Three distinct layers of polarization in the Indian stock market


Understanding the layers and drivers of polarization is now essential for success in the Indian market.

It is obvious to most observers that the Indian stock market has polarized heavily over the past decade as a handful of companies now run the Indian market. Where investors differ, however, is in their understanding and rationalization of this polarization. In particular, one popular school of thought argues that this polarization is somehow due to the lax monetary policies that have been followed by Western central banks since the global financial crisis of 2008. An analysis of the fundamentals of the Indian stock market shows that it is not it.

As we explain below, the polarization of the Indian market is fueled by two sets of structural forces – one Indian and one global – which have nothing to do with quantitative easing and which will continue to operate. over the next decade.

In our column for March 5, “The Awesome Dominance of India’s Top 20 Leviathans” we have shown that, “The top 20 profit generators in India (‘the Leviathans’) now account for 90% of corporate profits in the country. In addition to dominating the nation’s profit pool, the Leviathans also reinvest those profits much more efficiently into their businesses. “

However, the polarization dynamic of the Indian market goes beyond mere profitability. During the decade ending December 31, 2010, the Nifty added approximately Rs. 35 lakh crore in market capitalization. During those ten years, 80% of the value generated came from 26 companies and the median CAGR of total shareholder return was 34% for these 26 companies. Moving forward a decade, in the decade ending December 31, 2020, the Nifty added Rs. 71 lakh crore in market capitalization. 80% of the value generated over those ten years came from just 16 companies with a median TSR CAGR of 21%.

The creation of wealth by Nifty companies is carried by fewer and fewer companies which represent 80% of wealth creation on the stock market. Ten years ago, the 26 companies that accounted for 80% of decennial wealth creation in the Nifty (in the decade ending December 2010) only accounted for 26% of India Inc.’s PAT. Now, if we Let’s take a look at the 16 companies that generated 80% of the decennial wealth creation in the Nifty in the decade ending December 31, 2020, they account for 79% of India Inc.’s PAT.

In fact, the polarization of the Indian stock market therefore has three distinct dimensions:

A handful of companies – exactly ten – now win almost all of the PAT generated by the Indian stock market. This concentration of profits in the hands of the top 10 companies has quintupled over the past decade and it has nothing to do with central bank quantitative easing. Fewer and fewer companies – exactly twenty – now represent around 55% of the Free Cashflow to Equity generated by the Indian stock exchange. Ten years ago, the top 20 Free Cashflow generators accounted for around 41% of India’s FCFE. Again, this has nothing to do with QE.

In comparison, 26 companies represented the same proportion of the wealth created by the Nifty during the decade ending in December 2010.

Why is this happening then? Two different dynamics – one Indian and one global – are at play here. We begin by highlighting the Indian dynamic at play which is the networking of the Indian economy over the past decade.

A networked economy helps businesses run more efficiently

In our blog of March 1, 2019 Exit the Kirana store, enter the supermarket we had highlighted how over the past ten years, the length of roads in India has increased from 3.3 million kilometers to 5.9 million kilometers (6% CAGR). The number of mobile phone subscribers increased over the same period from 392 million to 1.161 billion (12% CAGR). The number of broadband users increased from 6 million to 563 million (57% CAGR). Ten years ago, about 44 million Indians flew by plane each year. Now, 3 times as many Indians fly each year (CAGR of 13%). Fifteen years ago, only one in three Indian families had a bank account; now almost all Indian families have a bank account.

For example, as the economy integrates, lending, which was once dominated by regional players, is now seeing the emergence of a few national leviathans like HDFC Bank and HDFC, with the two lenders entering the top 20 list. PAT generators over the past 10 years.

Global momentum is the rise of affordable, easy-to-use enterprise technology that, if implemented, increases profit margins, reduces working capital cycles and increases asset turnover.

