Wednesday, May 28, 2008

Closing RPower June Puts

I am closing out the position which I discussed 2 days ago. The June Puts are not really June puts - all futures and options on Reliance Power will expire on May 29 - i.e. tomorrow. On NSE, if one finds the detail on this option, one will still see June 26 as the expiry date. However, there is another section on circulars, where one can find the circular reproduced below. The good thing is - I did not lose money.

What this implies is this - people who have been buying RPower to take advantage of bonus shares have no way to hedge themselves today. There is going to be a rush to short futures after May 30. The right time to short is not today but May 30.



Download Reference No. NSE/CM PT/10634 April 29, 2008

Circular No. NSCC/F&O/C&S/831

Subject: Adjustments of Futures & options Contracts in the security Reliance Power Limited (RPOWER)
In pursuance of Byelaws of NSCCL pertaining to Clearing and Settlement of deals, Circular no NSCC/F&O/C&S/654 dated February 09, 2007 (download reference no CMPT/8498) and Circular No NSE/F&O/052/2008 dated April 28, 2008 members are hereby informed that the settlement of futures and option contracts in the security Reliance Power Limited (RPOWER) on account bonus issue in the ratio of 3:5 shall be as under.

The ex-date in this regard shall be May 30, 2008.

The following action would be taken by the NSCCL in this regard.

1. All existing contracts in the underlying RPOWER i.e. contracts with expiry dates May 29, 2008, June 26, 2008 and July 31, 2008 shall expire on May 29, 2008 and shall be finally settled at the relevant settlement price.

2. The settlement price to be reckoned for the purpose of final settlement shall be the closing price of RPOWER in the Capital Market segment of NSE, on May 29, 2008

3. The details of final settlement in respect of RPOWER shall be available in the F_PS03 and F_PS04 reports downloaded to members on May 29, 2008

4. All positions in the existing futures and options contracts on the underlying RPOWER shall cease to exist pursuant to the final settlement on May 29, 2008

5. The Pay in/pay out of final settlement of all F&O contracts on RPOWER shall be on May 30, 2008 (T+1 day).

For any further clarifications Members may contact the following officials of the Clearing Corporation: Mr.Chinnaraja C and Mr Ganesh Rangaswamy

Phone Nos. 022-26598165 Fax Nos: 26598243

Yours faithfully,

For National Securities Clearing Corporation Ltd.

Rana Usman


Monday, May 26, 2008

Buying R-Power Rs 400 June puts

I am trying to figure out futures and options. So today, I did the second option trade of my life. I bought some R-Power put options.

The IPO of R-Power in Jan 08 was a seminal event in the history of Indian markets - it called the top of the Indian stock market euphoria. But while Indian markets have fallen from 21K to around 16K since then, R-Power is sitting close to its IPO price of Rs 450. Why?

To figure this out, lets recollect the series of events around R-Power.

Early Jan 2008: Anil Ambani is able to con people to give his paper company a $25bn valuation.
IPO price = Rs 450.
Public shares outstanding = 228 million.
Public shareholding =10.09%. Rel Energy (now Infra) holds 45%, Ambani junior holds another 45%.
Total shares outstanding = 2.259 billion.

Early Feb 2008: R-Power lists and tanks.

Late Feb 2008: Anil Ambani comes out with a 3:5 bonus offer for all public shareholders. That is, the company will issue 136.77 million more shares but only to the public shareholders. This will bring up public shareholding to 15% in R-Power. Anil Ambani also transfers some of his shares to Rel Infra, so that Infra's stake in Power remains 45%, while his stake in Power falls to 40%

June 2, 2008: record date to determine eligibility of shareholders to receive bonus shares.

This is a very unique bonus issue. It is being offered to only one set of shareholders and not to others. So, it is a transfer of wealth from one shareholder to another. There are two possible adjustment factors - 62.5% (=5/8) and 94% (1 - 6%) for the stock post the dilution event, which has created confusion and opportunity.

