The Intellect Design Thesis

Many moons ago, Fundoo Professor wrote- I dont want to be a toll bridge, I want to be its meaningand if there was ever a business which embodied the idea of an emerging moat then it should be this business.

Read my thesis, analyse it and think about it.


Suman learns to trade and invest-I

Suman’s brows were furrowed. A slight tension gripped his jaws and his eyes reflected regret.

He was lying prone on his bed, staring at the ceiling. The critters of evening were singing their songs, but Suman’s thoughts were somewhere far away.


“Joining us in studio today is Rajiv Goyal of PLD ventures… Rajiv when we met last time in our studio you were confident that NIFTY will be scaling 9000 mark. Now that it has, would you like to tweak your numbers higher?”
“Sonia, thanks for having me here. The way we see in PLD Ventures its the start of a secular bull run and definitely we will see NIFTY at 12000 anytime soon.The earnings are healthy, our economy is firing…”

The broadcast on TV seemed to have perked up the mood of the men having their lunch.

“I bought NHV last month, 50% up…”, Shekhar remarked stealing a small piece of paneer from Suman’s plate.
“… the way things are going, I dont mind paying capital gains and booking my profits” added Shekhar smugly.

“DishTV – long till 88. Short till 82. Doubled my 5 lakhs”- Arun, chimed in almost disinterested.
Easy money,folks! 

Ravi suddenly lost interest in TV and blurted out- “You doubled? Seriously?”

Arun looked up and gave a wink.

“Pass the dal first”

Suman had nothing to add really. A sinking feeling washed over him. Left out, alone, fending for himself. Did I make a mistake in not investing? Oh god, Arun doubled his 5 lakhs. Shekhar has made 50% in one month. If I would have invested  1 lakh in NHV- my return ticket from Bangkok would have been paid of. 50% monthly implies…

Envy,regret,anger. Everyone around him has become rich.A feeling of fear and envy swallowed him. His mind reeled back to a documentary he once saw- of a mongoose being cornered by a bunch of cobras. Helpless and Afraid. He felt something similar. Helpless and Afraid. Only there were no cobras here.

If someone asked his mother, she will never be able to remember if Suman had a mean streak. His wife at times got exasperated with the supine way he handled the office politics- taking on his chin and settling for the next time- everytime.

But at that moment, suddenly Suman felt the bite of a lost chance.He was envious and in pain. He could have invested 10 months back when Puneet advised him to. I should have listened to him. He is a wise guy. What did I do?

Puneet Khurana has always been a taciturn guy- measures his words and advices. But generous in spreading and voracious in gathering wisdom. An acute observer, of what the Bard said – “the tides in the affairs of men“. He eats behavioural psychology and breathes investing. If there ever was a stoic-thats him.

Puneet adviced Suman about two years back. Urging him to plough all in the financial markets. Suman was unsure and even he will never admit it that he was afraid.

Afraid of the “hairiness” and uncertainity of the macroeconomic situation. Fiscal deficit was high. Oil was higher. And investor confidence, if it could go any lower would have stood frozen in South Pole.Suman distinctly remembered the conversation he had in Puneet’s drawing room.

“Suman, look at it this way- can things get any worse?”

The Jack Daniels in Puneet’s hand made a beautiful color and Suman’s gaze was transfixed at that. His ears kept hearing the urgings and his mind, afraid of the uncertainty kept ignoring it.

The day melted into evening and his thoughts of anger and envy melted into pain. He lay on his bed trying to will away the pain. His thoughts drifted away to that chance encounter.

10 months back, Suman met Manish- a self confessed Ed Seykota fan, in the local pub. During the conversation they both discovered that Puneet was their common friend and the conversation really flowed from there. The conversation flowed from their family – both had a kid, of the same age to their drinking tastes- Manish liked Beer and Suman liked his whiskey.

The evening was amiable but when the conversation came to markets- Suman was not only afraid of investing in the markets but knew practically nothing of the markets themselves.How shorting works, what are futures, how to trade- nothing, nada! Manish’s message was clear- invest now. Suman felt it to be a misplaced confidence.

Suman lay on his bed simmering in a concoction of envy, anger and regret.If Puneet had a telescope inside Suman’s mind he would have shaken him into sense- because Puneet knew how deadly a combination this is. And if Manish would have known then he would have shown him how do savvy trader/investors make money.

