Three Distinct Layers Of Polarisation In The Indian Stock Market

It is evident to most observers that the Indian stock market has sharply polarised over the past decade insofar as a handful of companies now drive the Indian market. Where investors differ, however, is in their understanding and in their rationalisation for this polarisation. In particular, a popular school of thought contends that this polarisation is somehow driven by the loose monetary policies that have been followed by the Western central banks since the Global Financial Crisis of 2008. An analysis of the fundamentals of the Indian stock market shows that it isn’t so.

As we explain below, polarisation in the Indian market is being driven by two sets of structural forces – one Indian and one global – which have nothing to do with quantitative easing and which will continue to play out over the forthcoming decade.

In our March 5 column, ‘India’s Top 20 Leviathans’ Awe-Inspiring Dominance’ we demonstrated that, “The top 20 profit generators in India (‘the Leviathans’) now account for 90% of the country’s corporate profits. Beyond dominating the country’s profit pool, the Leviathans also reinvest these profits far more efficiently back into their businesses.”

However, the polarisation dynamic in the Indian market extends beyond mere profitability. In the decade ending Dec. 31, 2010, the Nifty added around Rs. 35 lakh crore in market cap. In these ten years, 80% of the generated came from 26 companies, and the median Total Shareholder Return CAGR was 34% for these 26 companies. Moving forward by a decade, in the decade ending Dec. 31, 2020, the Nifty added Rs. 71 lakh crore in market cap. 80% of the generated in these ten years came from just 16 companies whose median TSR CAGR was 21%.

Wealth creation by Nifty companies is being driven by fewer and fewer companies that account for 80% of the wealth creation in the stock market. A decade ago, the 26 companies which accounted for 80% of the decadal wealth creation in the Nifty (in the decade ending Dec. 2010) accounted for just 26% of India Inc’s PAT. Now, if we look at the 16 companies which have driven 80% of the decadal wealth creation in the Nifty in the decade ending Dec. 31, 2020, they account for 79% of India Inc’s PAT.

In fact, polarisation in the Indian stock market, therefore, has three separate dimensions:

A handful of companies – precisely ten – are now taking home almost the entire PAT generated by the Indian stock market. This profit concentration in the hands of the top 10 companies has quintupled in the past decade and it has nothing to do with quantitative easing by central banks. Fewer and fewer companies – precisely twenty – now account for around 55% of the Free Cashflow to Equity generated by the Indian stock market. A decade ago, the top 20 Free Cashflow generators accounted for around 41% of India’s FCFE. Once again this has nothing to do with QE.

In comparison, 26 companies accounted for the same proportion of the wealth created by the Nifty in the decade ending December 2010.

So why is this happening? Two different dynamics – one Indian and one global – are at play here. We begin by highlighting the Indian dynamic at play which is the networking of the Indian economy over the past decade.

A networked economy helps more efficient companies

In our March 1, 2019, blog Exit the Kirana Store, Enter the Supermarket we had highlighted how over the past ten years, the length of roads in India has increased from 3.3 million kilometres to 5.9 million kilometres (CAGR of 6%). The number of mobile phone subscribers has increased over the same period from 392 million to 1.161 billion (CAGR of 12%). The number of broadband users has increased from 6 million to 563 million (CAGR of 57%). A decade ago, around 44 million Indians were taking flights each year. Now 3x as many Indians are flying each year (CAGR of 13%). 15 years ago, only one in three Indian families had a bank account; now nearly all Indian families have a bank account.

For example, as the economy gets integrated, lending, which was once dominated by regional players is now seeing the emergence of a few national leviathans like HDFC Bank and HDFC with both lenders entering the list of top 20 PAT generators over the last 10 years.

The global dynamic is the rise of affordable, easy-to-use enterprise technology which if implemented increases profit margins, reduces working capital cycles, and increases asset turnover.

Sunk costs drive industry concentration

In 1991, John Sutton of the London School of Economics wrote a prescient book titled ‘Sunk Costs and Market Structure’ which foresaw how the application of modern marketing techniques, R&D, and technology was leading to the polarisation of profits.