Let us buy 5 shares of R-Power stock today at price x. We will get 3 additional shares and will have 8 shares of the same company in a few days. If the price at that time doesn't fall below 5/8*x (=62.5% x), we would have made an arbitrage profit. And why should it fall below 5/8x? After-all, the company is issuing only 6% more shares (136.77 million additional shares divided by 2.259 billion shares shares outstanding earlier). So the price should fall by only 6%, and should be 94% of the price pre-dilution. If that is how it works out, we will make 50% profit (8 shares * 0.94 *x - 5 shares * x)/5x = 50%

Note that x is immaterial. By this logic, we should be willing to buy RPower at any price - 350, 400, 450, 4500. Clearly, that is wrong.

I think this is the logic that has kept RPower stong over the last couple of months. Even today, it is a $25 billion company without any real business, except the $2.5 billion raised in IPO. It has outperformed Sensex and it has outperformed other ADAG companies like RCap, which have similar fluff.

Once June 2 comes and goes, I think investors are going to start selling massively. They won't receive the bonus shares for a few more days, but they can definitely sell whatever they have to lock in part of the profits.

With options, there is the trickiness of the adjustment factor. What does the exercise price adjust to post issuance of bonus shares? Does it adjust to 94% (1-136.77/2259) of the strike price, or does it adjust to 62.5%? I think it will be 94% - (the exchanges have yet to come out with the clarification). The stock should, however, adjust much more - ideally, it should fall to 62.5% of the pre-dilution price - otherwise there is free money for public shareholders.

So, the Rs 400 put option will adjust to a Rs 376 put option. I am betting that R-Power is going to fall far below this level once the record date for bonus issue is out of the way. 62.5% of Rs 450 is Rs 281, and that is where the stock should go. Even then it will be a $17 billion company. Contrast that with Tata Power - $8 billion market cap, with an ownership stake of 30% in Bumi Resources, which is worth $6bn at today's prices.

Of course, I could be wrong. Exchanges could decide the adjustment factor is 62.5%, and markets can decide the adjustment factor is 94% - this is after all a Reliance stock.

The premium for the Rs 400 June put option was Rs 4. My downside for 1 lot of 450 is Rs 1800 while upside can be huge. So that is why I did this trade. Lets see how it works out.

I was also thinking - can one make arbitrage profit today by using futures? That is, I buy 5 shares of RPower, and sell 8 shares in the future markets. Suppose futures adjust to 94% post issuance of bonus shares. I would have made risk-free profit. Unless futures adjust to 5/8x, I will make profit at any x. Maybe this is also what has been pushing R-Power price up. I dont know how futures adjust for issuances of bonus shares, so this is going to an excellent learning experience.

Thursday, May 22, 2008

Oil at 133

I am less bullish now than I was last month (So where do we stand). As I had mentioned, oil price rise was the most significant risk to any bull theory. If oil price substain above $120 for the year - GS is out speculating $150 - equity markets will struggle.

This is a major shock - not because of the absolute price, but because of the speed at which it has gone up - up 70% in 9 months. Any recession requires multiple shocks. We now have multiple ones in the US - (a) the housing blowup starting late 2006 (b) subprime debacle and ensuing credit crunch starting mid 2007, and (c) sharp oil price increase in late 07-early 08. The one that is coming next is a sharp uptick in corporate bankruptcy rates.

US imports 12mn barrels of oil per day * $30 price hike this year (from $100 in Jan 2008 to $130 today) = $130bn of -ve exports = 0.9% hit on GDP on a $15 trillion economy). Oh, by the way, that is what the Fed expected growth will be this year (0.3%-1.2%) before oil prices moved up, so the new forecast should be 0%.

India imports 700 mn barrels of oil per year * $30 price hike = $21 billion hit = 2.1% hit on GDP ($1 trillion economy). Expected growth rate of economy w/o the impact of oil = 8% - 2.1% hit from oil = 5.9% GDP growth. India will grow below 6% if oil remains at $130.

Wednesday, May 21, 2008

Asset Prices as Driver of Fundamentals

This is quite random stuff, and like everything else, completely wrong.

I am increasingly getting convinced that the price of an asset (like a stock) impacts its fundamentals. Traditional economics will say that price is determined by supply and demand,
i.e. P = f (S, D).

I think
P = f (S, D, P).