Suman was close to losing it all. And he didnt know it.

He got up, took a long deep breathe and lifted his phone. A few jabs of keys and then a number. He is calling that number for the first time.

A ring.And then another. And then another.

“Hey Manish, this is Suman here.I need your help”

Can Suman get out of this cesspool of emotions? How will Manish help Suman? Can Suman master the financial market?

(…contd in Part II)

P.S: Its good to be back

How DISHTV was analysed,shorted and yielded truckloads of money


In the fall of 2011, somewhere in South Mumbai, a single line flashed on the computer.

“What do you think of DISHTV? Good buy?”

DISHTV, had already by then fallen quite a bit. From the highs of 140-150 it was trading at Rs 77-80. Once a darling, it was now hungrily eyed by investors and punters alike. Investors still believed in its “market opportunity” story and punters liked it for its volatility. On top of it, it was present on futures and options market as well. Optimists argued with an ever rising middle class and government’s push for digitization, DISHTV will have significant tailwinds. Coupled with the fact that DISHTV had access to easy programming content from Zee TV(its parent company), investors were merely biding for time.

In the mid week of August of 2011, I completed my thesis of DISHTV. The thesis can be found here(some bug in dropbox preventing me from sharing a working link here). It didnt take a rocket scientist to conclude that not only the company was significantly overvalued even at those levels but also followed an inherently unsustainable business model. It could have been easily killed, if things went like this since they lost money on every connection.

Since then, the market consolidated, the pricing has increased, their revenues improved and yet their inherent profitability levels were lower than ever before.


V-Mart: Adventures in Retailing Business

“In retailing, to coast is to fail.”

Warren Buffett.

V-Mart is trying out to win a game, where few have won before and those who have are always looking behind their shoulders. Retailing is a business meant for masochists. To win here, you just have to find a fanatic management.

A thesis on V-Mart (written by me) can be found here

I would request you to kindly acknowledge the source if you forward it to anyone else.

The Story of Two Kids-IV

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.


Acquisition Theory:

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.

Exchange Members Value
MCX 404,000 ~2264978
NCDEX 40,000 ~184082

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:

  1. A strong moat
  2. A monopoly
  3. An option on MCX-SX (due to its 38% stake).

In my opinion this is a solid value for money!

Mental Gymnastics

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

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

A Story of Two Kids- II

In the last post I narrated the story of the two kids who grew up on different sides of the road called Ethics. From here on, allow me to put the names on these anonymous guys and clarify some of the background.

The talented interesting kid, on whom we bet on, is Multi Commodity Exchange of India (MCX). MCX is India’s largest commodity exchange, world’s largest silver and gold bullion exchange, second largest in copper and natural gas futures and third largest in crude oil futures.

Exchanges, we all know is an excellent business to own. It is a business where the platform is the unique selling point and the business merely takes a rent from traders to use this platform. Minimal capital expenditure requirements, minimal working capital needed and yet plenty of cash coming in. It is the business equivalent of a toll booth.

A tollbooth adds nothing to the economy, but merely takes rent

A tollbooth adds nothing to the economy, but merely takes rent

Naturally this business will have a very high return on capital. However, the biggest advantage of this business is not in the numbers but in the nature. The traders need a place to buy and sell most efficiently. Thus they need maximum liquidity to conduct their business. Now this need of liquidity keeps them bounded to an exchange which already has plenty of traders. That is, traders will go to a place because there are other traders. So as the number of traders congregate it becomes a far more attractive place to visit for newer traders. As a result there is a snowball effect in  the number of traders frequenting it. This is a classic case of winner takes all syndrome at play. However lets explore this dimension a bit more.

What is the threat faced by MCX from competition?

To answer this, lets solve it backwards. Lets assume a new exchange has indeed set up. However there are no traders on its floor. Will any single trader switch from MCX (the older dominant one) to the newer one? What does that imply? It has a huge switching cost for the users of this platform.

Note the total lack of any capital requirement for opening an exchange. Yet note how it would be to trade on the empty one. Sometimes cost is not the barrier to entry.

Note the total lack of any capital requirement for opening an exchange. Yet imagine how it would be to trade on the empty one. Sometimes cost is not the barrier to entry.

