Where is the Correlation?

This article was originally published in Gulf News 

It is well known that oil revenues - and by default oil prices - are what drive GCC economies, despite efforts by individual GCC states to diversify their economies. Hydrocarbon GDP continues to dominate the economic structure, and consequently, periods of high oil prices and high economic growth, have fed into the stock market through increased liquidity and petrodollars. However, this relationship seems to be breaking, with oil price no longer driving stock market performance. From 2005 to date, crude oil and the S&P GCC Index have had a correlation of only 12%, a relatively  low figure. Since 2008, crude oil price increased by 19% while S&P’s GCC index fell by 46%. So why is this correlation diverging and is it likely to return?

Figure 1: Oil Price and S&P GCC Composite Index

Source: Reuters Eikon

Reason #1: The Oil Price-Economy-Stock Market link broken thanks to Banks

Bank lending has always been the conduit through which petrodollars have made their way into the stock market. The oil revenues feed into the citizens’ coffers through wages and social allowances, which are then placed with banks and are subsequently lent out. Roughly 10% of loan portfolios are for the purpose of stock market investing. In the past (especially 2005-2008) bank lending was growing at a frantic pace of 33% a year while in the subsequent period that average fell to a muted 5%.

Lending has considerably slowed over the last few years as GCC banks have exercised greater prudence and heightened risk aversion in the face of highly leveraged corporates and individual retail clients. Banks have been unwilling to lend as they have worked towards shoring up capital, increasing provisions and coverage of non-performing loans in addition to maintaining existing credit lines. On the other handmany retail investors have been deleveraging and therefore cannot procure the means to fund their activities in the stock market.

 

Reason #2: Increased Government Spending

Encouraged by the strong oil price and oil revenues and coupled with the need to shore up infrastructure on the back of demographic changes, GCC governments are investing heavily in infrastructure and other social projects, to the  extent that this is crowding out a weak private sector, which is mostly represented in the stock market. Also, some of the big family houses that are direct beneficiaries of this government spending are not represented in the stock market, leading to the lack of transmission mechanism between oil price and stock market performance.

 Reason # 3: Fear Factor

 The aftermath of 2008 global financial crisis has left deep wounds on the psyche of many corporates, high net worth individuals and retail investors. Many regional investors had substantial investments abroad and faced losses due to this. This has caused risk aversion and a fear factor that prohibits them from taking risk. In the past, the smooth transmission mechanism between oil revenues and stock market created the needed Feel Good Factor (FGF) that enabled investors to take risk and infuse confidence. The fear factor is doing exactly the opposite thing, leading to a disconnect between oil price and stock market. The fear factor is also exacerbated by the political developments in the form of “Arab Spring”

Reason #4: A “dependent” monetary policy

Most of the GCC governments peg their currency to the USD, forcing them to mirror US monetary policy even though the economic settings are not as nearly synchronized as it should be for the peg to function logically. This causes needless friction in terms of inflation and other side effects. For eg., even though the GCC region is growing well economically, thanks to high oil price, it has to have a loose monetary policy in line with US. However, this does not result in increased borrowing due to risk aversion both on the part of lenders and borrowers. In normal times, such low interest rates should encourage borrowers to borrow and seek higher yields in the stock market.

Reason #5: Increasing global connect

The GCC region is today more interconnected with the outside world than before, thanks to increasing trade. This means that events outside the region will have an increasing impact on the local economy. Lack of growth in inter-trade among GCC countries also forces this situation.

Why is the correlation important?

The GCC region is oil dependent and will continue to be oil dependent for the foreseeable future. Economic progress need not translate instantly into stock market riches as we have seen with many countries including China. However, it has to eventually catch up and reflect especially in predominantly one-product economies like those in the GCC. Hence, sooner or later, oil wealth should resonate in stock market success aided by regulatory reforms, institutional participation and bank strength. Also, oil price strength on account of improving global demand may enable return of confidence while oil price strength on account of supply fears may hinder confidence. While continued bank distress may delay the transmission process for the moment, correlation is bound to come back - at least in the medium term if not short-term.  This is a good thing and good for the region’s economic growth.

 

A Tale of Nifty Fifty Survivors

This article was originally published in the Global Analyst Magazine.

Whats so special about these companies?

