20 of today’s Nifty constituents are highly likely to be booted out over the next decade. We outline how you can identify the exits (relatively easy to do) and the entrants into the Nifty (a little harder to do) over the next decade. If you are good at spotting the 20 entrants into the Nifty you are likely to deliver 40% CAGR over the next decade.
“Though not a single household was wired for electricity in 1880, nearly 100 percent of US urban homes were wired by 1940, and in the same time interval the percentage of urban homes with clean running piped water and sewer pipes for waste disposal had reached 94 percent. More than 80 percent of urban homes in 1940 had interior flush toilets, 73 percent had gas for heating and cooking…In short, the 1870 houses were isolated from the rest of the world, but 1940 houses were ‘networked’, most having the five connections of electricity, gas, telephone, water and sewer…Networking inherently implies equality. Everyone, rich and poor, is plugged into the same electric, water, sewer, gas and telephone network.” – Robert Gordon in “The Rise & Fall of American Growth” (2016)
[Note: A shortened version of this piece was first published in Forbes India on 3rd Jan 2020.]
The Nifty typically churns by 40% over a ten-year period implying that 20 of the current Nifty constituents will find themselves ejected from India’s most actively traded benchmark index whilst an equal number will find themselves entering the index. If you or I can second guess some of these exits/entrants we will improve our chances of generating returns significantly higher than the long term returns of investing in the Nifty (the total returns from the Nifty were 10% per annum in the decade running upto 1st December 2019). For example, if we had taken the Nifty as it is stood a decade ago and invested only in those 30 companies which have stayed in the Nifty through the intervening ten-year period, our returns would have been 19% per annum.
Going by the historical trend since the Nifty was created, almost all the entrants into the Nifty over the next decade will come from 100 stocks currently just underneath the Nifty. In order to assess which of these 100 companies will find themselves in the benchmark a decade hence, it is worth first trying to assess how the Indian economy will change over the coming decade.
We see three noteworthy changes taking place in India over the next decade:
- The continuing formalisation of the economy and the concentration of profit share in almost every sector in the hands of one or two companies.
- The formalisation of savings, away from physical savings, and toward financial savings.
- The continuing formalisation of retail and, more generally, of distribution channels in India.
Let’s delve deeper into each of these changes.
1) Formalisation of the economy & concentration of profit share: India is already an economy with extraordinary levels of profit share concentration in many key sectors. For example, in paints (Asian Paints, Berger Paints), premium cooking oil (Marico, Adani), biscuits (Britannia, Parle), hair oil (Marico, Bajaj Corp), infant milk powder (Nestle), cigarettes (ITC), adhesives (Pidilite), waterproofing (Pidilite again), trucks (Tata Motors, Ashok Leyland), small cars (Maruti, Hyundai) we already have one or two companies accounting for 80% of the profits generated in the sector. Now this trend looks likely to spread to more fragmented sectors where hitherto the unorganised players had greater profit share.
Leaving aside Financial Services and Retail – which we will discuss further on in this piece – there are several other large sectors where the impact of the: (a) networking of the economy (widely available cheap broadband, low cost domestic flights, a reliable & extensive road network, widespread availability of banking services) ; (b) the impact of GST and the attendant crackdown on black money look likely to compress profit share into one or two hands. Smaller players who don’t use technology optimally, who cannot build deep competitive moats and who cannot access funding at low cost will die. Effectively, the networking of the Indian economy has sounded the death knell for the small-scale local manufacturer/retailer who was hitherto insulated from competition from the market leading player.
Sectors where I can personally see this dynamic playing out – in terms of the research that the team in Marcellus does – are the entire building materials space barring cement (where the cost of moving material naturally creates local champions), most FMCG categories including hitherto niche categories like Indian snack food, electricals in the broadest sense of the word (lighting, fans, kitchenware, cables, wiring, consumer durables) and most auto ancillaries (where the ability of the replacement market to support spare parts suppliers who operate in the black market will wither away).
The rewards for the winners is huge – they get the profits of the entire sector and market cap in excess of US$10 billion. The losers will be numerous and understandably they will make a lot of noise because of the sheer amount of pain they will go through. Many SME owners will find that their firm’s return on capital will fall well below cost of capital. They will also find that their children will prefer to enjoy life in Western cities rather than grinding it out in a factory for measly returns. The employees of these SMEs will also find their livelihoods squeezed. This in turn will create a natural vote bank for our politicians to canvass with all too obvious implications for the taxes that the rest of us will pay.