Additionally, opening exchanges is not an easy job due to regulation.  Coupled with the fact that MCX is one of the three permanent national exchange as recognized by FMC(link here). This has the advantage of rewarding a huge amount of trust and reliability on MCX as an institution. Also, this enables MCX to innovate its products more freely.This makes it far more difficult for an upstart competitor to ‘steal’ a lead over MCX. Thus there are significant barriers to entry in place. Moreover the advantage of scale (and trust) should be big enough for MCX to ride out a storm . Hence we can reasonably conclude there is a definitive barrier to entry and there is a high switching cost .

The rotten egg of a brother I was talking about is National Spot Exchange Limited(NSEL). NSEL due to regulatory laxity (there is no spot exchange regulator in India) has been able to commit huge amount of fraud. The actual issue was this:

NSEL had 1 day contracts which had its payment date based on T+2,T+4 sometimes even T+25 days cycle. That is a trade occurring on 1st Jan 2013 will have its cash payment on T+25 i.e 26th of January 2013. This led people to pocket a seamless amount of riskless arbitrage, by shorting a contract getting an X amount day after tomorrow (on T+2 leg)  and covering it at the end of the day on T+25 leg. This led to people earning a risk free return by investing in a bank during these 23 days. Annually it came to 12-15%.

Commodity prices should fluctuate and they were not fluctuating. On the NSEL they were “fixed”. If the spot or three-day contract was x, the thirty-day contract was one or 2% plus x depending on the commodity. One simply bought the three-day forward contract and sold the thirty-day contract. You paid for the two-day contract. You waited for the 30-day contract to end that you sold at a higher price. And pocketed the difference. 

That changed the fortunes of the NSEL and volumes perked up. Average monthly trading volumes shot up from Rs 1000 crore to Rs 28,000 crore till May 2013. Financial Technologies derived 57% of its profits from NSEL. The higher the trading turnover, the higher the revenues an exchange makes.

Source this

This arbitrage issue was carrying on for a long time, till the word spread and more traders came in to encash on this risk free system. Because regulation was absent and the management had its eyes focussed on turnover and trades the management found it difficult to curb this. It soon came to a point where the contracts floating on the market didn’t have underlying commodities to back them. Brokers to rope in more investors decided to issue hundreds of contracts on the underlying of a single warehouse receipt.  That is they were trading on “empty promises”.  The management knew about this festering problem but chose not to act.The commodity market regulator FMC found out what was happening and banned forwards trading. This resulted in a mad scramble for those who were stuck to claim the underlying to salvage their losses. However the emperor was wearing no clothes.

 The parent company(the father) is Financial Technologies of India(Ltd) and specifically Jignesh Shah. Jignesh Shah is known for his belligerence.He has publicly proclaimed himself to be Dhirubhai Ambani of financial markets. Coupled with it, arm twisting of SEBI officials post retirement is also reported. Rumours are there this was done because  Jignesh Shah’s dream of a stock exchange named MCX-SX was not allowed to be under his direct control.

There were reports that the ministry was not happy with Sebi as the market regulator led by Bhave was not budging on several corporate issues, including the granting of equity licence to MCX-SX and manipulation of shares of the erstwhile Reliance Petrochemicals Ltd (since merged with Reliance Industries Ltd). 

A well known economist (Ajay Shah) is needlessly harassed because he chose to write in a newspaper against the some of the arguments of FTIL in the MCX-SX and SEBI case.

FTIL ‘s core business is to sell trading software. Yet it owns 26% of MCX and 26% of MCX-SX and acts as an anchor investor. Pursuant to this imbroglio, FMC has passed an order asking FTIL to reduce its stake in MCX from 26% to 2%. As a result both FTIL and Jignesh Shah(and his men) have lost the status of ‘fit and proper persons’ to run this exchange.This is a fit response because the management knew about this from the first day. Even when the rumours were breaking out they were in denial. Many of the management officials did their rounds of major brokers and FMC regulator (who was taking an interest in the issue) promising total fulfillment of all obligations.  With this ensuing scandal, FTIL stock crashed from a high of 800 odd bucks to a low of 100. MCX too got painted by the same brush and dropped from 1431 (in February) to 250 in December.

