One Important Misconception about the Straits Times Index You Shouldn’t Make

wrong way sign

About three weeks ago, I had a brief conversation with an acquaintance about certain shares within the Straits Times Index (SGX: ^STI). While the following aren’t his exact words, the gist of his message was that he felt safe investing in a number of the blue chips because they had been “vetted” before they were included into the index.

That was when I realised that some investors might have the misconception that the Straits Times Index’s 30 constituents were selected based on the strengths of their business fundamentals, which surely is not the case.

The constituents for the Straits Times Index are selected based on three main criteria: their market capitalisation (number of shares existing multiplied by price per share), free float (number of shares existing not held by strategically important shareholders), and liquidity.

Notice how there’s no mention of how “good” any of the businesses are?

While market capitalisation might be a sign of a good business since the company must have done something right in the past to get to where they are today, the index’s shares weren’t selected based on whether their underlying fundamentals warranted that particular market cap.

More importantly, being included into the Straits Times Index tells investors nothing about how well a share will do going forward.

We only have to go back in time take a look at how shares like SMRT Corporation (SGX: S53) and Neptune Orient Lines (SGX: N03) have performed since 12 March 2010 for a good example for what I’m talking about. Both shares were part of the STI back then and have since been replaced by others.

Company 13 March 2010* 6 Dec 2013 % Change
SMRT S$1.72 S$1.27 -26%
NOL S$1.924 S$1.06 -45%
Straits Times Index 2,881 3,114 8%
*Except for the Straits Times Index, prices on 13 March 2010 are adjusted for cash dividends, stock splits, rights offerings, and spin-offs

Source: S&P Capital IQ

Being included in the index back then couldn’t save shareholders of SMRT and NOL from facing large losses, even as the broader market, represented by the Straits Times Index, managed to make some small gains.

Here’s one more important point to note regarding how shares are selected for the index: There’s no selection-criteria based on a share’s financial stability.

When investing, it’s important to note how strong a company’s balance sheet is by checking how its debt load looks like in relation to the cash it holds as well as its equity. Too much debt and a company might find itself on the edge of a dangerous precipice in the turn of an eye.

And on that front, we only have to look at shares like Starhub (SGX: CC3), Noble Group (SGX: N21), Singapore Exchange (SGX: S68) and SIA Engineering (SGX: S59) to prove my point. Here’s a table showing how the total debt to equity (TDE) ratios of the four shares – all are part of the Straits Times Index – stack up against each other.

Company Total debt to equity ratio
Starhub 828%
Noble Group 166%
SGX 0%
SIA Engineering 0.1%

Source: S&P Capital IQ

We can see how Starhub and Noble Group are carrying heavily levered balance sheets, while SGX and SIA Engineering have essentially zero debt. While I’m definitely not suggesting that Starhub and Noble Group are in any eminent danger of running into financial trouble, their high debt loads does show how the Straits Times Index’s selection criteria is indifferent toward financial stability.

Foolish Bottom Line

All told, it’s a misconception for an investor to automatically assume that the blue chips that make up the Straits Times Index are fundamentally sound companies and make for good investing choices just because they are part of the index.

The index constituents are not selected based on any of their business fundamentals and that’s something investors should take note of.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.