Outperforming the benchmark index can look simple yet difficult to implement.Exiting out-of-favour industries and spotting emerging industries can do the trick

Equities as an asset class tend to outperform all other forms of investments: fixeddeposits or precious commodities like gold and silver. However, while investing inequities, investors need to determine whether the gains are higher or lower to justify therisk taken. Suppose an investor had invested Rs1 lakh five years ago and that investmentis now worth Rs 2 lakh. This represents a simple return of 25%. To decided if this is onthe higher side or lower side, investors need to compare the return with a benchmark tojustify the risk taken as equities are more risky compared with other vehicles ofinvestment such as fixed deposits.

Against the simple return of 25% generated by the investor’s portfolio in the lastfive years, the equity index, say the Nifty, has appreciated 35%. This means that theportfolio has underperformed the benchmark and lost an opportunity to generate higherreturns.

It is extremely difficult to outperform the benchmark on a consistent basis. Very fewactively managed mutual funds are able to outperform benchmark indices in the medium tolong term. One of the reasons is it is difficult to outsmart the market consisting ofdiverse forces. The stock market is the place where every bit of information isdiscounted, making it most efficient. Unless investors have superior information,outperforming the market is near /impossible. An open market that encourages rigorousbattle between bears and bulls is not easy to outperform on a consistent basis.
Second, the stock indices always consist of the best-performing and most liquid stocks.The index maintenance committee of the stock exchange monitors the index constituents on acontinuous basis and removes stocks that are witnessing a decline in liquidity. The marketcapitalisation of the lead indices such as the Sensex (BSE) and the Nifty (NSE) accountfor a major a chunk of the overall market capitalisation of the exchange. Choosing themost liquid stocks as index constituents is a global practice and adopted by most stockexchanges worldwide. Moreover, as the economy witnesses a transformation, certainindustries tend to emerge as growth drivers of the economy. This necessities change in theindex composition.

For retail investors who prefer to invest directly in the market, outperforming theindex is a difficult task. Is there anyway by which retail investors can outshine themarket benchmarks? Yes, there is. If investors carefully analysis the changes in the indexconstituents and the corresponding shift in sector weightage in the index, they could bein a position to generate superior returns comparable with the benchmark equity index.

Investors bet on the textile sector as the most hot and happening sector five to sixdecades ago. Today, textiles hardly enjoy any representation in the lead indices: theSensex and the Nifty. Even the market favourite information technology (IT) is losing itsde facto position as the market mover. So what is the underlying message? A couple ofthemes or sectors drive the stock market any point in time. Over a period of time, a fewindustries emerge as growth industries and find favour with market participants. Theemerging sectors edge out other sectors that have lost their charm. Thus, if the investorsare in the right sector at the right time, they have a better chance to earn superiorreturns compared with the market.

Capital Market did a comprehensive study to understand the index churn and alsoattempted to peep into the future based on changes in the index composition. The studycovered the period between 1998 and 2008 and studied the Nifty consisting of 50 stocks.For each year, the top five industries by maximum weightage in the Nifty where noted.