And to refine it even more:
P+ = f (S, D, P+)
P- = f (S, D, P-)

i.e. the probability whether the next move in price is up is determined whether its last move was up or not, and vice-versa. (This is not a good mathematical representation of what I have in mind, but lets have it like that for the time being)

This is what price momentum is. Essentially, what this implies is that any fundamental analyst who ignores price momentum because it is a hobby of technical analysts doesn't appreciate that prices impact fundamentals, and misses out on an important variable in his/her thought process.
This will also explain why markets can deviate from prices determined solely by supply-demand arguments. If markets were efficient, there shouldn't be boom and busts. That is clearly not the case.

In the new framework laid out above, markets will necessarily go in a boom-bust phase, depending on the price momentum. A boom-bust market is an efficient market, not an inefficient one.

Isnt this what Greenspan is saying? Boom and bust is a part of capitalism and markets. You can either have a state controlled communist society where prices don't change and neither does anything else (except misery which keeps on increasing) or a market based society with its episodes of booms and busts. There is no third alternative.

Aban Loyd as a trading stock

I am taking my money out of Aban Loyd. I sold the stock at Rs 3900. Consensus EPS estimate for this stock is Rs 400 for FY09 and Rs 500 for FY10.

I am sure consensus is overestimating EPS because: (a) This company has extremely poor disclosure, nobody knows the numbers for its Singapore subsidiary. Costs for drillers are rising fast - there is a shortage of manpower. I dont think analysts are capturing that properly. (b) I am sure some of the new rigs are going to be delayed, as they have been over the last few years. So revenue and EPS is going to be pushed out. (c) Not sure whether people are capturing drydocking days properly.

But that doesnt imply that I am bearish on the stock. I think this sector has no problem till oil remains above $80. I simply dont see why I should buy Aban at 10x next year PE when Transocean is available at 11x PE - when Transocean has much bigger deep water fleet that is contracted out (in some cases) till 2016 and a much better disclosure.

The entire offshore drilling sector is getting valued at low multiples, when the visibility into the earnings of companies (esp RIG) is getting longer and longer. These are deep cyclicals, and the market is valuing them like that. But this cycle is just getting longer and longer, as oil hits new highs.

This creates one of the best opportunites to trade. Market is valuing Aban like a deep cyclical while fundamentals are strong for the next 2-3 years. Aban is an extremely volatile stock and gets hammered when market falls. So, there is lots of money to be made with this stock if one trades properly. That is what I have decided I will do with this one. I am going to use this as a test case to figure out how one can trade stocks, as I feel very comfortable with the underlying fundamentals.

Oil at 130

Oil is in contango. Surprise for the Fed - which has been looking at future markets over the last few years to justify why it thinks oil prices will head down in the future. Not only have future markets underestimated oil prices , now they are in contango. So I am sure the Fed is in a dilemma.

Why are oil prices going up? I dont see any good reasons for it, except the so called supply-demand imbalance. But gasoline is overflowing - as WSJ points out today, Iran is storing gasoline in tankers because there is not enough demand. Apparent problem is with diesel. But is it suddenly so huge that oil needs to go up by $30 in 1 month? Bulls will argue that problem is not with near-term supply, but with long-term supply demand - as a market in contango indicates.

I think there is one big positive with high oil prices. This is much better than a carbon tax to cut down greenhouse emissions. As altenative energy demand increases and these business models scale up, they will become viable without government subsidies. Global warming activists should be jumping with joy.

Monday, May 19, 2008

Cutting out of KRBL

I had bought KRBL at 139 a month ago and sold it at 119 last week. This is a very interesting stock as it illustrates the risk that govt can expropriate wealth that capitalists might consider theirs. Some people get govt to transfer public assets to them at low value - witness the real estate deals and how FSI's get increased and tax status changed after the deals have been stuck. Others can't stop govt from stealing what is theirs by passing taxes that are 'legal' - after all the government decides legality.

Basmati is an interesting commodity. It is probably the only commodity which India has marketed well enough that it is now a brand. It has also fought hard to make sure other pretenders from Vietnam etc don't steal the brand. India and Pakistan are the largest producers with India accounting for the lion's share. 90% of Basmati production is exported, as the rice is expensive (3x-4x price of normal rice). India exports about 1mn tonnes, at $1000/ton, this is export earnings of $1bn - 4000 crore for the rural economy. Not bad.

