Market cap yes, but don’t business operations matter?

An index is looked at as a barometer or a representative number for the underlying trends. We look at the WPI inflation index numbers put out weekly to judge the inflation trend just as we look at Sensex and NIFTY to judge the movement in stock prices. 

NIFTY is a representative index for large capitalisation stocks and hence market capitalisation of a stock is an important criteria to include or exclude a stock apart from factors like liquidity and impact cost. NIFTY should include most large cap stocks to be truly representative of the underlying price movement of share prices. However that is not all what an equity index like NIFTY does. Equity indices are also used for passive investing. A lot of money gets invested in a company purely because it is in the index and vice versa. It is here that care is required in the inculsion and exclusion of companies from the index.

With the inclusion of Reliance Power in the NIFTY, there will be three companies in the index without core operating earnings or business operations for that matter (Reliance Petroleum and Cairn India being the other two). There can be situations where well established companies (say HPCL / Tata Motors / Dr Reddy’s) make losses for some time on account of business conditions and do not have earnings. However here we have companies which are yet to commence operations.

This raises important questions

1) Is NSE not effectively de-marketing the Indian markets by making the Index look expensive?

2) If one can manage to get a start up company (say to export Ice to the North Pole) with the project commencement date after two decades at a large enough market cap and good liquidity and low impact cost, would it get included in the index?

3) Will index funds automatically start investing in such companies on account of inculsion in the index?

It is here that NSE’s criteria of including companies with 3 month trading data after IPOs is wrong. Creation of the index and consequent inclusion and exclusion of companies is not a mechanical process. Factors like industry diversification, track record and business operations should also play a role. It may be argued that these factors are subjective. Yes, they are. But that should not be reason enough to take a mechanical stance especially where low cost index funds are main investment vehicle for a lot of investors.

Otherwise we will have a situation where index funds buy dot com companies at peak valuations and then buy real estate and commodity companies at peak valuations and so on because that is the time when these companies will have a high market cap, good liquidity and low impact cost !!!