Sunk costs drive industry concentration

In 1991 John Sutton of the London School of Economics wrote a premonitory book titled ‘Sunk costs and market structure‘which predicted how the application of modern marketing techniques, R&D and technology led to the polarization of profits.

Sutton said that companies that invest in branding, in R&D – essentially, invest in intangibles (something that cannot be physically touched or felt) which are essential sources of competitive advantage – continue to dominate this industry provided, of course, intangible assets are a source of competitive advantage in this industry, i.e. this theory is not applicable to sectors like cement and steel where intangible assets confer little competitive advantage.

The technical name for these investments in intangibles is “endogenous sunk costs” or ESC and Sutton said that in the absence of ESC, an industry would experience fierce price competition. [which is exactly what we see in sectors like steel, cement, construction, and wherever else intangibles don’t matter].

Companies investing in technology benefit from increasing returns to scale

Sutton’s book was followed by a remarkable 1996 Harvard Business Review article by Brian Arthur. Entitled ‘Growing returns and a new business world‘, Arthur pointed out that the conventional idea of ​​diminishing returns to scale is being replaced by firms that generate increasing returns to scale. Increasing returns basically mean the tendency of returns (on goods produced or services provided) to keep increasing as production increases, while decreasing returns imply the opposite.

In Arthur’s words: “As the economy gradually shifts from the brute force of things to the powers of the mind, from resource-based mass processing to knowledge-based design and reproduction, it is therefore shifting from a yield base. decreasing to a basis of increasing returns. A new economy, very different from that of textbooks, now applies, and nowhere else is this more true than in high technology. Success will strongly favor those who understand this new way of thinking.

In addition, the network effects (for example, the compatibility of the software with the hardware and its development) are felt with the customers who, after an initial training, only have to adapt a little bit as they go. product update measurement, further strengthening the positive feedback loop.

The growth of profitability is more and more do not linked to traditional investments

Jonathan Haskel and Stian Westlake then developed this line of thinking in their 2017 book “Capitalism Without Capital”.

The central theme of the book is that business investments, especially over the past 40 years, have become increasingly intangible rather than tangible. Aggregating the data for the developed world, the authors show that at the turn of the century, developed economies began to invest more in intangibles (which traditional accounting techniques do not capture as capital expenditure) and less in tangible goods (such as factories and machinery). The preeminence of intangible investment according to the authors has highlighted four effects presented by intangible assets:

These four effects are crucial for a business to become a cohesive compounder because once a business grows using intangibles (such as a proprietary database), it can then reap the benefits of other businesses’ investments in it. intangible assets (like a third-party software platform like SAP), then create synergies between intangible investments (the proprietary database feeds SAP big data) that can potentially help the company take over the entire industry ( first on its domestic market, then on the world market).

The rise of giant companies, which are not only quite dominant in the context of their specific industries, but are also more and more dominant in the context of economics at large, poses a challenge to conventional valuation techniques (both relative and absolute). While conventional valuation techniques assume that large companies fall into mediocrity over the course of 10 to 20 years, the available evidence in India suggests otherwise (thus rendering conventional valuation techniques ineffective). This in turn prompts investors to seek other, more efficient ways to assess the fair value of Leviathans.

Over time, makers of consistent products will likely continue to increase their share of the total profit pie for India Inc.

Investing in the dozen or so companies that will be responsible for 80% of wealth creation in the Indian market over the next decade therefore involves a deep understanding of the ability of companies to use technology intelligently to build a business. dominant position in its sector. Investing in this way is much more difficult than traditional P / E based investing. For the same reason, investing in this way is much more rewarding.

Saurabh Mukherjea and Nandita Rajhansa are part of the Investments team of Marcellus Investment Managers. Marcellus’ next book “Diamonds in the Dust: Consistent Compounding for Extraordinary Wealth Creation” will be published by Penguin in July.

Note: HDFC Bank is part of many Marcellus portfolios.

The opinions expressed here are those of the authors and do not necessarily represent those of BloombergQuint or its editorial team.


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