Sutton said that companies which invest in brand building, in R&D – basically, invest in intangible assets (something that cannot be physically touched or felt) which are critical sources of competitive advantage – go on to dominate that industry provided, of course, intangible assets are a source of competitive advantage in that industry i.e., this theory is not applicable to sectors like cement and steel where intangibles confer little by way of competitive advantage.

The technical name of such investments in intangibles is ‘Endogenous Sunk Costs’ or ESC and Sutton said that in absence of ESC, an industry would see tough price-based competition [which is exactly what we see in sectors like steel, cement, construction, and wherever else intangibles don’t matter].

Companies that invest in technology benefit from increasing returns to scale

Sutton’s book was followed by a remarkable paper published in 1996 in the Harvard Business Review by Brian Arthur. Titled ‘Increasing returns and the new world of business’, Arthur highlighted that the conventional idea of diminishing returns to scale is being replaced by businesses that are generating increasing returns to scale. Increasing returns basically mean the tendency of returns (on the goods produced or the services provided) to keep increasing as output increases whereas diminishing returns imply the opposite.

In Arthur’s words: “As the economy shifts steadily away from the brute force of things into the powers of mind, from resource-based bulk processing into knowledge-based design and reproduction, so it is shifting from a base of diminishing returns to one of increasing returns. A new economics—one very different from that in the textbooks—now applies, and nowhere is this more true than in high technology. Success will strongly favor those who understand this new way of thinking.”

Furthermore, network effects (for example, the compatibility of software with hardware and its development) kick in along with customers, who after some initial training, need only adapt a little as the products update, further strengthening the positive feedback loop.

Growth in profitability is increasingly not related to traditional capex

Jonathan Haskel & Stian Westlake then developed this line of thinking further in their 2017 book ‘Capitalism Without Capital’.

The central theme of the book is that corporate investments, in the past 40 years especially, have become increasingly intangible rather than tangible. Aggregating data for the developed world, the authors show that around the turn of the century, the developed economies started investing more in intangibles (which traditional accounting techniques do not capture as capex) and less in tangibles (like factories & machines). The pre-eminence of intangible investing according to the authors have brought to the fore four effects that intangible assets showcase:

• Scale (intangibles are easily scalable to any length once developed initially),

• Sunk costs (intangibles have sunk costs tied to them i.e., costs that cannot be recovered),

• Spillovers (a company that makes an investment in intangibles may not be the only one, or not even the one to reap its benefits fully later; they are more often than not reaped by others), and

• Synergies (multiple intangible assets may collectively produce even higher returns than what they would produce individually).

These four effects are crucial for a company to become a consistent compounder because once a company scales using intangibles assets (such as a proprietary database), it can then extract spillovers from other companies’ investments in intangibles (such as a third party software platform like SAP), and then create synergies between intangible investments (the proprietary database feeds the SAP with big data) which can potentially help the company corner the entire industry (first in its home market and then in the global market).

The rise of giant companies, which are not only utterly dominant in the context of their specific industries but are also increasingly dominant in the context of the broader economy, poses a challenge to conventional valuation techniques (both relative and absolute). Whereas conventional valuation techniques assume that great companies fade to mediocrity over the course of 10-20 years, the evidence on hand in India suggests the converse (thus rendering ineffective conventional valuation techniques). This in turn is compelling investors to look for other more effective ways to assess the fair of the Leviathans.

As time progresses, the consistent compounders are likely to continue increasing their share of the total profit pie of India Inc.

Investing in the dozen or so companies that will drive 80% of the wealth creation in the Indian market in the coming decade, therefore, involves an in-depth understanding of the companies’ ability to make intelligent use of technology to build a dominant position in its sector. Investing in this manner is far harder than traditional P/E-based investing. For the same reason, investing in this manner is far more rewarding.

Saurabh Mukherjea and Nandita Rajhansa are part of the Investments team at Marcellus Investments Managers. Marcellus’ forthcoming book “Diamonds in the Dust: Consistent Compounding for Extraordinary Wealth Creation” will be published by Penguin in July.

Note: HDFC Bank is part of many of Marcellus’ portfolios.

The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.