While globally the trend is clearly in
favour of ETF’s or passive investing, emerging markets like India still offers
plenty of scope for stock selection and active management. Investors can take a cue from bellwether
indexes like Nifty 50 or Sensex and develop strategies around them to gain
alpha. In this context, the recently launched index by National Stock Exchange
(NSE) 2015 attracted my attention. . It is titled as “Nifty 30 Quality Index”
comprising 30 best Indian companies evaluated across three important parameters
i.e., Return on Equity (RoE), Debt to Equity ratio (D/E) and Net Income growth.
It is normally understood that highly profitable companies with low levels of
debt perform well over time compared to medium to low profitable business with
high leverage. True to this logic, the Nifty quality index returned 16%
annualized during the last three years compared to 13% for Nifty 50. Definitely
some alpha here for chasing quality.
While index investing is a good idea for
lay investors, professional investors can do more in terms of deciphering some
strategy around these indices. Any index is always a combination of great, good
and poor stocks. Buying the index (in the form of ETF) means not only buying
great and good but also poor stocks. This article attempts to improvise the
quality index by focussing only on great stocks and see if we can perform
better than the index.
The 30 companies in the quality index can
be broken down into three groups viz., , great, good and poor based on their
stock performance since the launch of the index.
While great group are super performers, the
good group eked out decent performance while poor group actually performed
poorly true to their name. The poor group pulled down the overall performance
of the quality index as they enjoyed higher share of the index by virtue of
their size. Here is the summary of the three groups:
April, 2013 to September, 2016
|
Great
|
Good
|
Poor
|
Total
|
No of stocks
|
14
|
9
|
7
|
30
|
Market cap weight (%)
|
33
|
31
|
36
|
100%
|
Average. RoE ( %)
|
28
|
45
|
27
|
33
|
Average D/E ( %)
|
44
|
10
|
2
|
18
|
Annualized Net Income growth (i%)
|
27
|
2
|
0
|
7.4
|
Portfolio Performance
|
34%
|
17%
|
8%
|
16%
|
Dissecting the 30 companies constituting
the quality index, we can see that 14 of them are star performers, 9 good and 7
companies draggers with more or less equally divided weights among themselves.
It is interesting to note that all three groups enjoy high return on equity.
However, the great group has the highest debt to equity ratio while the poor
group has the lowest. However, the key among the metrics is the net income
growth. The great group show a robust net income growth of 27% annualized while
the good group show only 2% growth. Worse, the poor group show 0% growth. If
you carve out these three groups as distinct portfolios, the great group portfolio
returned an astounding performance of 34% annualized, the good group 17%
(equivalent to the quality index performance) while the poor group returned
only 8% severely underperforming the overall quality index.
In each of these groups there are
surprising entries as well. For eg., in the great group we have companies like
Emami and Tata Motors recording negative income growth but stellar stock price
performance. The poor net income growth can be attributed to latest quarters
and hence they may be penalized going forward. In the good group category, Tech
Mahindra enjoys high RoE, low D/E and high NI growth but performed average
relative to index which is surprising. In the poor group, we don’t see any
surprises as all of them report poor net income growth.
Caveat: This analysis looks at the past performance
and extrapolates into the future. There is a good possibility that companies in
the great group can drop down to good or poor and vice-versa. Hence, it behoves
to revisit this strategy annually to make changes to portfolio.
PS: The author thanks Rajesh Dheenathayalan
for data assistance