From the highs to the lows

From the highs to the lows

Now, the incumbent CEO has changed from FTIL insider (Sreekanth Javalgekar) to an independent FMC appointed person R.Premkumar, a retired IAS officer. He himself has come on media and explicitly commented that there is no connection between MCX and NSEL. Ravi Kamal Bhargava, a retired IAS officer, has been appointed as Chairman of the Audit Committee till the reconstitution of the board. Bhargava is currently FMC-nominated independent director on the MCX board. (link here )

This leaves us with the question of trust. Imagine this-  what will cause the maximum apprehension in the mind of traders in MCX? Answer: Non fulfilment of their trades. However FMC has quickly moved in and asked for a formation of a robust and well funded Settlement Guarantee Fund. As of 31st December 2013  the Settlement Guarantee Fund of MCX stood at 367cr. With these new incremental changes, it looks like traders can afford to be less apprehensive.

In short, MCX is moving away from a more risky setup to a less risky setup, resulting in an increased assurance for those using its platform. This assurance of safety is different from that of trust. Spoken a little differently, a man might know that  the rope is going to take his weight easily, but he wont trust walking on it over Niagara. Still more, a layman may be able to walk completely straight on a thin line on ground; however may not trust his ability to ropewalk over the Rockies.

Ropewalking over the rockies

Ropewalking over the rockies

Thus, the point here is, traders and brokers might be interested in switching due to low trust. But are the switching costs low enough to enable them to transition? Evidence doesn’t point towards any slump.Secondly, with the installation of a new chairman and an audit committee, has it led to stability?I believe it has.

 Here MCX will just need time to ride over this storm. With a strong moat, MCX does have time in its favour. Especially one has to remember this problem has cropped up not in MCX but in NSEL, a completely different entity. NSEL and MCX are different in their setup. While NSEL is not at all regulated, leading to lopsided harmful incentives prevail, MCX is far more regulated and far better regulated.

The Rupee Value traded over the course last one year

The Rupee Value traded over the course last one year. This is as of 18th Jan 2014. Hence the volume levels are extraordinarily low for Jan 14

However not everything is hunky dory. There are also certain risks in MCX. MCX is facing a severe volume erosion. However it is not plausible to conclude that NCDEX is stealing away over MCX. The total value in itself is seeing a sharp tumble. While in the past months, there has been a switch seen from MCX to NCDEX (9 out of past 12 months the volume growth or decline in NCDEX has beaten MCX), the total value has also fallen sharply. This sharp tumble can be ascertained to levying of commodities transaction tax as well (which is extremely high 10/- per lakh).

Note the largest fall of 36% came in the month of July (which was also the month when FMC banned forward trading in NSEL. The brokers might have smelled a big enough rat to kill MCX as well. CTT-torn

I won’t argue that NSEL case has not spooked brokers. It has. But my question is,  Is it irreversible?

Disclosure: Long MCX

A story of two kids-I

Imagine you reside in a country called Capitex. This country is similar to our world in many ways except for one. Here you can enter a contract with a kid to own a part of his future income stream for a price paid today which will help him in his education, development etc. This seeming evolution has something to do with their social structure. Capitex society is a very tightly knit society. Here social approval and sanctions travel far and travel fast. Naturally, an unethical or a doubtful person will not be allowed to sell his stake to any far off person. Perhaps this is a side effect of such an innovation, so that investor risk and information asymmetry is minimized.

Now you have identified a very interesting and talented boy who has certain things going for him. You go ahead and own a part of his future income stream. Now, it so happens that he also has a twin. Their father is more predisposed towards this boy’s twin and unfortunately the father is not a very good man to associate with. Sure he knows how to nurture a talent, he knows how to get things done. But he can also be ruthless in his dealing, disproportionate in his vindictiveness and has a leaning towards bragging.

They grow up and go their own ways. There is seemingly zero connect between the two brothers except  for the father. The two brothers do well in their respective business. Our investment slowly becomes systemically important, has honest advisors to assist him and is subjected to  “sane and effective” behavior oversight. However his twin, well… lets just say he was a man of his own ethics.

One fine morning, the twin gets arrested for perpetrating a big fraud. The economic offenses task force appointed by the government swoop in and conclude that the twin was trading “empty promises”. The father knew about it, and he refused to act. Plus many of the safeguards which was necessary to follow by the twin were either found to be insufficient or just non existent. It’s a huge breach of trust here.

As is wont, the social sanction snowballed into a complete isolation. The brother, your investment, though he has no connect with this bad egg for 3-4 years has also found himself to be vilified, mistrusted and well to say politely tarballed. The father is also facing similar social sanctions. Now our investment, this brother has grown to be systemically important, the advisors and behaviour regulators are opining that the father should sever all his ties with the brother. As investors like you, there are others who fear that the father might pressurize this good son to pay for the faults of his bad egg.

