Judge a scrip by the company it keeps

Stock price will fall if excluded from a benchmark index & vice versa.

In February, Suzlon was dropped from the National Stock Exchange’s (NSE) benchmark index, the S&P CNX Nifty, and replaced with Grasim Industries. Similarly, last October, Bajaj Auto entered the Bombay Stock Exchange’s (BSE) Sensitive Index (Sensex) pack by replacing ACC, the cement major.

When benchmark indices change constituents, there is a lot of interest on stocks that come in and those that go out. “The Sensex and the Nifty are products the BSE and NSE sell. To show the best performance of the benchmark index, the exchanges want to put the best performing stocks, so that the indices deliver better returns,” said a broker. Typically, stock exchanges review their constituents every six months. It is not necessary that they change the constituents of the benchmark indices at every review.
 

KEEP AN EYE OUT

• Exchanges drop stocks with weightage of less than 0.5 per cent on the benchmark index 
• There is lot of selling pressure on an excluded stock, as index funds offload it 
• Scrip could be removed if it has been performing badly for some time
• Stocks included in the key indices are traded in the F&O segment
• Small investors can take advantage of leveraged trading opportunities and also employ hedging strategies
• Hold on to or buy scrips which have been newly added to the index

What happens to a stock when it is excluded or included in the key benchmark indices? One, it becomes automatically eligible to trade in the Futures and Options (F&O) segment if it is included. This will happen from the next contract after the announcement is made. Once a scrip is in the F&O segment, the volumes traded increase, as the trading volumes in derivatives are much higher than that of the cash segment. “A lot of small investors with less capital can trade in these stocks and take advantage of the leveraged trading opportunity in the F&O segment. You can also take part in hedging strategies once a scrip is here,” says Alex Mathew, head of research at Geojit BNP Paribas Financial Services.

When a scrip is excluded, though, it is not mandatory for it to be dropped from the F&O segment. Suzlon and ACC, which have been excluded from the benchmark indices, are still being traded in the F&O segment.

When a scrip is excluded from the benchmark index, there will be a lot of selling pressure on it as index funds will begin to offload, explains Jagannadham Thunuguntla, head of equity at SMC Capital. “Temporarily, there will be significant movement in these scrips. These funds will rejig their portfolios. Whenever a scrip is excluded, the fund will offload that scrip, and buy shares of the scrip that is included.” Since the announcement of inclusion or exclusion is done six weeks before it happens, the investor can sell or hold accordingly.

Even foreign funds can offload those stocks. BSE has two index tracking funds, ICICI Prudential Mutual Fund’s SPICE ETF and Kotak Mutual Fund’s Sensex ETF. Benchmark Asset Management Company’s Nifty Bees tracks the Nifty 50.

The main eligibility for a stock to be included in the benchmark indices is its free-float market capitalisation. Free-float takes into consideration only those shares issued by a company that are readily available for trading. It generally excludes promoters’ holding, government holding, strategic holding and other locked-in shares that will not come to the market for trading in the normal course.

The other criteria include the scrip’s listing and trading history over the past three months, the company’s results in the past four quarters and so on. The companies are filtered based on these parameters and those having a weightage of less than 0.5 per cent in the index (Sensex or Nifty) are excluded.

The Sensex has 30 of the biggest stocks and the Nifty has 50. Reliance Industries is the heaviest scrip in both the benchmark indices.

If you possess a scrip that has been newly added to the key benchmark indices, it is advisable to hold on to it. If you don’t have these in your portfolio, you may buy. Whereas, if it is excluded, you should consider the reasons why it has been dropped from the index, says Radhika Gupta, director at Forefront Capital. “A stock could be excluded maybe because the price has fallen quite a bit or the company has been continuously performing badly. In case the stock has been performing badly for long, you may want to exit the stock and invest in better performing ones,” says she.