A Stock inclusion in the index and its effects

Don't buy or dump a stock simply because it becomes a part of — or is dropped from — a known index Companies move in and out of indices because of changes in certain parameters, such as sector, market capitalisation and free float, that the index creator follows When MSCI, a firm which creates stock indices, announced on May 11 that Rural Electrification Corporation (REC) would be included in the MSCI Emerging Market Index, the stock of the company rose 7.64 per cent and touched its all-time high of Rs 282 in two days. The reason: There are many global index funds which invest in stocks that are present in the MSCI indices and in same proportion. So, all index funds which track the MSCI Emerging Market Index will have to buy REC shares. Every time a company becomes part of a prime index, investor interest increases. Cipla is another example. On March 20, the Bombay Stock Exchange announced that Cipla would replace Sun Pharmaceuticals in the Sensex from May 3. In the next three days, it gained 4.5 per cent. In most market capitalisation based indices, entry of a stock means it has a large market cap (number of outstanding shares multiplied by the share price) and indicates, in most cases, that the company has large revenues and profits, is among the leaders in its category (large-cap, mid-cap or emerging markets) or sector (health care, real estate or banking), has large trading volumes and is widely owned. Does it mean stocks entering an important index are a blind buy? No, say experts. The fundamentals of the company do not change just because a certain class of investors (index funds) is pouring money into the stock. Companies move in and out of indices because of changes in certain parameters, such as sector, market capitalisation and free float, that the index creator follows. The parameters do not include fundamentals or ratios for evaluating a company. A fund manager agrees the price of such stocks rises. But, the rise is marginal and short lived. There is nothing meaningful. When a company enters an index, there can be a price increase as index funds rebalance their portfolios. Funds that replicate the index in question need to add new stocks in their portfolio in the same weight as that of the benchmark they follow. They buy the stock coming in the index and sell the stock that's going out. However, this is not done instantly after the announcement. These funds can take a day, a week or even a month to align their portfolios with the changes. The price also goes up as speculators try to make a quick buck when index funds are purchasing the stock. For investors, it always pays to stick to fundamentals such as management credibility, business strengths and investment ratios. Just like a stock getting in the index does not necessarily mean abetter investment opportunity, a stock going out does not mean it is unattractive. In fact, value and contrarian investors feel the scrip going out of the index deserves scrutiny, as it may give better returns compared to the one entering the index. Prices of incoming stocks rise as investors seek them more than the outgoing stocks. This may make the index stock expensive. An analysis of stocks that moved in and out of the Sensex between 1979 and 2005. There were 42 replacements. Of these, 22 stocks that moved out of the index outperformed the stocks that replaced them. Stocks coming in the index do bear the certificate of being of a well-governed company but an investor should not make an investment decision just based on such movements. INDEX INSIGHTS INDEX PICK INDICATES More credibility, well-governed Stock will be more liquid Stock will be widelyowned Price may rise, but short term   ON INDEX OUTING Firm's fundamentals don't change Can get at reasonable valuations, as passive funds increase supply by selling these