KRBL is the largest basmati rice miller and exporter in India. Surely - one would have thought -with rice prices shooting up throughout the world, this company should benefit. And with the stock at 4x Fwd P/E, this should be a multibagger. At least, this is what I thought.

Export taxes: Well, I was wrong. Rice prices are going up and feeding into inflation, so the govt has come up with an export duty of Rs 8000/tonne (or Rs 8/kg) to prevent exports. Last I remember, Basmati was selling for Rs 80/kg, so this is a 10% tax. This will reduce exports of Indian Basmati, which will then get sold locally pressuring domestic rice prices.

Now one can argue that it is all in the interests of the common man, so govt has done a great job. It is making sure that some capitalists dont benefit at the expense of vast majority of poor people. I disagree with this. I think this tax will hit Basmati supply in India - the very outcome that the govt wants to avoid.

Thin margin business: The margins are thin for millers (5%-7% PAT margins), so a 10% tax can effectively destroy their economics. So they will be forced to raise prices, which will hit export demand.

How elastic is the export demand? Some people will argue the following to justify price hikes can be absorbed without impacting demand: a) Basmati is a brand of which India produces the lions share, b) It is the rich man's rice, so price elasticity is less, (c) Indian basmati is anyway more expensive than Pakistani variety, and (d) there is a supply constraint of rice globally.

I dont think thats the case. I think argi commodities have high price elasticities and are almost perfectly substitutable. Besides, if export demand doesn't slacken and domestic rice prices remain high, govt will again increase export taxes. So there is going to be a big demand impact.

Long-term supply reduction: As exports take a hit, millers will dump rice domestically, which will cause a fall in domestic Basmati rice prices. So thats good for the common man.

But what about next year? Millers won't again procure the same quantities of Basmati paddy that they did this year - after all export demand will be down. Some farmers will switch to other crops.

More importantly, this will give an opening to Pakistan, Vietnam and other countries to capture market share in the international Basmati market. If demand is there, and India is willing to fulful that only at exorbitant prices, demand will find other supply sources. The longer the Indian govt persists with this tax, the more likelihood it is that Pakistan takes away the market.

Of course, the govt will say that this is a temporary tax, and as soon as rice prices normalize, this tax will go away. I just look at HPCL and BPCL and think that it might not turn out to be the case.

This tax reduces incentives to create supply. Indians won't buy a lot of Basmati at the price it normally sells, and govt wants to discourage exports. How can govt incentivize people to produce something if they end up losing money in the process?

Saturday, May 03, 2008

India's fiscal deficit..

This is my first attempt to understand finances of Indian govt, so this analysis could very well be wrong.

As can be seen from RBI data above (all numbers are % of GDP), there have been two big swing factors that have pushed India's saving and investment rate from 23% in FY02 to 36% in FY07. First has been corporate saving (or corporate profits), which has improved by 4.4%. Second, and even bigger, has been improvement in public sector saving by 5.2%. It has been better fiscal management of the budget and much improved finances of PSU's that has led to the biggest savings which have been used to finance investment.

Now, the fiscal situation threatens to turn ugly. Combined state and fiscal deficit in FY08 was close to 5.5% and will become worse.

First, India imports roughly 1bn barrel of oil. Oil prices have jumped by $20 since budget was presented => a hit of $20bn = 1.6% hit. (assume GDP at $1.2 trillion)

Second, fertilizer prices have gone through the roof. Mosaic CEO was saying that India's fertilizer subsidy this year will be higher than its defence bill. Defense bill is $25 billion for India. Last year fertilizer subsidy was $2billion. That is an extra $23 billion hit on account of fertilizers. That is close to 2% of GDP.
So, in total, these two add up to 3.6% of GDP.

Third, farm loan waiver of $15 billion = 1.2% of GDP. Lets ignore it.
Fourth, pay commision will impact state finances. Lets ignore it.

