Recovery may see churn in 50 per cent of stocks

Market recovery in the next few months may induce a fair amount of stock selling of companies with low cash flows and weak balance sheets. This selling or churning of stocks (as it is better known) may go up to 50 per cent, according to a report by equity management firm Noble Equities.

“At present, the churning ratio is only 13 per cent, suggesting that the market is not yet done with ejecting weaklings from the BSE 100,” said the report.

Investors will be compelled to switch to stronger companies. Going forward, this could also mean that performance of the index will remain significantly muted than it has been over the past few weeks. This churning will result in only 50 per cent of the companies in the BSE 100 index remaining when market peaks again.

In the previous bull market, companies with strong EPS growth but weak operating cashflows and balance sheets outperformed much stronger peers as investors rushed to buy cheap stocks. However, with capital getting expensive, such companies will not be able to stay visible for long. This shift from weaker to stronger stocks will become more pronouncd with FY09 annual reports of companies coming to focus.

While this process will get more active, it could create foundation for a more lasting rally centred around stronger companies. In the process, a lot of BSE 500 companies will get upgraded to BSE 100 and so on. The process of renewal of stocks has just begun. Such stocks (the weakest companies) which have been outlined as Group 4 in the report have underperformed by 14 per cent since March 9, 2009, when the market recovery began.

Saurabh Mukherjea, head of Indian equities, Noble, says, “Those investors who are able to identify companies that will move to the next step in the ladder at the beginning of market recovery, are bound to get four times returns than the BSE 100 index.”

“This could be an uncomfortable summer for Group 4 companies and their shareholders. With the overall market sensibly priced and the economy slowly but surely recovering, investors will be reluctant to take funds out of the market. Hence, when the Group 4 shareholders switch out of their holdings, the obvious place for them to shift funds would be Group 1 companies.”

Group 1 companies are the ones with high liquidity strength and low need for new capital. These companies include Idea Cellular, Asian Paints, Dr Reddy’s Labs, Piramal Healthcare and Sesa Goa among others. Group 4 companies are Dish TV, Adlabs, Thomas Cook, Cipla, Novartis and Pantaloon Retail among others.