Should you buy stocks that get added to the stock market index - Motilal Oswal
Should you buy stocks that get added to the stock market index - Motilal Oswal

Should you buy stocks that get added to the stock market index

The Nifty of 1995 was vastly different from the Nifty of today largely because there have been substantial inclusions and exclusions. The big question is how you should approach stocks that get added to the index and the stocks that get removed from the index. Intuitively it would be logical to assume that stocks that get included in the index should appreciate and stocks that get excluded from the index should depreciate in price. But we will have to look at it from two perspectives. Firstly, we need to understand how these stocks performed prior to the inclusion date and secondly we also need to understand how they performed post the inclusion date.

 

If inclusion of stocks driving returns is true then do we gain by investing in market index funds? Should you invest in index funds India to benefit from these changes? Above all, let us look at index fund investing for beginners. To get clarity on this subject we have analysed the 6 months pre-inclusion date and the 6 months post inclusion price date of the stocks that got excluded and included in the Nifty effective September 29th 2017.

 

Key Changes to the Nifty Effective Sep 29th 2018Nifty ActionStock NameNifty ActionStock NameInclusionBajaj FinanceExclusionACCInclusionHPCLExclusionBank of BarodaInclusionUPLExclusionTata Power

ExclusionTata Motor DVR

 
Why are stocks excluded or included in the Nifty?

What exactly is the justification for the NSE Index Committee to include and drop stocks in the index? In fact, there could be a variety of reasons for the same. Firstly, the Nifty needs to reflect the changing face of the economy. For example, IT was a major component of the index in early 2000, oil was a major component in 2007 while banking and financials have the biggest representation today. Currently, financials constitute about 35% of the Nifty index. Secondly, the Nifty typically tends to weed out underperformers from the index which explains why the pharma companies have been gradually moving out of the index while more of financials have been coming into the index. Thirdly, certain stocks by the sheer weight of their market cap may justify inclusion in the index.

 

What happens to Nifty Inclusions prior to and after the effective date?
Let us first look at the 3 stocks that were included in the Nifty effective September 29th 2017 and see the performance of the stocks 6 months prior to the inclusion and 6 months after the inclusion. The chart below compares the relative price performance of these 3 stocks from the beginning of April 2017 to end of March 2018. This virtually splits the price performance into two halves pre and post the inclusion of these stocks in to the Nifty Index. How does the performance look like?

 

                                      Chart Source: Bloomberg

 

If you look at the half way break-down of the above chart, then it is clear that Bajaj Finance and HPCL outperformed in the 6 months prior to the inclusion date. Post the inclusion date, Bajaj Finance has been almost flat while HPCL has actually given negative returns. UPL has been flat to negative before and after the inclusion date, showing that it is largely agnostic to the inclusion in the index. There are two things to remember here. Bajaj Finance had been in the midst of a multi-year rally and post-September the fears over Fed rate hike and domestic factors were weighing on all financial stocks. In case of HPCL, post September the impact was negative as it looked likely that the government could rethink on free pricing and also that oil companies may be asked to bail out one another. That has not gone down well with the markets.

 

What happens to Nifty Exclusions prior to and after the effective date?

 

                                   Chart Source: Bloomberg

 

When it comes to the Nifty exclusions the impact on price has been negative for 3 out of the four companies. Only ACC has managed to give positive returns, although even in case of ACC the returns post the exclusion have been negative. In case of BOB, Tata Power and Tata Motor DVR, the negative returns have been quite pronounced. So what are the key inferences that we can draw from the above two charts analyzing the price movements prior to and post the inclusion and exclusion of stocks in the Nifty?

 

4 key takeaways about index inclusions and exclusions..

 

1.  The impact prior to the inclusion date has been positive in most of the cases. In fact, we have seen increasing volume activity and also trading activity in these stocks that are included in the index. That is obviously coming from retail investors and traders who are trying to trade around the news.

2.  The real impact on price is possibly coming from the actions of index funds and global ETFs. These funds tend to benchmark their portfolio to the Nifty Index so any exclusion or inclusion results in a reduction or addition to their portfolio of these respective stocks. That is why the positive impact on index inclusions have been more pronounced prior to the actual inclusion date due to pent-up expectations.

3.  The macro and the overall market situation has a major impact just as company specific factors also have a sharp impact on the price performance. In case of BOB, Tata Motor DVR and Tata Power the negative performance post the exclusion is due to their individual problems in these companies and has little do with the index exclusion.

4.  The crux of the story is that in the medium term to long run the price impact of such inclusions and exclusions is quite limited. What matters are a favourable business environment and the performance of the company in question?
 

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