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IDFC AMC

Economic & Market Cycle

 

  • Sectors perform differently during an economic and market cycle. On this basis, the
    sectors can be broadly grouped as cyclical or defensive sector.
  •  

What is cyclical sector?
 

  • Cyclical sectors are those sectors which are highly correlated with the economic cycle. These sectors move in line with the economy.
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  • Cyclical sectors are affected by economic indicators like interest rates, inflation etc.
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  • Sectors which are cyclical in nature include Auto, Capital Goods, Financial, Metals, service industries like Tourism, Hotel etc.
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  • Cyclical sectors being highly correlated with the economy outperform when the economy is booming and underperform during recession.
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  • When economy is on an upswing, consumer’s discretionary spending increases resulting an increase in demand of goods and services of these sectors. This in turns leads to capacity expansion for the companies, which result the sectors to outperform.
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  • Cyclical sectors movement being in line with economy tends to have beta more than 1.
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What is defensive sector?
 

  • Defensive sectors also known as non-cyclical are those sectors which are not correlated with the economic cycle.
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  • Defensive sectors are not affected by economic indicators and do not depend on consumer’s discretionary spending.
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  • These sectors produce goods and services needed by consumers in their daily life and include sectors like FMCG, Healthcare, Utilities like power, oil & gas etc.
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  • Defensive sectors not being correlated to the economy outperform during recession and underperform during economy upswing.
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  • When there is recession, defensive sectors outperform as demand doesn’t decrease because it represents the daily need of consumers and do not depend on their discretionary spending. However during economic boom it underperforms the market as demand doesn’t increase in comparison to capacity expansion.
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  • Defensive sectors not being affected by economy tends to have beta less than 1.
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  • Chart below shows the risk1 and return2 of different BSE sectors plotted against the
    Sensex having return of 17.2% and risk of 33.3%.
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Risk & Return of BSE sectors

  • From the above chart, it’s observed that cyclical sectors like auto, capital goods, realty, and metal are more volatile in comparison to defensive sectors like fmcg, healthcare.
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  • Chart below shows minimum, maximum and average returns for Sensex, defensive and cyclical sectors.
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Sensex Returns

  • From the above chart, we can observe that defensive sectors show lower variation while cyclical sectors show higher variation.
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  • Chart below shows relative outperformance of the sectors compared to Sensex during different market phases3.
  •  

 

  • It’s observed from the above chart that defensive sectors like fmcg, healthcare respectively outperform around 77% and 86% of the time during bear phase.
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  • Conversely, cyclical sectors like metal, capital goods respectively outperform around 60% and 97% of the time during a bull phase.
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  • This indicates that cyclical sectors outperform during bull phase and defensive sectors outperform during bear phase.
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  • In continuation to above, chart below shows annual relative returns for the above mentioned sectors and Sensex annual returns.
  •  

Annual relative returns

 

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IDFC AMC

Sector Rotation

By: Punam Sharma

What is sector rotation?
 

  • Different sectors perform differently during any economic and market cycle.
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  • Economic cycle is affected by economic indicators like GDP, interest rates, inflation etc. Market cycle is affected by changes in the financial market which is a result of changes in the economy.
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Economy Cycle

 

  • Sector rotation refers to identifying the cycle and buying stocks of the sector which will perform during that cycle.
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  • Sometimes a sector leads other sectors. In other words, performance of one sector has multiplier effect on the other sectors.
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  • When for example interest rates fall (indicator of economic cycle), auto sector performs. With increase in demand for vehicles, sectors which supply raw materials (like tyre, steel etc) in other words commodities, metal sector also start performing.
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  • The auto companies also utilize their full capacity of production due to increase in demand of vehicles, they need to increase their capex which will lead to capital goods sector performing. Thus, it’s seen how a sector leads other sectors.
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  • Another example is of financial sector and capital goods sector. Financial sector leads capital goods sector.
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  • When interest rates fall, cost of borrowing becomes cheaper. Increase borrowing demand benefits financial sector as companies borrow to increase their capex. This in turn increases demand for capital goods leading the sector to perform.
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  • To show the lead effect of financial sector towards capital goods sector, we have taken BSE Bankex index and BSE capital goods index.
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  • For the same we have calculated the indices one year daily rolling returns relative performance against the Sensex from January 2003 to March 2013.
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daily rolling returns

 

  • From the above chart, it’s observed that BSE Bankex leads the BSE capital goods.
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  • During 2006-2007 BSE Bankex falls first then BSE capital goods falls.
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  • Similarly when BSE Bankex starts rising then BSE capital goods starts rising.
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Which sector will outperform this year?
 

  • Every year different sectors outperform and underperform.
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  • Table below ranks sectors 1 performance during each year.
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sector performance

 

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IDFC AMC

Market Capitalization

By: Punam Sharma

Why consider Market Cap?
 