Following are the key highlights that emerged from the comprehensive study of the churnin the Nifty in the last 11 years.
* The Nifty covered a minimum of 19 sectors (1999) and maximum of 25 industries (2000and 2001) in the last 11 years. Currently, the Nifty represent 21 industries.
* The trend in the last 11 years shows that the top five industries commanded weightswell over 50% in all these years. This clearly indicates it is a few industries that drivethe equity indices and the market at large. The industry concentration was the highest in1999, when the top five sectors accounted for over 65% weightage in the index, while itwas the lowest in 2004, with the top five industries contributing over 54% weightage tothe Nifty. Currently, the top five industries — refineries, telecommunication –services, computers-software, oil exploration and power — enjoy a 55.65% weightage inthe Nifty.
* Between 1998 and 2008, 29 of the 50 Nifty were replaced. Looking at the currentstatus of the few stocks such as TVS Suzuki, IFCI, IDBI, Cochin Refineries, Arvind Mills,MRPL, MTNL and Nestle, it is difficult to believe that they were part of the Nifty index.Again this brings back to the theme that it is a few sectors that drive the index and theoverall market. It makes sense, therefore, to invest in the emerging sectors that arelikely to gain prominence in the future.
* In 1998, the fast moving consumer good (FMCG) and personal care sector dominated theindex. Hindustan Lever (now Hindustan Unilever) was known as the index heavyweight.Personal care enjoyed a weight of 21.36% in 1998, going up to 23.79% in 1999. Since then,it has witnessed a sharp decline. Currently, it commands a weight of around 2% (HindustanUnilever) in the Nifty. The fall of personal care was marked by the emergence ofinformation technology (IT) as the next driver. The IT sector shot up to become the indexheavyweight, with a weightage of 8.27%, which went up to 18.62% in 2000. From 1999 tilldate, IT remains among the top five sectors by maximum weightage in the Nifty. In 2006,the IT sector enjoyed its heydays, with a weightage of 19.62% in the Nifty. Currently, itaccounts for a 10.39% weightage and stands at the third spot. The shift from personal careto IT in the last 11 years is very much clear (see table: Heavy transformation).
* Presently refineries (15.54%), telecommunication (11.11%), software (10.39%), oilexploration (9.89%) and power (8.72%) occupy the top five slots in the Nifty, with acombined weightage of 55.65%. Out of these, power seems to be the real emerging theme. Forthe first time in the last 11 years, power has secured a position in the top five slots.The power sector is represented by companies such as NTPC, Tata Power, RelianceInfrastructure and Power Grid.
* Apart from personal care, the sectors that have gone out of favour includepharmaceuticals (current weightage 2.84% compared with 9.30% in 2002) and automobiles(current weightage 2.33% compared with 7.82% in 1999).
* Emerging industries include power (8.72%) and construction (4.35%). Interestingly,construction had no representation a couple of years ago. Electrical equipment is anotherindustry that came into prominence in recent years. But it has shown lots of variation.Its current weight is around 5.75% compared with 7.08% in 2006 and 1.79% in 2002.
* Over the last 11 years, the Nifty has became less skewed. In 1998, the top fivestocks cornered a weightage of over 45% of which Hindustan Unilever accounted for 17.62%.Currently, the top five stocks account for around 35% weightage. This is actually a goodindication as index manipulation becomes difficult when the index weightage is distributedmore evenly.

The power sector could be the next big theme that the market is likely to pursue, goingforward. At the same time, the theme that could fall out of favour with the investorscould be the software.
Apart from monitoring changes in the index, investors can also adopt the topdownapproach. Looking at the economy and its current position, investors can determine thesectors that could benefit the most in future. They should take a long-term view, say, offive years to determine sectors that would hog the limelight. While evaluating the varioussectors, the focus should be on factors such as size of opportunities, both domestic andglobal. Also check whether the opportunity is big enough to accommodate many players inthe industry so that it can ensure reasonable profit without cut-throat competition. Thesoftware and telecommunication are the best examples.
Also, look at the future growth prospects of the industry, demand and supply dynamicsthat would determine the prices of products and services offered such as in the case ofoil exploration and refineries. Other factors include regulatory changes (telecom andpharmaceuticals), technological advancement, government support through policy and fiscalmeasures (infrastructure development), and so on.

A the major pitfall of this strategy is that it is easies said than done. It is atricky issue to figure out the next big theme. It could also lead to huge losses. One wayout of this is to select four to five sectors that could do well in the future. This willavoid the risk associated with the concentration of the portfolio in a couple of stocksand sectors. Remember diversification is the key and investors should avoid exposure toone or two sectors.

Once investors have decided to opt for this strategy, they should classify theirexisting portfolio in different sectors to understand their sectoral exposure.Subsequently, they can restructure their portfolio based on the industries that they haveselected on their future growth prospects.

