The Story of Two Kids-III

A Case for MCX

In the last post, I highlighted how the volumes at MCX have tumbled and the NCDEX has fared better than MCX in 9 out of 12 months. Looked this way, it seems the great difference between MCX and NCDEX has shrunk in favour the latter. The question then floats in the air- has the moat disappeared?

Let me throw a different light at the picture.  MCX has consistently kept its market share above 80% even in the worst of the months.  This 80% is in the vicinity of the average company quoted figures for its market share.

MCX has retained its 80%+ market share which it claimed for the last 5 years.

MCX has retained its 80%+ market share which it claimed for the last 5 years.

In light of this, can it be said that the moat has indeed disappeared? I would argue no. Had NSEL fiasco been the significant reason for a tumble we would have seen a more significant erosion in the market share. After all, what is an exchange, other than a place that you can trust?

Commodity Transaction Tax (CTT) has been levied from July, we can see a drastic drop of 36% in its value, however there has been a consistent 7% growth rate in NCDEX. There is an anomaly here.  I have a theory to explain this, but you can also call it confirmation bias. However humor me for a second.

The Theory

MCX is highly liquid-a lot more liquid than NCDEX. Earlier when CTT was not there, high frequency arbitrageurs chose MCX because of the higher liquidity. Of course NCDEX had less liquidity which would have made arbitrage opportunities more juicy but I reckon the impact cost would have killed the players. Thus they were locked into MCX. This again led to a winner takes all syndrome.

The annual Market Share as claimed under its annual report. Note the market share hovering around 81-82%

The annual Market Share as claimed under its annual report. Note the market share hovering around 81-82%

As a result over a period of time, only manual slower and smaller arbitrageurs traded on NCDEX whereas the big boys played in MCX. When CTT was levied, about 20-30% of returns were instantly shaved off from the returns of institutions. This should explain why there has been a disproportionate fall in MCX while NCDEX barely budged.The minor 7% growth, I reckon came from some migration from MCX platform to NCDEX platform by brokers far down the pecking order.

So right now, in my opinion Commodity Transaction Tax has become an even more of a headache than NSEL fiasco for MCX. Specifically CTT is levied on non agricultural commodities. Since Precious Metals, Copper, Crude form the bulk of the trade volumes in MCX, it has suffered adversely.  Now the question is, where will it all lead to?

And this is where I intend to make a case that MCX’s current valuation is not justifiable.

A Stress Test

In FY2013, the total value traded is to the tune of Rs 149tn and the company earned Rs 4.8bn in transaction fees. Now for April 2013 to December 2013 we have data of the value of trade done. For January we don’t have the complete data set but till 17th of January only. Let us imagine that there is no more trading happening in MCX for the end of this month. As a result there is a 45% fall from December’13. Let us extrapolate the value of trades happening in MCX for the next two months of CY 14 as well. So February and March 2014 both are down 45% successively from the previous months.

This is truly a pessimistic scenario and calculation. Why? Because of these factors:

  1. The biggest fall in 2013 and for quite some time has been that of 36%.
  2. The 45% fall so assumed is merely virtual since January has not ended yet and we have assumed no more trades are occurring.
  3. February and March are considered to be maintaining the same trend of 45% fall.

This results in a total traded volume of Rs 75bn thus leading to an exchange fee of Rs 2.4bn. Historically the profit margin has been in the tunes of 62.5%. As a result the new EBT is pessimistically Rs 1.5bn, since capex and working capital requirement is minimal, we assume the free cash flow as about Rs 1bn. At enterprise value of Rs 24bn, the yield is 4.1%. Assuming a 7% discounting rate (since this discounting rate will reflect the risk reflected by my limited understanding. This 7% rate assumes I understand the current scenario very well), the steady state growth rate is 3%. This is the most optimistic rate given by market for its future growth.

The Marginal Analysis

Charlie Munger once commented: “Wise Investors think at the margins”.Let us try to analyse the current scenario based on possibilities and pathways. Now lets try to answer these questions:

What developments will prove the above optimistic rate to be right?

  1. There will be no volatility in commodities
  2. An increase in commodity transaction tax
  3. A continuation of haphazard policymaking regarding allowance and banning of agricultural commodities.