 

  • Stock price of a company by itself doesn’t reflect the actual value of a company. In other words if the stock price is high doesn’t always conclude the company is growing or has high value.
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  • Market cap tell us what is the value of the company in the market i.e. for how much the company can be sold in the market.
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  • It is based on market opinion on back of the company’s earnings, macro-economic factors etc.
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  • To help investor know the growth and risk associated with the company, market cap of company can be classified into large cap, Midcap and Small cap.
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Classification of Market Cap
 

  • BSE classifies companies into large cap, midcap and small cap using the 80-15-5 method.
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  • All the companies are arranged from highest to lowest according to their market cap.
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  • The top companies contributing to 80% of the total BSE market cap are classified as large cap companies.
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  • The next set of companies contributing 15% i.e. between 80-95% of the total BSE market cap are classified as mid cap companies.
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  • The remaining set of companies contributing 5% i.e. 95-100% of the total BSE market cap are classified as Small cap companies.
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  • This is known as the 80-15-5 method where large cap, midcap, small cap companies contribute 80%, 15% and 5% of the total BSE market cap.
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  • Chart below shows the BSE market cap classification of the top 1000 stocks listed on BSE indices using the 80-15-5 method.
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BSE Market cap classification

 

  • The top 1000 stocks listed on BSE indices account for 97% of the total BSE market cap
    of 6,585,343 crore1.
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  • Table below shows break up of large cap, midcap and small companies of the top 1000
    stocks listed on BSE indices.
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  • From above table, we can see that few companies contribute to 80% of the total market
    cap.
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  • Chart below shows one year rolling returns of large cap (Sensex), BSE midcap and
    small cap index during bear and bull run.
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Rolling returns of large cap

 

  • Chart below shows risk2 associated with large cap(sensex), BSE midcap and small cap
    index.
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Risk associated with large cap

 

  • All the above classification are based on full market capitalization. However BSE for
    calculating index and assigning weights to stocks in the index uses the free float market capitalization.
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Free Float Market Capitalization
 

  • Free float market capitalization is calculated considering only those shares of the company which are readily available for trading in the market.
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  • It excludes those shares which will not come to the market for trading in the normal course like promoters’ holding, government holding, strategic holding and other lockedin shares.
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  • A Free float market index reflects market movement more rationally as it takes into consideration only those shares that are actually available for trading in the market.
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  • Using free float market capitalization limits the influence of large cap companies having low free float in the index.
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  • To calculate free float market capitalization BSE decides a free float factor for each company based on information provided by them as prescribed by BSE.
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  • The free float factor is then multiplied with the full market cap which determines the free float market capitalization.
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  • For example a free float factor of 0.50 means that only 50% of the full market cap is considered.

 

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IDFC AMC

Beta

By: Punam Sharma

What is Beta?
 

  • Beta is a risk measure, which measures stock price/fund volatility in relation to the change in price of the underlying benchmark.
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  • Beta explains degree to which the stock/fund will fluctuate in relation to its benchmark.
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  • The benchmark chosen is a market index.
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  • Beta of benchmark is 1 because it compares the change on price against itself.
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  • Stocks/funds can have beta value of 1, more than 1, between 0-1 and 0.
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Stock/Fund price movement

 

  • From chart above, we can see high beta stock is more volatile than the benchmark. If benchmark goes up by 5% then high beta stock/fund goes up by 8%. Likewise a low beta stock is less volatile going up by only 3 %.
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  • Beta is calculated as Covariance of Stock/fund, benchmark divided by variance of benchmark.
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  • Beta is calculated on historical prices and only reflects systematic risk (market risk).
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What is R-Squared?
 

  • R-squared is a measure which shows us the validity of beta. It reflects correlation
    between stock/fund and benchmark used to calculate beta.
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  • It reflects if a stock/fund is measured against appropriate benchmark.
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  • R-squared ranges between 0-100 and is read as a percent (generally written in decimal
    like 80=0.8).
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  • The higher (closer to 100) the R-squared the better as it reflects the stock’s/fund’s
    performance is in line with the benchmark.
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  • Suppose fund has R-squared of 80, it means that 80% of the benchmark movement is
    captured by the stock/fund.
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Measuring Volatility
 

  • R-squared indicates reliability of the beta value, beta should always be read with Rsquared
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  • Beta depends on the benchmark against which it is calculated.It is possible that
    benchmark used to calculate has no correlation with the stock /fund movement.Using Rsquared we can find out if an appropriate benchmark is used.
  •  

  • Beta and R-square have to be considered together to asses the risk profile of the
    stock/fund.
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  • Matrix below shows risk profile of a stock/fund with benchmark using Beta and
    Rsquared.
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Risk profile of stock/fund

 

  • For example a fund has R-squared of 90 and beta of of less then 1 it reflects better risk adjusted returns i.e. it performs 90% in line with index and is less volatile than the index.
  •  

  • Charts below show ITC price movement1 in correlation with BSE FMCG index and
    Sensex.
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ITC price movement

 

  • From two charts above, the slope of the line on the left (v/s FMCG) is higher than that on
    the right implying the following: ITC has high beta (1.2) when plotted against BSE FMCG index and lower beta (0.7) when plotted with Sensex.
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  • When we compare the reading in the two graphs we see that there is a lower deviation
    from the beta line in the chart on the left than on the right. This implies that there is more correlation with the FMCG index than with the Sensex. This is represented in the Rsquared. R-squared for ITC with FMCG index is 0.75 and with Sensex is 0.13.
  •  

 

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