In this writeup I want to explore the NIFTY 50 as a portfolio and see what makes it tick, how we could beat it and/ or if it were even worth trying to. Recently there was an article in Barrons which mentioned the persistency of alpha generation in the Indian markets – developed markets worldwide are all moving towards passive investing with ETFs responsible for most of the trading on exchanges. In these developed markets, it has become increasingly become difficult to beat the benchmark. Remember Warren Buffett’s famous bet on the S&P 500 vs hedge fund performance? For India, even with history promoting active management in the Indian context, anecdotally at least for the last 2 years, it seems that a passive investor in the NIFTY 50 ETF would have been in the top decile of performance what with the broad market giving up significant gains made during 2017 and earlier. An average retail investor in India who has invested in SIPs and mutual funds has underperformed in the last 3 years compared to the NIFTY 50.

Fans of the movie Moneyball will appreciate the fact that it is not the superstar that will win the match (since he has proven to be too expensive with not enough return for the price) – rather the idiosyncratic contributions/ specialties of individual team members (acquired at cheap prices and underappreciated by the market) working together as a team that will break records. In financial academic terms, we are alluding to the covariance of stocks amongst themselves which will lead an optimal risk/ return payoff – the genesis of the Efficient Frontier. The point here is that we are trying to find a portfolio of stocks with a better expected risk/ return payoff than the NIFTY. With ~1100 stocks in my stock universe, it would be a non-trivial exercise and with some fancy optimization tricks trying to search for this portfolio (the starting point would be a co-variance matrix of size 1100*1100). The other problem with this approach is that it is too academic and is suited best for asset classes awhole with generally accepted risk and return expectations. With individual stocks, it becomes too difficult to believe that the past history used to calculate the co-variances would be repeated in the future. Any optimal portfolio thus generated would be backward looking with the benefit of hindsight of past data, as opposed to what could be expected from the portfolio.

The approach I favor instead is to imagine the NIFTY as a 2-stock portfolio: 1. Stock A is an industrial company and 2. Stock B is a financial company. Before I proceed further, I want to talk about the structure of the NIFTY and the drivers behind its performance. The first thing to understand is that the NIFTY (like other global benchmarks) is float weighted instead of price weighted or market cap weighted. This in itself throws up some quirks. The HDFC twins (HDFCBANK and HDFC) along with RELIANCE and ITC are the 4 biggest weights on a float-adjusted basis. ITC and HDFC have about half the market cap of HDFCBANK which itself is 80% of the market cap of RELIANCE. Yet, once we adjust the market cap by the float, these 4 have almost the same weights in the index. TCS’ market cap is more than twice that of INFY, yet its weight in the NIFTY is lower given its float. Overall, Stock A mentioned above has a weight of about 63% and stock B the remaining 37%.

So, the mindset I want to use here is that when I look at the NIFTY it is as if I am owning 2 businesses – Stocks A and B. Whatever the constituents of the NIFTY, I want to distill them into these 2 assets and -putting on the wily businessman hat - see if I would like owning them or if there is something better out there. Once again, when I calculate averages to analyze these businesses, I will be taking the weights of the NIFTY constituents to calculate these averages. However for some averages, it would make sense to use the full market cap as opposed to the NIFTY weights of the constituents.

Stock A:

1. ROE of 22% 

2. P/ Adj. Book of 3.4 (Adj. Book where I capitalize some portion of historical SGA to get a better sense of BV) 

3. YOY sales growth of ~12% (based on available latest data)

4. YOY reported earnings growth of ~15% (based on available latest data)

5. YOY PBIT growth of ~14% (based on available latest data) 

6. No growth Earnings Power Value is almost 70% of the (non-float adjusted) market cap of the company i.e. 30% of the market cap is attributed to future growth

7. Market cap of at 78K Cr (this is the median market cap of the non-financial names in the NIFTY)

8. Net Debt / Equity of ~23% 

Stock B:

1. ROE of 12%

2. P/B of ~3.25

3. YOY reported earnings growth of ~13.6%

4. Market cap of 107K Cr. (again this is the median market cap of the financial names in the NIFTY)

5. Net Debt / Equity of 630%

Right off the bat, a few things stand out – these are 2 large cap businesses with very decent ROEs and earnings growth. In other words they are well run companies. But, can we do better? This whole exercise comes down to the philosophy of finding companies which are underappreciated by the market (compared to the NIFTY) which (we hope) will be eventually unearthed by the market.

So, with this data as a start, how could be try to beat the NIFTY. First some ground rules. We will be using a filter of 3000 Cr as a minimum mkt cap for a proxy of investibility. Below this number, stocks fall into the small cap category with limited available data available. For the industrial group, I then apply filters of ROE > 20%, P/ Adj Book < 3.5 and Net Debt / Equity < 30%. I get a list of 24 companies outside the names already in the NIFTY. I get a similar list if I use No growth EPV as a filter instead of P/ Adj. Book for valuation. 

For the financial group, again I filter for market cap > 3000 Cr, ROE > 10%, P/ Adj Book < 3.5 and Net Debt / Equity < 700%. I get a list of only 20 companies. 

Almost all the companies that come up in the 2 lists above are there for a reason, either because they have idiosyncratic issues that have been well advertised to the market or the whole sector is facing headwinds (like Autos). The point is that the hunting ground for a value-oriented portfolio manager has become extremely narrow and I would imagine that he would find himself holding substantially similar names as constituents of the NIFTY. The NIFTY constituents already seem to have been chosen, and their market caps adjusted by Mr. Market such that together they form a highly efficient company (stock A and stock B).

 So then, what options do we have now? Well, one way is to expand our investing universe/ style. Introducing shorts into the portfolio could be one way (with commensurate introduction of risk). The other way would be to focus on deep research – work to gain some edge – either by talking to company management or channel checks to gain short term timing edges. (In a perfectly efficient market these edges should wither away). Yet another way is to introduce small cap names in the portfolio. All of these have risks associated with them. For a retail investor then, it would make sense to just buy index funds or NIFTY ETFs instead of the effort of portfolio construction. I believe that India could regress to the rest of the world when it comes to the persistency of alpha. The only hope then of trying to beat the NIFTY would be taking on more risk.