ACC	HDFC	Reliance Infra	ICICI	Infosys
Ambuja Cements	ITC	SBI	L&T	BPCL
HDFC Bank	M&M	Telco	BHEL	Sun Pharma
Hindalco	Ranbaxy	Tata Power	Cipla	Wipro
Hindustan Lever	Reliance	Tisco	Hero Motors

 

They all survived the index (“Nifty”) for a decade or more. Not a small feat by any means!

How did we arrive at this list?

Nifty, as an index, is comprised of 50 leading stocks. But the index committee at National Stock Exchange (NSE) do carry out periodic changes (quarterly or more) whereby stocks are excluded and included based on a variety of criteria including financial performance, liquidity, etc. Since 1996 when the Nifty was constituted, nearly 100 companies have participated in this ritual of getting in and getting out. While 49 companies have survived the Nifty (out of which 24 survived for 10 or more years), 53 companies got axed out at some stage or other due to various reasons including poor performance, mergers, delisting, liquidity, etc. Out of the 24 companies that survived for 10 or more years, 17 of them survived since the formation of the index i.e., for 16 years! (the grey shaded companies in the box above)

From the current list of the index, we backtracked it based on the data provided in the NSE website about inclusions and exclusions. Here is a visual description of this in and out process.

Why is it important?

Getting included in the index is considered a feather in the cap for a company. Well governed companies work for such accreditation since inclusion attracts institutional investors (domestic and foreign) and improves the liquidity and profile for the stock. More important than the inclusion is the ability to stay put in the index without being axed. Surviving the nifty becomes important in that context since companies should continuously qualify under various parameters to be part of the index.

How is their performance?

The “survivors” averaged an annualized return of 18% during these long years of stay in the Nifty compared to Nifty’s 12% annualized return. Sun Pharma topped the list with a 35% annualized return followed by Infosys (34%) and HDFC Bank (33%) (see the risk-return chart). The lowest in the pack was Hindalco at 5%.  They all enjoyed good daily liquidity and have consistently produced excellent top line and bottom line growth. We also can notice other companies in the survivor list that survived for less than 10 years and is still going strong. They average a return of 12% again with good liquidity. As they season and age (like the survivors), they may pick up in performance and out beat the Nifty index.

 

 

The power of compounding is so astounding that an investment of Rs.10,000 back in 1996 in say HDFC Bank would now be worth Rs. 10 lakhs while the same invested in Nifty index will be worth only Rs.61,222 and worse, Hindalco worth only about Rs.21,808. However, this is not to suggest investing only in one or two companies as it takes away the benefit of diversification.

The “non-survivors” (totaling 53 companies) averaged an annualized return of -3% with liquidity just one third of survivors. Their average staying period in the Nifty index was less than 6 years ranging from 2 years on the bottom (Jet Airways, Andhra Valley, etc) to 14 years (ABB).

So what should be the portfolio strategy?

The key here is to monitor a company’s ability to survive Nifty for say a good period (10 years!) whereupon it becomes a candidate for inclusion in one’s portfolio till the time it is evicted out of Nifty for one reason or other.  All the 17 stocks that survived the Nifty till date will qualify for portfolio inclusion after a waiting period of 10 years. In other words, Since Nifty was formed in 1996, that testing period of ten years would end in 2005 when these stocks will be natural inclusions. A quick check of the performance of these hardcore survivors post portfolio inclusion (i.e, 2005) show that the performance is mostly superior to the naïve nifty investment. The only work here is to monitor the quarterly inclusion/exclusion exercise of the NSE which I feel is not that big a deal. 

Company	Year of inclusion in the portfolio	Purchase price	Sale price	CAGR (2005-2012)
HDFC Bank	2005	123.9	558.8	24%
M&M	2005	164.5	736.7	24%
I T C	2005	55.9	245.3	24%
L&T	2005	318.5	1337.1	23%
HDFC	2005	180.7	697.9	21%
ACC	2005	424	1298.7	17%
RIL	2005	253.7	769.4	17%
SBI	2005	717.6	2093.5	17%
HUL	2005	161.2	454.4	16%
Tata Motors	2005	94	256.7	15%
Ambuja	2005	65.5	174	15%
Tata Power	2005	40.5	103.1	14%
Nifty	2005	2297.1	5314.2	13%
ICICI Bank	2005	463	909.6	10%
Tata Steel	2005	331.8	431.2	4%
Hindalco	2005	111.4	124.3	2%
Ranbaxy	2005	473.2	493	1%
Rel infra	2005	562	525.4	-1%

 

The author thanks Ms. Sowmya Dorai for data analysis.