How Sensex captures the power of equity

The first stock market boom I witnessed was in 1985. Optimism was high about the young PM Rajiv Gandhi and his FM V.P. Singh. They announced the first set of reforms that encouraged private investment and business expansion, and the equity markets boomed.At that time there was no index to track. The BSE Sensitive Index had been computed and was ready to launch. Its values had crossed 400 in the computations at the research and stats division of the BSE. But the team was busy working out another index called the BSE National Index, with prices taken from Delhi, Kolkata, Ahmedabad and Chennai. M.R. Mayya, who headed the BSE, wanted to launch both indices together.Brokers were not very keen about these developments. In one of the presentations to gauge the possible reception, one of them asked: “If we cannot buy or sell this index, what use is this number to us? Will anyone care about it?” The worry was if all the effort to carefully construct and back calculate the index to 1979 will go to waste.No one understood or appreciated what market capitalisation weighting was. Why can’t the index take the price of one share of each of the 30 shares and average it out? If someone kept buying one share each in that manner, if the number of shares they issued was lower, there won’t be any more to buy. But a large-cap business with a larger number of shares will be present in many more portfolios. So the index must be weighted by market cap, we argued.The press was not sure if the index number had to be published. They knew about the Dow Jones index. They were wondering if we were just copying the West. They asked many questions about what was included and why. When we told them that a small set of shares is enough to track the overall market, there was no appreciation. Why not include all the shares, was the argument.Prof L.C. Gupta, a doyen in capital market research, published a book calculating such an index. He concluded that stocks did worse than saving deposits and that returns were not even 4%. When I published the results of a portfolio of top 100 stocks from 1964 onwards, and argued that the long-term return from equity was 16% per annum, Prof Gupta who chaired that seminar session asked what the intervaling effect I was alluding to, meant.If a share is not traded, and is not liquid, the stock price is not representative of its returns in the period it remained idle, I pointed out. Therefore, an index must only consider liquid stocks. Stocks that trade everyday, so that prices are refreshed to reflect new information. It took tremendous effort to convince various sections that the Indian stock markets needed an index.The unprecedented boom of 1985 started a new genre of financial journalism. People bought and read opinions about IPOs with interest. A large wave of retail investors flocked the market with the boom. Mayya had to announce the index whose values were moving up every day. He did so in January 1986. No one bothered much about the National index or about what happened to MRF in Chennai or Sriram in Delhi when the action was squarely happening in Mumbai.Being included in the Sensex was a thing. That only top stocks with high liquidity got in made it something of a league companies wanted to be seen to belong. The index included the largest, most liquid, profitable businesses that were industry leaders. This list was dynamic. In 1985 there were no listed private banks that were liquid; IT was not a sector; telecom held no private player; PSUs were not listed. As time rolled, stocks were replaced and this beacon simply held the best. That is its greatest merit.When the Sensex crossed the 1,000 level in July 1990 we were in the middle of the Harshad Mehta driven boom. Many of my friends told me that it was the end, as the index had moved from 100 to 1,000. How much more can it appreciate they wondered. So with every new peak that was celebrated as the new high, and every crash that was mourned as the end of the world, we have this index scaling 50,000 and everyone gasping at the new high.There is no story in that number. It is like saying I am now 60 years old and this is a new high for me and see how I grew from one cell to this number. It is as silly and naive as that. The index only mirrors how equity as an asset class has performed over the years. As new businesses are formed and as they succeed, their share prices rise to reflect that value, and the index captures this growth.The thing to marvel about is that power of equity which the Sensex represents. Businesses can thrive or fail, but there are always a bunch of winning businesses that lead, grow, and appreciate in value. So many popular stocks in the Sensex of the 1980s are no longer big or successful. Who cares today about Hindustan Motors, Wimco matches, Century Textiles, or Gujarat Narmada Valley Fertiliser Company? These were bluechips then. The index climbs up because the market doesn’t crash and halt with failures. It celebrates new successes. The story of the Sensex is the story of revising a portfolio to keep the best.To make the return that is embodied in the Sensex there are only two ways. One is to simply buy the index through an index fund or ETF. The second is to construct a portfolio of the same stocks, with the same weights, and keep actively replacing laggards with leaders.There is a third choice. Create a diversified portfolio of carefully chosen stocks and actively manage it. You will strive to do better than the index but you will be surprised to find that on an average you seem to be doing just as well as the index. The paradox that mutual funds deal with. Some do better; some do worse. Completely randomly. As a group they average out. Thus any diversified equity portfolio will perform mostly like the index. That is asset class return for you! Celebrate the index; but make sure you invest in equity and choose a diversified portfolio that throws out laggards ruthlessly. That is the story of the Sensex.(The writer is Chairperson, Centre for Investment Education and Learning)

from Economic Times https://ift.tt/2YGGRI4