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Tuesday, March 25, 2008

Don't drive away blue-chip stocks

Article from ET

The stock market has shed an unthinkable one-third of its value from its peak in January. At such a time, retail investors need expert advice more than ever before.

However, experts always try to bring the real economy into the picture, as they believe the market will catch up with the former sooner or later. However, there’s another school of thought that believes the stock market has a mind of its own and doesn’t follow the trend in the real economy. By real economy, we mean corporate earnings.

This confounds retail investors who can’t figure out whom to follow. However, we at ETIG believe that long-term investment in equities is not a catch-22 situation. It can be as simple as sticking to bluechip stocks, i.e. companies which are market leaders and have a long track record of consistent revenue and profit growth.

To test this hypothesis, we analysed the monthly returns of 45 such market leaders across sectors, beginning January 1993, by constructing a ‘blue-chip index’. This index comprises companies like Hindustan Unilever and Colgate-Palmolive from the FMCG sector, Ambuja Cements and ACC from the cement space, auto majors like Mahindra & Mahindra and Tata Motors, engineering giants like ABB, Larsen & Toubro and Siemens, apart from leading stocks from pharma, financial services, hospitality and IT sectors. This was done to ensure that all sectors in the economy are duly represented.

We analysed returns over the past 15 years so as to cover all phases of the economic cycle. Another reason for considering such a long time period was that the constituents of the bluechip index were market leaders at the start of the period; they may have fared poorly in the bearish run of the ’90s, yet they remained at the top in their respective sectors.

It was expected that the blue-chip index will beat the Sensex, but the margin by which it outperformed the Sensex was beyond our imagination. If you had invested Rs 100 in the Sensex at the beginning of January 1993, it would have grown to Rs 700 by February ’08. During the same period, an investment of Rs 100 in the blue-chip index would have grown to Rs 1,700, outperforming the Sensex by a staggering 141%. To put it differently, blue-chips gave an annualised return of nearly 21%, compared to the Sensex return of 14%.

These returns are backed by equally strong earnings growth by these blue-chip companies, which indicates that fundamentals do matter. In fact, the earnings of these companies have grown at a faster pace than the corresponding growth in market cap of blue-chip stocks during the past 15 years.

During all these 15 years, seldom did the blue-chip index underperform the Sensex. The extent of outperformance also kept on a secular upward trend. In fact, during the bull run, starting ’03, the
outperformance grew by leaps and bounds, indicating that the bluechips are better placed to take advantage of emerging opportunities than their smaller rivals.

If one were to counter this argument, an easy criticism is that such blue-chips include stocks which became blue-chips over the course of the past 15 years. For example, Infosys Technologies and Wipro were not blue-chip companies in the early ’90s. But the number of such young bluechips is insignificant in our index.

Rather, we have established companies like Reliance Industries, Hindustan Unilever, Grasim Industries, Colgate, Tata Motors, ITC, M&M, Tata Steel, MRF, Raymond, Indian Hotels, among others, which were top companies in their sectors even in the early ’90s.

Another cause for concern with regard to such an index is that bluechip stocks can be grossly overvalued since all classes of investors, from retail to institutional, want to include such stocks in their portfolio. Comparing earnings growth and value of the blue-chip index, we found that while earnings in ’07 were 22 times that of earnings in 1993, the blue-chip index of December ’07 was only 19 times its value in January ’93. This shows that blue-chips are reasonable valued even today. All an investor needs to do is identify the market leaders and invest in a diversified pool of such stocks.

Warren Buffet once said, “Hard work does not kill, but why take a chance?” This saying is apt for investors who leave no stone unturned to find out the most complex investing ideas, failing to recognise that sometimes, the simplest of ideas like investing in market leaders and staying invested for a long period of time can be a much better strategy.

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