There's scarcely any necessity to caption the pictures appearing on this page and on the next few pages. These gentlemen are all members of the India Inc A Team. Their pictures, biographies and sound bytes appear everywhere - across news channels and in billionaires' lists. And, also in the databases of large institutional investors.
The latter is hardly surprising. Collectively they run the biggest and most successful of India's companies and that is where the bulk of mutual fund corpuses are invested. Fund managers are cautious individuals; before they start hunting for unusual stories andextraordinary gains, they park around 56% of their corpus in the usual suspects - that is, the giant stocks that comprise the population of mainstream indices such as the Nifty and Sensex.
Market values in most stock markets exhibit what is known as the Pareto Principle (sometimes called the "80:20 rule" where 20% of the total population performs 80% of the useful activity). A few big stocks generate the lions' share of market capitalisation. There are over 5,000 stocks listed on Indian exchanges. But the top 50 stocks (which make up the population of the Nifty) together generate over 50% of total market capitalisation. At the other end of the scale, there are over 4,000 stocks, which together generate less than 10% of the total market cap.
The top 10 picks of Indian fund managers (and this is closely mirrored by foreign institutional investors as well) consist of giant stocks with an average market capitalisation of Rs 87,000 crore.
The fund managers are making what is known in gaming terminology as a "safety-play". As a bloc, a portfolio of Sensex/Nifty stocks will offer returns that are fairly close to that of the indices themselves. By parking over 50% of their cash within his population, the fund managers ensure that their returns will not drop below a certain acceptable level in the worst circumstances. Even if a big loss is reflected in a dropping NAV, it will be mirrored by similar losses across the market.
It's a win-win gambit since India is very much a growth market and even the largest businesses are still delivering double-digit annual returns. In fact, well over 65% of fund flows are into growth stocks - regardless of size. Very few of the top 20 large cap holdings of mutual funds have disappointed their shareholders in the bull run of the past three years.
In the past five years, the Nifty has delivered an absolute return of 274% (about 30% per annum) and the stocks that comprise the top 20 mutual fund holdings, have returned an average of 42%. In the past three years, the Nifty has returned 35% per annum while the top 20 has returned 56%. In the past year, the top 20 has returned an average of 59% while the Nifty has risen 49%.
As you can see, the returns are better than the Nifty although the top 20 is a more volatile set. That's natural with a smaller universe of stocks and an unweighted average. A comparatively small stock that under/out performs will affect thetop 20 more than it would affect the Nifty, which is weighted according to overall market capitalisation.'
Of course, there are extreme outperformers such as Grasim (+104%) and Zee Telefilms (136%). And there are underperformers - notably HPCL (-13%). But this set as a whole has delivered pretty satisfactory returns that are in line with, and better than, the broad market. That means fund managers have not been under pressure to think out of the box when picking their core holdings.
You can pretty much stick a pin into the top 20 list and find a safe stock. Can you do better than that? John Maynard Keynes once compared successful stock-selection to picking the winner at a beauty contest. It isn't a question of picking the girl you consider the most beautiful; it's a question of picking the girl the judges will consider the most beautiful (incidentally Keynes was married to a beautiful Russian ballerina).
Similarly, when you pick a stock, you get decent returns only if other people also think the stock is investment-worthy. This entire study is an attempt to win such a beauty contest - we are tracking stocks that other people, namely fund managers, consider attractive. According to our logic, the higher the degree of consensus on a stock being investment-worthy, the more likely is the stock to yield safe returns.
That's why we have given an estimate not only of total fund holdings but of the total number of funds invested in a given stock. This is to ensure that there is a high degree of consensus about the stock. Otherwise, there is a chance that one or two funds making massive bets could skew the picture.
In a beauty contest, judges normally use a weighted system where they rank the contestants 1, 2 and 3 with points awarded for each placement. Well, we haven't done that but we can offer a snap shot of the number of companies, which have committed to holding the top 10 stocks as their top, second or third holding (see box Popularity Contest). As is obvious from the table, Reliance and Infosys are clear winners in terms of widespread popularity.
Instead of simply mirroring stocks that the funds' love, we have also outlined a method of stockpicking, which is mechanical but it should keep an investor out of trouble and, in the long term, yield results that equal the benchmark market indices at the least. We suspect that it could produce returns that beat the funds.
Here's how the logic works. All these stocks are covered in obsessive fashion by the in-house research departments of the institutions that own them as well as by other investment advisory houses and brokerages. Each of the top 20 has been the subject of multiple research reports. It's easy to derive both consensus estimates on financial projections and advice (buy/hold/sell) as well as the occasional contrarian view.
We accessed multiple sources with a concentration on ICICI Direct to derive our consensus estimates. Our sources include Merrill Lynch, First Global, JP Morgan Securities Equities, Macquarie Research Equities, UBS Equities, Motilal Oswal Securities, Kotak Securities, Prabhudas Liladher, Brics Securities and Edelweiss Capital among others.
We have used those estimates and a specific valuation tool to derive ballpark price-target projections. First, we have multiplied the 2005-6 price earnings ratio (PE) with the estimated 2006-7 earnings per share (EPS) to derive a price target for April 2007.
The extent of possible nearterm capital appreciation can be gauged from this, although there are bound to be both pleasant and unpleasant surprises in store for anybody who thinks that target is set in stone. The full methodology is explained in the box (see Arriving at Target Price)
What's interesting is that the price-targets we derived from a consensus of analyst estimates, suggest that there is a lot of room for appreciation for these stocks from even the exalted levels of Nifty 3962.