A Gate Pass to the Nifty50

In this week's FinMail we are going to understand why does an Index includes or excludes a stock. We also understand the factors that determine the inclusion/exclusion of the stock.

The Story:

NSE in its press release on 23rd February 2021 announced that as a part of its periodic Index Review, which by the way happens every 6 months, Tata Consumer Products will be the newest addition to the Nifty50 Stock Index from March 31, 2021. It will replace GAIL in the index. With this, GAIL will end its 18-year long stint in the Nifty50 Index. With this, India's Bluechip Benchmark Index will feature the 5th Tata Group Company including TCS, Tata Motors, Titan, and Tata Steel.

Being curious we searched the reason behind the inclusion/exclusion of a company in an index. Earlier we thought it is the market cap of the company that decides the inclusion/exclusion of the companies. As in, the top 50 listed companies by Market Capitalisation will be included in the Index. So we thought that the market cap of GAIL must have declined and the market cap of Tata Consumer Products would have increased but that was not the case. The market cap of GAIL is ₹63,954 crores and the market cap of Tata Consumer Products is ₹56,136 Crores. So in terms of market cap, GAIL is bigger than Tata Consumer Products and yet GAIL will be excluded.

Keeping both these companies sideways, the Market Cap of Adani Green & Avenue Supermarts (DMart) is ₹1.81 lakh crores & ₹1.94 lakh crores respectively and yet they are not a part of the Nifty50 Index which shows India's 50 biggest companies! So what is the reason behind a company being excluded or included in the index?

We just got curious like you are right now and we started researching about it and decided to cover this issue. What we found was an interesting thing to note and yet a simple one. We thought everyone should know this and thus here we are.

So what is the real reason?

Which stock would be excluded or included in the index is decided by the governing authority of the index or the company that created the Index. There are certain factors and guidelines which decide the exclusion or the inclusion of a stock in the index. In the case of Nifty50, the company that manages the Nifty50 Index is NSE Indices Limited which in turn is a subsidiary of NSE is the authority that reviews the Index on a semi-annual basis and notifies the changes in the indices every 6 months (if any). So, we looked upon the NSE website and found the methodology document that determines the guidelines that an index should follow.

According to the Methodology for Nifty Indices following factors determine the inclusion of a stock in the Nifty50 Index:-

1) Free-Float Market Capitalisation Weighted Method

2) Liquidity and Impact Cost

3) Trading Frequency

4) Other Eligibility Criteria

Let us understand all these factors

1. Market Capitalisation by Free-Float Methodology:

As we said earlier that, the market cap is not the deciding factor for a stock to be included or excluded in the index but it is the free-float market cap that determines the inclusion or exclusion of stock in the index. But what is Free Float Market Capitalisation? You may ask,

In simple terms, Free Float Market Cap is the total value of shares of a company which are available to be traded in the market. Didn't understand this? Let's dive deeper.

To understand the concept of Free Float Market Cap, let us take a look at what Market Cap means.

Market Cap of a company = Price of the stock * Total Number of Shares.

Suppose shares of ABC Ltd are trading at ₹10 and the number of issued shares is 1,00,000.

then the market cap of ABC Ltd is 10*1,00,000 = ₹10,00,000

Now Free Float Market Cap is a refined version of the market cap which excludes the shares that are not available for trading. Such shares are held by Promoter/Promoters Group or shares that are locked in or cannot be sold. In short, the shares that are not available in the market to buy or sell are excluded from the calculation of Market Cap when using the Free Float Method. Thus,

FFMC = Price of the stock * (Number of Issued Shares - Locked-in-Shares)

Now let us understand this by using the previous example.

As we looked, there are 1,00,000 issued shares of ABC Ltd but out of that 20,000 shares are held by the management of the company and promoters, so they are not available for trading in the market. Hence,

FFMC = 10 * (1,00,000 - 20,000) = ₹8,00,000.

Earlier the Nifty50 Index was based on the Normal Market Cap method but this methodology has its own limitation which is that it can concentrate too much weight to a particular company. This leads to the index price being influenced and driven by the price movement in such big companies only. Using free-float market cap will allow an index to reflect the movement in prices of stocks that are available on the market to be traded.

So back to the story, the free-float market cap of Tata Cons Products was ₹31,200 Crores and that of GAIL was ₹19,100 Crores (at the time of review) and this is one of the reasons for the inclusion of Tata Stock.

2. Impact Cost:

Impact Cost is the cost that a buyer/seller faces while buying/selling security. This cost is due to the demand-supply gap. The buyer might have to pay more than the ideal/quoted price while buying the security because less supply is the impact cost.

In the same way, the seller might get less than the ideal/quoted price while selling because of the less demand. The difference between the actual price and the quoted price of a security is Impact Cost.

Impact Cost typically increases when dealing in a large block of securities. The buyer or the seller has to pay a premium or bear a discount because of the large volume. This difference in ideal price and the actual price paid/received is the impact cost.

For a stock to be eligible to be listed on Nifty50, it should have an impact cost of 0.5% or less for 90% of the observations for a portfolio worth ₹10 Crores.

3. Trading Frequency:

The stock that is to be included should have been traded 100% of the times in the last 6 months which is easily achievable by a stock of a large company.

4. Other Eligibility Criteria

The stock which is to be included in the index must be a part of the Nifty100 Index and should be available for trading in Futures and Options Segment. If the rule of availability of trading option in 'Futures and Options' would have not been in place, Avenue Supermarts (D-Mart) would have replaced GAIL because its FFMC stands at ₹35,200 crores but is not eligible for Nifty50 as its shares are not available in the Futures and Options Segment.

So as we can see that there is no one particular factor that determines which company will enter the benchmark index for bluechip companies but a mixture of various eligibility criteria. Amongst them, Market Cap using Free-Float method does carry more importance but if other criteria are left unfulfilled, the stock can be excluded from the entry to the index as we saw in the case of Avenue Supermarts.

Why it is done?

The fundamental idea behind creating the stock index is to represent the broader market so that it can represent the nation's economy. It is like a sampling method, i.e creating a sample space that represents the whole sector/market. The ideal thing is that the sample should represent the population as precisely as possible, and so is the case with the Stock Index that intends to represent the market as well as the nation's economy And that is the reason why Stock Market Indices keep removing and adding securities from time to time.

That is it for this week's FinMail. Keep learning and we will see you in the next week.

General Trivia:

Only 13 companies have been part of the Nifty50 Index from its inception in the year 1996. The 13 companies are HDFC Bank, Reliance Industries, HDFC, ITC, Hindustan Unilever, L&T, State Bank of India (SBI), Tata Motors, Dr. Reddy’s Laboratories, Tata Steel, Grasim Industries, Hero MotoCorp, and Hindalco Industries Ltd.