01).
• Towards the end of the noughties, the rise in rural-led consumption (fuelled by rapid growth in subsidies) benefitted auto (Hero MotoCorp, Bajaj Auto, M&M and Maruti) and FMCG (HUL and ITC) stocks.

Further, the likelihood of churn from new company listings was also limited, at least in the first half of the noughties.

In light of the three resets that Modi is likely to engineer, the next ten years in India appear likely to be akin to the 1990s rather than the noughties as the period spanning 1992-2002 too was a decade defined by irrevocable structural changes being administered by the political leadership. So amongst today's Sensex constituents, which companies are the most likely exit candidates?

The most logical way to identify Sensex exit candidates is to look for companies whose value generation engine is already sputtering. A relatively straightforward way of doing this is to score the Sensex constituents on the basis of their ability over the last ten years to deliver ROCE of at least 15 per cent per annum (most sane estimates of cost of equity in India suggest that it is at least 15 per cent) and to deliver revenue growth of at least 10 per cent per annum (since nominal GDP growth in India was at least 10 per cent in the preceding ten-year period). The more years (out of ten), the Sensex constituents fail to deliver on these two metrics, the lower the score given to them. On this basis, there are nine companies which are relatively clear-cut exit candidates: Tata Power, NTPC, Hindalco, Tata Steel, Hero Motocorp, State Bank of India, Sesa Sterlite (Vedanta), Bharti Airtel and Reliance Industries.

Then we come to a group of another ten companies which don't do too badly on the two criteria. They aren't champions of ROCE and revenue growth but nor are they struggling. Amongst these ten, six companies - M&M, HDFC, L&T, Bajaj Auto, BHEL and ONGC - have positions of overwhelming dominance in their sectors. Their position is similar in many ways to that of Hindustan Motors and Premier Padmini in 1991 (when both of them were Sensex constituents by dint of their dominance on the Indian car market in a closed economy). For example, Bajaj Auto has operating margins of close to 20 per cent and ROCE close to 50 per cent, ratios unmatched by any other two-wheeler company anywhere in the world. As Modi's resets kick-in, it is relatively clear that the intensity of competition will rise (thanks to foreigners like Honda and domestic players like TVS) and impact Bajaj's margins and ROCE. As a result, earnings growth for this company will become a challenge. Hence, I also see these six sectoral leaders as Sensex exit candidates.

There is another way to think about the 15 exit candidates I have identified for the next ten years:

• Companies which face a challenge as regulatory change deprives them of unusually cheap access to natural resources: Hindalco, Sesa Sterlite (Vedanta), Bharti Airtel, Reliance Industries, Tata Power, Tata Steel and NTPC.
• PSUs which face a challenge for access to talent and capital in a reset Indian economy: BHEL, SBI and ONGC.
• Dominant oligopolists who find competition intensifying in a reset economy: Bajaj Auto, Hero Moto, L&T and M&M.

India's economic evolution since 1991 has shown us that churn in the Sensex is the only constant. So whilst it is possible that some of my exit candidates could reinvent themselves and have a stellar run over the next decade, it is more likely that most of these names will have a more difficult time going forward than they have had over the past ten years.

Saurabh Mukherjea is CEO - Institutional Equities at Ambit Capital and the author of Gurus of Chaos: Modern India's Money Masters.

This column appeared in the June 2015 Issue of Wealth Insight.