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Nifty, Sensex: Different strokes
Devangshu Datta in New Delhi
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November 26, 2007

In 1998-99, a big bull-run across three sectors went unnoticed and unremarked for months. Counters like Infosys [Get Quote], Satyam [Get Quote], Wipro [Get Quote], NIIT [Get Quote] and Zee shot up without exerting any apparent influence on the overall market.

Market moves are tracked via indices like the Sensex and the Nifty. Sectors that are not well-represented in the indices go under the radar. In 1998, information technology, communications and entertainment (ICE) had zero representation.

Once these ICE stocks were inducted into indices, their influence on overall sentiment became obvious. What's more, ICE stocks saw accelerated momentum as institutional focus increased.

A similar unrecorded bull run happened through 2005-06. Only this time, the focus was real-estate stocks. Inside a market-wide bull market, the real estate sector was the top scorer. In just two years, listed real estate stocks have grown from under 0.5 per cent of total market capitalisation to about 4.6 per cent.

DLF, Unitech, Omaxe, Sobha, Parsvnath, Anant Raj, Puravankara, Indiabulls Real Estate [Get Quote] and Ansals are all success stories. Many realty stocks have delivered triple-digit or even four-digit returns. Quite a few are now large-caps with futures and options profiles.

But it is only recently that the real estate boom has been reflected by the indices. Unitech was included in the Nifty in October and now DLF has entered the Sensex. Unitech was a convenient replacement for IPCL [Get Quote], which was merged with Reliance Industries [Get Quote].

DLF replaces underperforming Dr Reddy's Laboratories. The sector is still under-represented. Unitech has about 1.87 per cent weight in the Nifty and DLF about 1.75 per cent weight in the Sensex.

DLF (market cap of about Rs 148,000 crore) has almost thrice as much market-cap as Unitech (about Rs 55,000 crore). So it may seem paradoxical that Unitech has a higher weight in the 50-share Nifty than DLF does in the 30-share Sensex.

This highlights an important difference in the way the Nifty and the Sensex are calculated. The Nifty takes the full market cap of all 50 stocks and calculates weights accordingly.

For example, on November 23, the Nifty had a total market cap of about Rs 33,28,000 crore (Rs 33,280 billion) and Reliance with a market cap of about Rs 404,000 crore (Rs 4,040 billion) had the highest weight of 12.2 per cent. Unitech receives full value for its market cap in the Nifty.

The Sensex weights companies on the basis of free float- that is, the shares not held by the promoter or institutions and hence, freely available for trade. DLF only has a free-float factor of 0.15, which translates into a free market cap of about Rs 22,000 crore (Rs 220 billion) -- Unitech has a free-float of 0.3 or about Rs 16,500 crore (Rs 165 billion).

Both are valid methods of calculating indices and free-float probably reflects trading sentiment a little better, though the methodology makes it a fuzzier calculation. Weights are assigned to free float bands (for example 10-15 per cent float = 0.15 weight) and the exchange often has to make ticklish judgments if a specific holding is free float or not.

Anyway, without getting into theoretical arguments about the merits of free-float versus full-cap, we can say that DLF is likely to experience a boost in trading and experience a short term bull-run now that it is an index constituent.

Sensex index funds and ETFs will have to buy it. Managers of funds benchmarked to the Sensex will consider it, if they don't hold it already. This effect may be temporary because there is already a great deal of coverage.

As an example, Unitech was inducted into the Nifty with effect from October 5 at a price of Rs 327 (when the Nifty was at 4497), with the announcement made on September 13 (Nifty: 5185) when it was trading at Rs 280. It had a bull run, moving to a high of Rs 404 by November 19 (Nifty 5906), before correcting sharply back to Rs 339 (Nifty 5608) in the past week.

Until that correction, Unitech had outperformed the Nifty, gaining 44 per cent between September 12 and November 19 (while the Nifty rose 33 per cent) as well as 23.5 per cent between October 5 and November 13 (Nifty up14 per cent).

DLF (PE of 72) has a higher valuation than Unitech (PE of 41) and better price performance since its listing. It could, therefore, deliver more returns upon inclusion in the Sensex. The stock has easily outperformed Dr Reddy's (the stock it replaces) and the Sensex itself.