This will be offset to a very small degree by tax growth, better tax administration etc. Still, a 3% extra hit to fiscal position will happen from oil and fertilizer subsidy, if the prices of these don't moderate over the next year.

It is not that suddenly India growth story is over. In the short run, govt can do a lot of things, esp selling stakes in PSU's to improve its situation. But, if this situation were to persist for 2 years, it would be alarming.

I am not sure how the public sector savings number are computed above, and how it ties to the fiscal deficit of state and centres. Do PSU's get consolidated here, which implies that the oil bonds get taken care of? What about fertilizer subsidies?

So where do we stand?

Here is my theory of what is going to happen, some of which are facts and some of which are guesses which might turn out to be wrong.

Growth Rates:
a) Is US amidst a slowdown? Yes. Expect several quarters of -1% - +1% growth. However, it is not falling off a cliff. Strong exports are helping US.

b) Are Europe and Japan going to slow down? Definitely yes. UK, Spain etc have the same housing problem as US. Japan will be impacted, but it has hardly contributed anything to global growth in the past few years, except for its cheap yen. So I wouldnt worry about Japan.

c) Are emerging markets slowing down? Definitely yes. Emerging markets will get a lagged impact of US slowdown. Plus these countries face higher inflation from food as it is a bigger portion of their consumption basket, so their central banks are tightening.

If emerging market growth rate slows, US export growth will also slow down over the next few months. If not offset by something else (like govt spending, or the lagged benefit of substanital monetary policy easing) this could hit expected US GDP growth, and lead us into a vicious cycle.

d) Credit Crunch: Is there a credit crunch? Yes. Are banks more cautious than before? Yes. Will credit growth not be as fast as before? Yes. Does it mean that US falls off a cliff? No. It might merely stabilize for a long period of time. If credit contracts, it is dangerous, which is what we have had over last 9 months with runs on the shadow banking system. If it stabilizes, then we will avoid the worst come outcomes, which is where I think we are.

I believe monetary policy works. I think the US economy stabilizes around here for an extended period of time. The risk is more in Europe and emerging markets.

Inflation and Interest Rate:

a) Commodity Inflation: There has been a surge in commodity prices since Sep 2007 since Fed started cutting rates. For some commodities, rate cuts, dollar depreciation and speculation explain quite a bit of this latest surge. For some others, there could be supply-demand argument. After all, steel companies have negotiated iron-ore price increases with BHP - these are not being set on any exchange. Commodity price inflation is the real wildcard right now in any bull theory.

Of the various commodities, the most easiest and most difficult one to tackle is agflation. All one needs is a few good rains and monsoons in the world and wheat and rice prices go back to normal. All we need is a few rains not to happen and we get political and social unrest to change everything.

b) Will US inflation explode? No, because of various reasons. First, food is not a big part of consumption bucket. Second, rents and house prices are 30% of CPI, which are headed down because of housing oversupply. Third, Fed has cleverly defined a core inflation number and made sure everyone focuses on it over the last 30 years. Fourth and most importantly, the bond market is not very worried. Inflation expectations remain well anchored, and it is expectations that determine future inflation (inflation expectation theory). There is no question that Fed will cut more if credit markets start worsening again.

c) Will European inflation go up? I think inflation dynamics are the same in US and Europe, except that ECB focuses on overall inflation rather than just core inflation. BOE has already started cutting rates. How long ECB resists a rate cut is the million dollar question.

d) Emerging market inflation: This is the biggest problem, considering US is so heavily betting on export growth. Inflation here is driven by commodity prices, which is why they are wild card. If these countries tighten so much that they significantly slow down before US domestic economy has picked up, it will be a blow and lead to a vicious cycle.

Equity Markets:
a) US: Does 0% growth and higher inflation mean that equity markets need to crash and burn. Not necessarily.

First and most importantly, with dividend yield at 2.1%, savings account yield at 2% and headline inflation at 4%, there is no incentive to save. Any long-term cash needs to be parked in an index fund rather than in a bank account.

Second, the Fed is backstopping the equity markets to negate the effect of a decline in real estate wealth on consumers. While consumption elasticity to real estate wealth is higher than stock market wealth (this is a guess), a surging equity market helps.