And how can it be proven wrong?

  1. A return of volatility
  2. Formation of a proper spot regulator and restructuring of FMC to insulate commodity market from knee jerk political action
  3. A push for financial awareness and reforming of Indian agriculture : a successful transition to agri commodities.
  4. A reduction of CTT.
  5. An increase in financial innovation.

If we explore these possibilities we can shed some more light on the probabilities of their occurrence.

1.There will be no volatility in commodities:There is an anecdote when a woman came upto an ace investor and trader and asked him to predict the market. He sagaciously commented “It will move”. I attach a zero probability to a complete absence of volatility in the long run. In the short run there will always be periods of low volatility, but volatility will return.

2.An increase in CTT:It is highly unlikely that the government will increase CTT. This is primarily because the current CTT rates are in line with derivative STT rates.

3. A continuation of haphazard policymaking regarding allowance and banning of agri commodities: This is and remains a serious risk in Indian agri commodity market. Each time there has been a price spurt politicians have fallen over themselves to cry foul regarding speculation. In light of this, agricultural commodities will remain as the ugly duckling of commexes.

This has a high probability of about 60-70% to continue. However there has been a slow change in the mindset of the government. Last year when onion prices surged to Rupees 100 /kg government didn’t stop any export.  I think there is a reasonable chance that with time Indian agricultural markets will mature.

And the next possibilities which prove the expectation of 3% wrong are:

  1. A return of volatility:High Probability
  2. Restructuring of FMC, formation of a spot market regulator:As per the new FSLRC code, SEBI,IRDA,PFRDA  and FMC will be combined together to form a unified regulatory body . This will enable faster pace of innovation, consumer protection and a proper framework of regulation, justice delivery and appeal. This should in turn make any knee jerk reaction by government untenable as it will attract a lot of litigation on tribunals. I would rank this as extremely high. In the next 10-12 months, we should see light of this. Moreover FMC has started implementing those institutional reforms which was recommended by FSLRC. We are seeing as a result considerable amount of politico-bureaucratic will. I consider it a high probability that the process of incremental FMC reforms will start in the next 6-7 months.
  3. A push for financial awareness, a reform of Indian agriculture and MCX’s successful transition to agricultural commodities: I rank this very low probability scenario. It might happen but it will be a black swan case.
  4. A reduction of CTT: I will rank this scenario again as a very low probability scenario. Transaction Taxes are levied to plug tax avoidance. As long as Indian taxation system is not entering into DTC-GST regime, we will keep having tax avoidances and continue inefficient techniques of tax collection. Till then levying transaction taxes will be easy way out for policymakers. It will take a long time (it was said a slew of reforms will occur in 2014, but don’t bet on optimistic politics), and thus it has a low probability of materially affecting our investment in the next 1-2-3 years.
  5. An increase in financial innovation: MCX under earlier management has seen a huge amount of push for newer instruments (however scuttled by FMC). Since the board of MCX will now consist of 50% independent directors and the rest 50% belonging to shareholders, we should see a continuation of the pace of innovation set by earlier management. I will set its probability as low in the short term as all the directors will be highly wary, but in the long term I feel innovation will carry on.

In light of this, I am  claiming that there are more number of pathways to prove this ‘optimistic’ estimate of 3% long term growth rate as wrong than right. The reader’s estimate of the probabilities can be very different. I would welcome any discerning reader to attach their estimate of the probabilities with adequate reasoning in the comment section. Additionally if one finds more ways of proving this estimate right or wrong, please do share.

Back to the Future

Let us try to see this scenario from a different point of view. The last time MCX crossed Rs 75bn in total turnover was in mid 2010. In 2009 the total turnover was Rs 59bn.  Let us try to analyse what if 2014 turns out like 2009 once again.

In 2009, the total transaction fee was Rs 1.8bn and income from operations as Rs 2.1bn. Applying the same profit margin as then (41.6%), the profit after tax comes to about Rs 873mn.  This implies the steady state growth to be about 3.4%.  In every way, the prices are depressed.

I believe if we do buy at these levels, then we are effectively posing ourselves for a positive black swan.

In the next and the last post we will talk about the possible catalysts that can unravel, valuations and competitive advantage period for MCX.

Disclosure: Long MCX

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