New Delhi, The stocks exiting the BSE 500 index over the last 5 to 10 years had little to do with business downturns but were mainly due to corporate governance and accounting lapses and capital misallocations at these companies.

According to a report by Marcellus Investment Advisors, the annual churn in the BSE 500 Index is as high as 12 per cent per annum which means that 60 new companies become part of the Index every year, replacing 60 incumbents.

This high churn ratio signifies that most existing incumbents are unable to sustain their place in the index and, over the course of time, make way for more deserving candidates.

The report said that if one were to look at BSE 500 as it stood in December 2009, out of the total 500 member stocks then, only 274 stocks continue to remain in the index.

In other words, nearly 45 per cent of the stocks have exited the index over the last ten years. On their way out, most of these stocks saw significant erosion in their shareholders' wealth (on an average, the companies which exited the index have lost 40 per cent of their December 2009 market cap).

A closer analysis of the stocks exiting the BSE500 over the last 5 to 10 years indicate that most exits had little to do with business downturns but were mainly due to corporate governance/accounting lapses and capital misallocations at these firms, the research said.

"Hence, for every Bajaj Finance and Eicher Motors which significantly enriched their investors, there has been an Educomp and Lanco Infratech which left their minority shareholders high and dry," it said.

While the number of companies which have generated enormous wealth for their shareholders are bound to be a handful, the number of companies which have destroyed shareholders' wealth would be much more.

The report points out that some of the biggest corporate frauds in history have come to light during an economic crisis and a tanking stock market.

Drying up of liquidity, and constricted access to capital makes it increasingly difficult for managers to hide the unsustainability of their business or revenue models.

The risks assume critical importance during a crisis. The most spectacular accounting frauds usually come to light when the stock market is tanking and the access to capital starts drying up. For example, Satyam Computers imploded in January 2009, four months after the Lehman Bros bust triggered a liquidity freeze in India.

The central driver of accounting fraud is the promoter's need/desire to siphon cash out of the company. When liquidity is easily available, he can either cover his tracks by borrowing money in his own name and infusing it in the company (say, through short-term loans) or the company itself can avail of short-term loans. The surfeit of liquidity sloshing around the company creates an impression that everything is alright. However, when liquidity tightens, these short-term loans dry up and staff/suppliers/ creditors raise the alarm that the company is out of cash. By then, the promoter has taken typically flight, the report adds.

In addition, the money that the promoter borrows is usually collateralised by either his properties or his shares. A liquidity crunch typically hits the value of both of these asset classes. That, in turn, leads lenders to issue margin calls to promoters.

Thus, the promoter - who has already pilfered money from his listed entity - now finds himself being chased by his lenders.

"It wasn't a coincidence we think that two prominent Indian jewellers took flight six months after wholesale money market rates started rising in India (from August 2017 onwards). Unless a miracle shores up the value of real estate and shares in India, we should expect more promoters to take flight rather than taking the trouble to meet margin calls," it adds.

In a growing economy, corporates can show genuine growth in revenues and hence justify the growing working capital needs.

Hence, in a booming economy, everyone - shareholders, auditors, lenders - buys the logic of rising short term borrowing to finance working capital needs even though the actual driver of higher borrowing might be the promoter's pilferage of cash.

When the economy then slows - in the wake of rising interest rates - that fig leaf is removed. The auditors, with their professional reputation on the line, now become less willing to sign off on growing pile of receivables.

"Given that from 2018 onwards, the Ministry of Corporate Affairs has oversight of the audit profession in India, we expect an increasing number of auditors to pull the plug on promoters who are cooking the books," the report said.