Third, US markets are not outrageously expensive. Yes there will be earnings downgrades in the later half of this year, so S&P trades at 18x instead of 14x. But 18x is not outrageous - markets have traded here before. And maybe they are actually trading at 18x. Besides, by 2H08, investors will start looking at 2009.

It is not reality but expectations that sets equity prices. In a funny way, these expectations can then actually turnaround to impact reality. If equity prices remain high for a wrong reason but end up benefit consumer spending, it will help the underlying economy, which will then become a justification for higher equity prices.

b) India: Why US is so important for India is because of the amazing correlation between US and Indian stock markets. If US equity markets go up, the likelihood of Indian markets doing the same becomes very high.

There are a lot of concerns with India today. First, growth is expected to slow from 8.5% last year to around 7.5% this year. Second, inflation is high and is now running at 7.5%. Third, there are elections this year. So inflation becomes even more important. Fourth, fiscal deficit is widening each day that oil and fertilizer prices remain high. It has been the turnaround in fiscal deficit that has contributed the maximum to take India's saving rate/GDP from below 30% five years back to 35% today. If fiscal deficit remains persistently wide for a long time (2 years), savings will fall and investment will take a hit.

Does that mean that Indian markets will crash and burn? No. If US markets remain strong and Hong Kong and Brazil move up, India wont remain a terrible laggard. As equity prices go up, they create their own dynamic - where they impact reality as much as reality expects them. In the next post, I will discuss the stocks that are the most leveraged to this dynamic - the brokerage stocks.

Friday, May 02, 2008

Equity markets as the solution..

Just expanding on the previous post here, in the wake of much better than expected employment numbers. There are 3 sources of money to drive consumption:

a) Income: If employment doesnt fall as much as expected, income would be better.
b) Wealth: Most of the wealth is tied in either real estate or equity markets. If real estate prices fall but equity prices go up sufficiently, it would be neutral.
c) Credit: which is where the fear is. But it is abating. And Fed is exchanging all sort of securities for pristine treasury securities. Banks are busy raising equity.

Household real estate in the US totaled $20.6bn at end of 2006. ( I guess prices peaked in summer of 2006, so it should be lesser now. Lets assume increase in homes offsets that impact. $9.8 trillion were liabilities. So wealth was $11 billion.

Suppose housing prices decline by 25%. Thats a loss of $5 trillion of wealth, or home equity falls from $11trillion to $6 trillion.

The total stock market cap in US is $25 trillion. If this goes up by 20%, the negative impact of household wealth would have been neutralized. Of course, the question of rapidly appreciating asset prices to drive up consumption growth will remain. But, the worst possible outcomes would have been avoided.

This is what the Fed is doing. It is making sure that equity markets don't fall and credit remains available. It has now cut interest rates to 2%, below S&P yield of 2.1%, making sure nobody keeps cash in bank. So the wealth effect is being taken care of.

It is all a cycle - either a virtuous cycle or a vicious cycle. Equity markets go up => consumer doesnt falter much => businesses dont take a massive hit => employment doesnt fall much + Fed eases a lot => house prices stabilize sooner rather than later => credit starts flowing more freely. If US stabilizes => Fed looks at increasing interest rates => dollar becomes stronger => commodites weaken, then it takes care of the inflation problem also.

I think there is now a fair chance that we see a massive rally. US economy is extremely resilient - it took multiple shocks in 2001 to take it into a mild recession. Fed has probably eased more than it should have but it is no hurry to increase rates soon. The emerging market bubble that we were all taking about 7 months ago started but burst in between. I think we are going to see a second coming.

Equity markets as the solution to the problem

Bears say that because house prices are declining and savings rate in US is 0, consumer spending will take a hit. That argument is wrong.

For there are two big sources of wealth - homes and stocks. Each is worth about $20trillion. That is where most Americans have put their wealth. So if stocks go up, they take away some of the pain from declining home prices. The wildcard is commodity prices.

Fed has eased a lot since Sep. Whether it is more or less, only time will tell. There is always the possibility now that it has eased more than was necessary and so stocks will rocket from here. I think Dow at 15K, Sensex at 25K before the year ends is now a very distinct possibility.