DLF listed on July 5 at Rs 570 (IPO at Rs 525). It is now trading at Rs 869 and saw an all-time high of 999 on October 31. DLF's current return on listing price is 52 per cent. In the same period, the Sensex moved up 27 per cent. That trend of out-performance on the part of DLF may continue or even accentuate in the short run.

The inclusion of DLF could also have some effect on the differential between the returns of the Sensex and Nifty. The two major indices move in close tandem in terms of direction � they have a correlation of better than 0.9, which means that they move in the same direction practically all the time.

But the relative magnitude of movement on a given session can be different for the Nifty and Sensex. This depends on the performance of the stocks that are not in common. DLF is the only Sensex-30 stock that is not part of the Nifty-50 basket.

The Nifty has 20 extra stocks overall, which collectively carry about 21 per cent of the Nifty's total weightage. But a big session for DLF on an otherwise quiet day could lead to a bigger swing for the Sensex compared with Nifty. 

Given the fact that real estate is clearly under-represented, it may be reasonable to assume that the NSE will induct DLF into the Nifty sooner, rather than later. If that turns out to be the case, "front-running" Nifty index funds, by buying DLF is a logical trade.

The induction of a new sector into the premier indices makes this a good time to examine both indices in terms of differences in sector coverage and therefore, likely behaviour patterns. We can come to some interesting conclusions.

One major difference between the Sensex and the Nifty is simply the lack of depth in Sensex derivatives compared with Nifty derivatives. The Nifty generates over 10 times the volume and open interest in F&O.

Even in the cash segment, the NSE generates much more volumes than the BSE. That extra liquidity means the Nifty's moves are more efficiently arbitraged and NSE price spreads are generally "tighter."

If we classify both index baskets into uniform sectors, the differences become clear. The Sensex is hugely overweight in financial stocks (22.4 per cent) versus the Nifty (11.9 per cent). The Sensex is also overweight in auto stocks (4.8 per cent) where the Nifty's exposure is 3.56 per cent.

The Nifty is overweight in oil, gas and refining (25.2 per cent) where the Sensex has 19.9 per cent. The Nifty (11.3 per cent) is also overweight in telecom (Sensex 8.6 per cent) and in metals (8.8 per cent) where the Sensex has 4.6 per cent.

In power too, the Nifty has 7.9 per cent exposure while the Sensex has just 4.3 per cent. In other sectors, including housing (which includes Unitech and DLF), IT, pharmaceuticals and healthcare, the weights are roughly the same for both indices. 

Obviously, differences in index performance would be caused by moves in the sectors where the differences in exposure are large. The Sensex is much more interest rate-sensitive and could, in fact, be seen as largely a finance-sector play. The Nifty on the other hand, will react much more to changes in energy, power and metals, and to telecom.

These five are all highly volatile sectors. In broad terms, interest rates are market-driven but Indian banking is also queuing up for FPOs enforced by Basel II norms. Government policy also imposes a much lower cap on FII holdings in banks.

If banking regulations are eased and more consolidation occurs, while other things stay equal, the Sensex is likely to outperform the Nifty. 

The Nifty's higher exposure in closely-related sectors such as energy, power and metals as well as telecom, makes it much more policy-sensitive. Telecom, of course, is growing very fast but it's quite possible that the spectrum imbroglio will continue. But that seems to have been priced in by the recent sell-off in telecom counters.

Energy-power-metals are all part of the same value chain. A lot of metal companies are integrating backwards into power and power companies are integrating backwards into energy in the hopes of tying up fuel sources.

The government has started offering captive coal mining blocks to power players and to metals producers. Oil and gas prices are controlled but gas in particular is coming closer to free-market norms and to independent regulation.

If the thrust on infrastructure creation continues and the next government comes through with further reform and liberalisation of these sectors, there will be much more upside to the Nifty than to the Sensex.

Reforms in any one of the three key related sectors could have positive effects across the entire value-chain. But in the short-run, this kind of reform is less of a "sure thing" than the banking FPOs, which are guaranteed to increase the Sensex's finance exposure. The Nifty is likely to be the better long-term play.

These five sectors have very different profiles and there is every chance that the divergences in the two indices will grow over the next five years. If you're investing in index funds, remember that.

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