2) Financialisation of savings: As I travel around India, I see that in small town India owners of SME businesses have understood the devastating implications of not being able to retire with a large enough corpus. The RBI’s remarkably well researched August 2017 Household Financial Committee report says that 95% of Indian households’ stock of wealth is in physical assets (see: https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/HFCRA28D0415E2144A009112DD314ECF5C07.PDF).
As most people now realise that physical assets struggle to keep up even with the rate of inflation, SME owners are first turning their black money savings into white money by paying Income Tax. Then they are searching for providers of financial savings products who can give them steady compounding. As a result, in this economic downturn, equity inflows into mutual funds are holding up as are insurance premiums written by even third rung insurers (see the data on https://www.amfiindia.com/mutual-fund)
The financialisation of savings has happened to a certain extent in big cities like Mumbai, Delhi, Bangalore and Chennai. In smaller cities, most SME owners have only a smattering of financial assets (usually fixed deposits and Life Insurance Company policies). Furthermore, in smaller cities, the market for real estate is completely frozen solid. There have been no deals all year long in several of the smaller cities we have visited. Hence a big part of the impetus towards financial savings has come – and will continue to come – from small town India.
With potentially US$500 billion per annum of financial savings arising from annual income and with potentially another US$100 billion per annum arising from the balance sheet shift (from physical to financial), my back-of-the-envelope estimates suggest that the annual flow into financial savings could triple over the next decade (from US$200 billion today to US$600 billion). That in turn will not only create an environment conducive for insurers and asset managers, it should also bring down the cost of capital for the country as a whole. [To understand this maths in more detail, see my blog: https://marcellus.in/blogs/marcellus-rising-equity-inflows-from-small-town-india/)
3) Formalisation of retail & distribution channels: 30 years ago as a newspaper delivery boy in London, I saw the English high street change. Of the 60-odd shops to whom I would deliver the evening newspaper, the first to shut down were the travel agents (disrupted by the rise of online). Then by the early noughties the convenience stores (which used to sell candies, biscuits, bus passes, etc) started shutting down disrupted not so much by online but by: (a) the large supermarket which had opened a couple of kilometres down the road; and (b) the convenience-store format rolled out by the large supermarkets for local neighbourhoods such as the one I grew up in. An additional challenge for the owners of the convenience stores – which were usually run by Gujarati migrants – were that their children were landing lucrative jobs in the City of London and hence uninterested in running the family store.
A similar challenge is now befalling the kirana stores in the suburb of Mumbai where I reside. And as the local kirana stores wind up, the beneficiary in my neighbourhood is the local DMart and a few enterprising shopkeepers who are spending money in growing their stores and refurbishing them to create 7/11-type formats. With the decline of the kirana store, the traditional FMCG distributor is also dying.
In fact, if I look around India high streets more generally I see that local eateries too face rising competition not just from Starbucks and Dominos but also from the organised ice cream parlours (Haagen Dazs, Baskin Robbins, Naturals) and from Indian fast food chains (Chaayos, Theobroma, Busago, etc). The same applies in the retailing of other items (clothes – Westside, jewelry – Titan, electronics – Chroma). As the economy formalises, it doesn’t take much to figure out who will win this unequal fight.
Implications for the Nifty
If we look at the Nifty as it stands today, we can see a number of metals & mining companies, power & infrastructure companies, old-style conglomerates who struggle with rational capital allocation, and public-sector banks. We find 23 such companies within the Nifty and we can say with a degree of conviction that most of these companies will be out of the Nifty a decade hence. As highlighted at the beginning of this note, ejecting these companies from your portfolio is likely to bump up your decadal returns from investing in large cap Indian companies.
Looking at the more positive side of Nifty churn, which are the companies which will make it into the Nifty? Going by the three structural trends identified above and using Marcellus’ proprietary forensic accounting and capital allocation models, the following companies appear to be potential Nifty entrants over the next decade:
- Berger Paints
- Divi’s Lab
- Info Edge
- Abbott India
- Page Industries
- ICICI Lombard
- HDFC Life
Whilst we cannot possibly tell you in a public forum what returns the above companies will give you, we know that had we been clever enough ten years ago to predict the names of the 20 companies which have entered the Nifty in the interim period, our portfolio would have compounded at 40% per annum. (Disclosure: the first eight of the ten stocks mentioned above feature in most of Marcellus Investment Managers’ clients’ portfolios.)
Saurabh Mukherjea is the Founder of Marcellus Investment Managers and the author of “The Unusual Billionaires” and “Coffee Can Investing: the Low Risk Route to Stupendous Wealth”.
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