In this last post, I would be talking about some myriad dimensions of an investment made in MCX. The core of my argument revolves around the idea that there is a distinct possibility that trading volumes will pick up in the near future in commodities, the moat of MCX is still intact and no substantial damage has taken place to MCX. Investing in MCX involves weathering a few storms ahead. Nothing can help us, and unlock value better than some catalysts thrown at us by Mr. Market.
The current pricing and the moat involved can attract acquirers- domestic and foreign. It can very well get acquired by a foreign exchange, or by a domestic financial institution. While the former is more desirable as the management would know the innovations to bring in, it will be more difficult to get it approved by government. The domestic options on the other hand will be smoother.
A New Anchor Investor
Such an investor can assuage the fears of traders (if any) and truly mark this period as a mere temporary crisis.
Investment by well known value investors
Value investors like laymen also move in herds. However this herd is far more sophisticated and far more independent minded than laymen. With the buying done by BlackStone PE and Prashant Jain of HDFC Equity Fund, it is bound to attract other value investors thus helping in price discovery.
Forward Contracts Regulation Act gets passed
In the last 12 months a huge amount of regulatory lacunae has come into fore. Chit fund scams to NSEL scam, potato scam to Sahara issue everything points to a huge gap in the system. Strangely financial market regulation is one aspect where government has been quite proactive in bringing about changes. I feel that in next two sessions (the lame duck session in Feb-March and the May session) will see some major regulations coming through. Some clarity on regulators will come through and FCRA has a high chance of being passed.
From talking about possible catalysts, let us train our eyes on an estimation of the moat and competitive advantage period.
Moat, CAP and ROIC
In the case of MCX, the competitive advantage is derived from the superior network effects as compared to its competitors. As a result (/since), MCX has 10x the number of terminals as its nearest competitors (404,000 vs 40,000).
To estimate how huge this effect is, we need to use a mental model called Metcalfe’s law. Metcalfe said that for a social network (which an exchange is) the value of a network is dictated by nlogn where ‘n’ is the number of members in the network.
This implies to something startling. MCX has a moat 50x deeper, wider than NCDEX. It is simply too difficult for NCDEX to kill MCX. If MCX survives then MCX thrives!
Let us rewind and try to analyse how big is the competitive advantage period (CAP) for MCX. That is, for how long will MCX be able to protect itself through this moat. The CAP is a function of three parameters- the rate of change of the industry, ROIC and barriers to entry. In the second post we devoted some pixels in arguing that the business of exchange has significant barriers to entry. With ROCE as extremely high (tangible ROCE is north of 50%), ROIC is bound to be very high. Additionally, the rate of change in the industry is quite low. The medium can change, the instrument can change but the system doesn’t. That is, traders trading gold futures might move tomorrow to trading gold options; traders today trading through internet can perhaps start trading through telepathy but the system that MCX is –wont change.
So, it can be estimated that MCX will have a very long CAP. Take for example, exchanges like CME or London Stock Exchange. They have been in existence since 19th century. However, for MCX the current prices reflect a CAP of merely 13-14years.
This reflects something paradoxical. If it survives 6-7years more, then all these headwinds will completely dissipate. Indian markets will mature, volumes will rise, newer instruments, better regulation, higher amount of trust all will become essential facts of life. Which implies it will be far stronger to survive far more than 14 years. As a result this price is surely wrong!
If you believe that such a rosy picture is not possible, think again! Our political wisdom is slowly moving away from banning commodity futures to effective risk management and price shock mitigation (no export of onion was banned)
“There are apprehensions about futures trade that it is leading to price rise in commodities. But a number of studies have indicated there is no evidence to prove it,”
-K V Thomas, Minister of State, Food and Consumer Affairs
In September half yearly report, the long term liabilities representing the membership fees given by brokers to exchanges was practically unchanged. This reflects that our thesis regarding the moat is intact.
Price vs Value
For long I have not completely talked about the valuations. Now I am ready to talk about them. At about 130-150cr as net profit in the base rate as per some estimate and a 2000cr enterprise value, an EV/FCFF of 13-15 comes about. This price includes:
- A strong moat
- A monopoly
- An option on MCX-SX (due to its 38% stake).
In my opinion this is a solid value for money!
I am inclined to do some mental acrobatics at this point to further substantiate and offer some evidence towards this thesis. In the earlier post, I talked about how MCX has moved from a more risky setup to a less risky setup. I peripherally touched it and moved on. Let me invoke the first mental model which can be used here well.
Antifragility is a concept thought by Nassim Nicholas Taleb which concludes that time is the enemy of the fragile and friend of the robust, antifragile. Due to the numerous changes brought (SGF,change in management, a more proactive regulation) MCX has become more robust and antifragile. This is my contention that MCX has a higher chance to survive after NSEL case than before.
Think about it, could MCX survive with 19cr of SGF and a small cabal of brokers defaulting on their payment? Think about it, are cautious board members better or adventurous cowboys who think they are invincible?
The second mental model I will invoke here is that of Mr. Market. In my opinion Mr. Market is depressed and he is selling his stake of MCX at a price, that is not commensurate with real value inherent in it.
Disclosure: Long MCX