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An impossible feat?
Outperforming the index on a consistent basis seems impossible but can beachieved
It is impossible to beat the benchmark index on a consistent basis. This was the factorthat led to the formation of index funds and exchange traded funds (ETFs). Mutual fundmanagers
manage equity schemes actively to outdo the benchmark. In reality, most fail. Thus, indexfunds (mutual fund schemes that replicate the index by creating identical equity portfoliojust like the equity benchmark) were introduced as a passive investment strategy to equityinvestment. It is a different story that many index, funds miserably fail to match the returns generated by the benchmark index, defying thevery purpose of their existence.

Can a retail investor outshine the index on a consistent basis in the medium to longterm? The answer is a big yes! Investors can outperform the index perpetually. It issimple mathematics. Let’s see how it works.

Suppose an investor wants to benchmark his returns against the Nifty. As in the case ofindex funds, he should replicate the Nifty. For this, he would require to buy all the 50stocks that constitute the Nifty in the same proportion as the weights enjoyed by these 50stocks in the Nifty. The Nifty only measures the capital gain or loss as it only accountsthe changes in the prices of the 50 stocks and does not account for dividend paid by thecompanies to the shareholders. An investor holding these shares would be eligible toreceive dividends. This dividend income would help the investor to outperform thebenchmark index. This is the simplest way to outperform the benchmark index. The indexthat takes into account dividend income apart from capital gain and loss is known as thetotal return index.

A quick glance through the return generated by the Nifty and the total return indexcalculated for the Nifty would bring more clarity. For instance, while the Nifty reportedpoint-to-point capital gain of around 243% between 1999 and 2008, the total return indexfor the Nifty generated superior return of 297% in the same period. The difference betweenthe two can be explained by dividend yield of the Nifty, which, on average, stood at 1.54%for the last nine years. The highest dividend yield was reported in 2003 at 2.93%, and thelowest in 2000 and 2006, at 1.06%.
Technically, investors can easily outperform the index on a continuous basis.Practically, it is difficult to create an equity portfolio that perfectly mirrors theindex, particularly when the investment corpus is small.

One of the reasons for this is the wide difference between the prices of the stocks dueto different face values. Ambuja Cement, with a face value of Re 1, trades at around Rs90. On the other hand, Grasim Industries, with a face value of Rs 10, trades at around Rs1900. As both have very small weightage in the index, taking exposure to Ambuja Cement iseasy, but not to Grasim Industries. Thus, there is bound to be errors in replicating theindex to the last cent.

Further errors creep in while incorporating changes announced in the index constituentsby the index committees of the stock exchanges. The analysis of the last 11 years showsthat around three new stocks are introduced in the Nifty every year. Thus, investors needto accordingly buy new stocks and sell the outgoing stocks. It could also requireinvestors to buy and sell other index constituents to perfectly replicate the index.

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Jumping from sector to sector
Because not all sectors will do well all the time
As an investment strategy, sector rotation believes that not all the sectors orindustries will do well all the time. Thus, it is prudent to move from lagging sector toone that is emerging. As a rule of thumb, emerging sectors report above average growth insales and profit and, hence, command premium valuation in the market. Depending on thestage of economic development, certain industries tend to emerge victorious and remain sofor some period and, subsequently, make way for other industries. Indeed, the so-calledsmart money moves from mature sectors to the more happening sectors to earn superiorprofit.
Sam Stovall has studied this investment strategy in detail and authored two books onthe topic: ‘Sector Investing’ and ‘Standard & Poor’s Guide toSector Investing’. As per his studies, different sectors gain in different phases ofeconomic cycle: expansion and recession. Since 1945, the US economy has gone through 11recessions and 10 expansions. If this economic cycle is sub-divided into varioussub-stages, the trend of stocks belonging to certain industries gaining in value becomesevident.
Now, the problems. Economic cycles are complex to understand. Whether we are out of aparticular stage or entering a particular stage is hard to guess. This impacts the timingof entry and exit. Second, as is the case with equities, every day is a new beginning andpast trends are no guarantee of future performance.
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