Market Capitalisation of a stock: It is (the total no. of shares in the market) x (the current price of the stock). In short, it is the amount of money one would require to buy all the shares of a particular company.
So, the Market Cap of a company would increase if the number of the shares in the market is increased or if the stock price goes up.
Now let us have a look at the BSE Sensex. It is comprised of 30 shares chosen from the top 100 shares traded on the exchange, based on their Market Cap. Which means they separate the top 100 companies with the highest market cap and then select 30 from this list.
Maybe these top 100 companies would have a higher price than similar companies – the higher price could be justified because these companies are really good in what they do – that is the reason they have become so big.
But let’s give a thought what happens when a company is chosen to be part of the BSE Sensex. The fact that it enters the Sensex means the various Index Funds (Mutual funds that mimic the Sensex) compulsorily have to buy the stock. Also, there are a lot of foreign funds that invest only in shares that are part of an Index. Does this ‘compulsory’ buying of the share result in an increase in the share price? It would seem so. Out of the 5 shares that I mentioned in my previous letter, the top 3 – Dr.Reddy’s, Lupin and Cipla are part of the Index and have the highest P/E ratios.
This means the price of these stocks are higher as compared to companies in similar businesses and this is just because they are part of the index and they don’t have correspondingly higher earnings.
Which means that when we buy a stock that is part of the index, it is an expensive stock!
To be continued………….
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PS: Truth is stranger than fiction, but it is only because Fiction is obliged to stick to possibilities; Truth isn’t – Mark Twain