Now there are some questions here:

  1. Is the good son legally mandated to pay for the bad son’s misdeed?
  2. Will the good son be allowed to pay by behaviour regulators?
  3. Will the severing of ties with the father be a good thing for the brother or a bad thing or a neutral thing.
  4. Finally and most importantly, common men like you are panicking regarding the fitness of this brother to respect his obligations, should you or should you not worry about this?
  5. If you should not, what will be your approach? Wait and watch or buy more of his future income stream?

Can capital be allocated intelligently?

Capital allocation is an important business for an investor. For an investor, his long term returns are controlled by answers to these two questions- where to invest and how much to invest.Most of the portfolio allocation done in contemporary financial scene is based on individual conviction of the idea and cash at hand .

Little thought is given to opportunity cost and the end goals in mind. However investors like Warren Buffett and Charlie Munger, they approach the question of portfolio allocation in a different way. Their allocation strategies revolve around opportunity cost and quality of the business.  They have become so adept at valuing businesses that their conviction decides whether to conduct the investment operation at all or not. Thus with one of the big factors taken care of, they focus on the quality of business. Cash for Berkshire Hathaway can be assumed to be in abundance which it mostly is.

When we look at the future of businesses we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply don’t know what’s going to happen in the future, that doesn’t mean it’s risky for everyone. It means we don’t know – that it’s risky for us.  It may not be risky for someone else who understands the business… However, in that case, we just give up. 

-Charlie Munger

However for the rest of us, all the factors play their part. So the question remains, how to do portfolio allocation intelligently? I would like to answer it in a different vein.
Intelligent Investment is always done with an end goal in mind. Intelligent investing also involves an objective study of an investment’s quality and the numerous costs involved. Most of the costs are quantitative in nature and is visible. However the opportunity cost is something which is invisible and not tangible. Hence an ideal portfolio allocation strategy should take care of opportunity cost.

Keeping this idea in mind, it will be worthwhile for an investor to see himself not as an investor but one running a company. As a result he being the manager has to make capital allocation decisions on different sectors of the business where each such sector will fetch different returns.

In corporate decision making the desirability of these decisions are made in terms internal rate of return(IRR). In this case it can be measured through the company’s return on capital employed (ROCE). Thus all things equal, the investor must try to maximise his portfolio’s ROCE, by investing in high roce businesses and ignoring low ROCE businesses. This will automatically move towards minimization of opportunity costs.

 “Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.” 

-Charlie Munger

However acquiring ROCE also has its own cost, and an investor has to shell out monies to acquire that investment vehicle. As a result, his investment returns are indirectly proportional to the original principal he invested.

Imagine a company with excellent business fundamental and high ROCE. However it is trading at a very high premium. So even with such business fundamentals no tangible returns are made for the the next, few years. Hence there is a fall in time value of money and this is a cost.(since 100 Rupees today is not the same as 100Rs 5 years later).

Thus an investor should aspire to maximise his portfolio’s ROCE at the minimum cost. For an investor, the ROCE of his investment operation will be the weighted average roce of the constituent companies in his portfolio. As for the financial cost to acquire such investment vehicles, a weighted average of the ratio of enterprise value to maintenance free cash flow should be the the other parameter of such a portfolio.

Hence if we imagine a portfolio to be uniquely identified by its ROCE and Cost, then a portfolio with higher ROCE should outperform in the long run  the portfolio with a lower roce, given everything else being equal.Similarly, a lower cost portfolio will outperform a costlier portfolio for the same ROCE. However for the interesting case, of high ROCE and higher cost, a portfolio consisting of such stocks in generally outperforms another portfolio of lower ROCE and lower cost(provided the premium of the first portfolio is not very high). This perhaps can be explained using two concepts.

The growth in book value can be found by, multiplying the amount invested with the excess of ROCE over the weighted average cost of capital. As a result, this excess is the rate at which the invested capital compounds. Since compounding is a nonlinear phenomenon and a 100bps change in the compounding rate can create disproportionate effects over the long run, hence the effect of higher ROCE dominates over the effect of higher cost.

A related an interesting extention of the idea can be found here, by Shyam Pattabiraman: