Indian Equities: Invest in “Quality” but….

January 21, 2017

While globally the trend is clearly in favor 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 focusing 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:

 

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 under performing 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 behooves to revisit this strategy annually to make changes to portfolio.

 

PS: The author thanks Rajesh Dheenathayalan for data assistance

 

 

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