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Sensex and the bigger fool theory

By Ram Kumar Kakani
June 23, 2007 14:53 IST
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As celebrations of the index achieving new peaks were going on among the market community and in the popular business media, I was besieged with the problem of my portfolio not improving much in the last couple of years. Like a typical academic from the old school, I started probing the issue further and looking for externalising my failure.

The more I poked into the data and facts, the more I was convinced that the last one or two years rally was a shallow one. Increasingly, I realised that there were a couple of things which were clearly visible: one, the index rally was driven by only a few big stocks; and two, the increasing narrowness of even the broad equity markets.

I look at both of these points using common market knowledge and simple stock market numbers (instead of relying on sophisticated data mining exercise):

Limited big winners in the index: In the last two years, the BSE Sensitive Index has rallied from 6,400 levels to the present day 14,300 levels, an increase of more than 120 per cent in just two years - exemplary performance by any standards.

I started looking at the sector wise composition of index and found that the nation's biggest indicator was skewed towards only a few sectors. For instance, the biggest sectors in the Sensex constituents are finance and banking (20.1 per cent), IT (18.1 per cent), petrochemicals (17.2 per cent) and telecom (10.1 per cent). The rest of the sectors constitute less than 35 per cent of the Sensex.

Sadly, a large proportion of the real economy and even listed equity markets are either fully ignored in the index or given very little importance. Some of these include fertiliser, agriculture, media and retailing.

I then started digging into the main winners within the index and found that there were only a few big winners (see table 1). I could clearly see that the Sensex had a few big winners - big enough to ensure that the Sensex reached new heights.

BSE Sensex drivers in last two years (Table 1)

Index and
individual stocks

Adjusted price
on 18.05.2005

Demerger, dividend,
and other benefits

Price on 18.05.2007

Percentage change
in two years (%)

Current weight
in index (%)

BSE Sensex 


Not applicabale



Not applicable

Reliance Industries 












Bharti Airtel 






Larsen & Toubro 












State Bank of India 












In other words, I could easily conclude that the Sensex had an overwhelming number of relative underperformers. Some of the index constituents, which have severely underperformed the Sensex included ONGC, Hindustan Lever, Reliance Energy, Ranbaxy, Hero Honda, and Dr. Reddy's - possibly indicating market participants are not very impressed in their future stories.

I turned my attention towards the big winners alone. The list included Reliance Industries, Bharti Airtel, Larsen & Toubro, and ICICI Bank, among others. A cursory number-crunching told me that these four scrips could easily explain a large portion of the index performance in the last two years. To an extent all of them have had interesting stories about their future for the market.

For instance, Reliance Industries had enormous value unlocking due to its demerger, sorting of family tree issues, business gains due to increased monopoly in petrochemicals, its Reliance Fresh retail initiative, and its expansion plans in petrochemicals sector.

On the same lines, Bharti Airtel and Larsen & Toubro had demerger stories, and have also been unrelenting in their aggressive new initiatives and their expansion plans.

While these stories are undeniably value-adding, the enormity of the gains in these big players also suggests that it is highly probable that a large portion of these gains are not explainable. For instance, these could be capital market mis-pricing issues due to large liquidity supply or these could even be temporary bubbles.

Increasing shallowness of the markets: I then turned my attention towards the broader equity markets. Being larger, I thought it prudent to look at the average daily business done by the National Stock Exchange (see table 2).

I also included the BSE Mid Cap Index and BSE Small Cap Index as these truly reflect the broad market movements and have a non-institutional investor bias. The table gives the average daily summary of business transactions in the last three consecutive years. It conveys some interesting insights.

Average daily summary of business transactions at the NSE (Table 2)

and year

No. of securities
traded in NSE
cash segment

Traded value per
security in NSE
cash segment
(Rs crore)

No. of securities
traded in NSE
F&O segment

Traded value
per value
in NSE F&O
(Rs crore)

BSE mid-cap

BSE small
cap Index

Apr 2005







Apr 2006







Apr 2007







One can see a positive picture of increase in the number of traded securities both in the cash segment and the futures and options market. There is also an increase in the gross F&O activity. While good practices followed by the best global exchanges state that stocks ought to be included in either the index or be allowed to trade in the F&O markets after having a good trading history of more than two to three years, we observe that the number of stocks trading in the Indian F&O markets has more than doubled.

Even recently listed stocks with no price history such as Everest Kanto Cylinder, Parasvnath Developers, and Reliance Natural Resources are included in the F&O segment.

This behaviour by the intermediaries can be explained by the desire to achieve new heights in business done, overall bull market fever and other stakeholder constraints. I hope the institutional intermediaries have done enough homework on this and would keep the investors' interests at the highest level.

However, the same table also conveys some interesting cues - surprisingly, there is a decrease in the traded value per security both in the cash segment and in the F&O segment in the last one year. In fact, the fall has been quite significant (given increasing liquidity, more online trading, and lowering transaction costs).

Add to this the negative returns in the BSE Mid Cap index and BSE Small Cap index during the last one year and one can without a doubt appreciate the increasingly shallow Indian equity markets conveying increasing investor disinterest.

Also, an interesting fact has been the lack of any new issues from companies with a size of less than Rs 50 crore (Rs 500 million). For instance, in the recent past, I have not read about a par value issue (that is, no share premium). The whole story hints at the decreasing interest of both the exchanges and the investing community in creating and/or nurturing smaller-sized firms or broadening the markets.

The above discussion reasonably explains the recent capital market gyrations,  a lack of portfolio appreciation among large number of investors, and also corroborates the narrowing equity markets.

In fact, they do put to question the viability of the short-to-medium term sustainability of the bull run. May be, the bigger fool theory is at work or, may be, the existing buyers have some aces up their sleeves.

Whatever the reason, one conclusion can be that the stakeholders involved, especially the institutional intermediaries should consider new and innovative ways of improving the size and quality of Indian capital markets including diversifying the stock index constituents and shifting focus towards attracting higher proportion of the long-term investors instead of just sticking to their existing stale strategies.

The author is a professor at the S P Jain Center of Management, Singapore Campus. The views expressed are personal.
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Ram Kumar Kakani
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