Analyzing the strategy for new FnO entrants

I was trying to run some numbers to see if the strategy of locking in profit after new stocks make their entry into FnO is working. Except in case of Ispat Industries & WWIL, the strategy would not have worked. If someone accumulated stocks on 28^th Nov (after announcement) and 29^th Nov, the acquisition cost of Ispat Industries is Rs 46 while that of WWIL is Rs 61. This is taking high values on both days for conservative estimates. If someone shorts the futures of these stocks the profit lock in is to the tune of 14% & 11% respectively. If the acquisition of stock is done on 28^th Nov itself, the returns increase to over 20% & 16% respectively. Incase of Info Edge, GBN & MICO, the returns are negative. For Info Edge it is -10%, for GBN & MICO it is -6%. The other stocks are lack luster.

This deviation from the usual strategy may be because of two factors. One is that the time period between announcement & listing in FnO decreased drastically to less 48 hours. Two, as the strategy has become popular, people immediately flock on stocks that jack up to hit circuit filters in just few minutes.

My take is that, one should select fundamentally strong stocks and preferably the ones with stock price less than Rs 100. This is because the stocks with sub 100 price levels have good trading interest thus moving prices positively. This is why you see Ispat & WWIL looking strong in todays trade after they got listed in F&O market.

Strategy when new F&O stocks are announced

15 stocks are going to be added into F&O on NSE from tomorrow. There were 14 stocks that were added in Sep and 31 in May. 28 of the 31 that entered the F&O in May gained as much as 3%-30% before the D-day. In the case of 14 stocks that added in Sep, 13 of them saw gains from 4%-40%. The similar thing is happening with the 15 new inclusions now. Stocks like Ispat, WWIL and Redington are on a different zone of their own. The reason why the stock prices go up is because of the positive impact due to increased liquidity, increased participation of institutions and removal of circuit filters on these stocks. The strategy institutions use in this case is i) Buy in cash before inclusion in F&O, usually, over a period ii) On the D-day, Short the stock futures thus locking in the arbitrage (The futures will be at a premium due to increased buying activity).

To explain further, lets say the average cost of acquiring in spot market is Rs 100. On D-day, lets say the spot price is Rs 103 and that in futures market is Rs 104. If you just sell the stock, you just get Rs 3. Instead if you sell the future, you lock in Rs 4. Once the profit is locked in, irrespective of price movement, the profit remains.

As more people understand this strategy, more people jump in to take advantage of such opportunity and thats why we see the stock prices going up at such rapid pace when any announcement of inclusion into F&O is made.

Overview of Infrastructure Construction Equipment Industry

As more and more money is spent on infrastructure, the demand for equipment will increase. $492bn is allocated to infrastructure in 11^th five year plan. A part of this will be used in contracting Infrastructure and Construction Equipment (ICE). About 4%-24% of infrastructure project cost is attributed to equipment costs. Over the last two years, ICE industry is growing at about 30%.

Drivers for ICE:
1. Construction companies want to rent equipment to keep their balance sheets lean
2. Even smaller equipment companies are getting easy credit to purchase equipment
3. Some equipment financing companies are focusing on small and medium sized equipment companies
4. Financing companies have an oversight on their clients providing expertise during the loan period
5. Domestic demand for ICE is clearly visible. Only after that can these companies look at exports (for which low cost manufacturing base and R&D capabilities are necessary)
6. Capacity expansion is seen in the future
7. Product line expansion is also visible

Stock Specific:
1. Sanghvi Movers has a fleet of 260 cranes and enjoys 50% market share
2. Action Construction Equipment, BEML and Gremach Infrastructure Equipments are companies that are active and have to be watched in this space
3. SREI Finance provides finance for such ICE companies
4. Techpro is one company that might see the light of markets through an IPO soon

Foreign Interest:
1. PE players are also moving in this sector. Darbey Overseas of US has pumped in $17mn in Escorts Construction Equipment. GIC of Singapore & IDFC funded $50mn to Quipo
2. Foreign players have set up Indian subsidiaries like in the case of JCB (UK) & Schwing Stetter (Germany). JCB sub has seen 300% increase in revenues in five years
3. Foreign players have also entered into JVs like Terex Corp (US) and Vectra Ltd (UK). Caterpillar & GMMCO, Komatsu & L&T, Hitachi & Telco Construction Equipment company are few examples of foreign players having alliances with Indian players. With companies like Scania of Sweden (to tie up with L&T) & Yanmar Construction Equipment, this sector could see more action

Challenges to existing domestic players:
1. Competition from foreign players
2. Chinese imports may hit the market
3. Imports from any other low cost country

Key differentiators for domestic players that could withstand challenges:
1. First Mover Advantage
2. Product Mix
3. Distribution Network
4. Technology
5. Alliances
6. Pricing
7. After sales service

Source: Facts & Figures have been referenced from Business Line

Should Fund of Funds be chosen as an investment vehicle?

Fund of Fund (FoF), as the name suggests, invests in multiple Mutual Funds (MFs) that might have underlying as equity or debt. The NAV of FoF is the weighted sum of funds in portfolio. The high rate of taxation weigh against FoF and hence one may NOT invest in it.

Positives:
Investor need not worry about which funds to invest in as the headache is taken by the FoF
FoF does not pay entry or exit load when it moves from one fund to another and hence the investor need not pay for those charges

Negatives:
FoFs are treated as debt mutual funds for taxation
Short term capital gains tax is 33.99% vs 11.33% incase of equity MFs
Long term capital gains tax is 22.66% without indexation or 11.33% with indexation vs ZERO for equity MFs
Dividends are taxed at 14.16% vs ZERO for equity MFs. Expense ratio is about 50 bps over 200 bps of underlying funds

Examples:
DSP ML World Gold Fund
Sundaram BNP Paribas Global Advantage Fund
DWS Global Thematic Offshore Fund

Why are Indian markets reversing?

Yesterday, the markets turned down suddenly. It was a usual morning with both the midcaps and smallcaps doing pretty well as they did over the last few days. Infact, they were doing better than large caps. But suddenly there was a reversal. Reasons I could garner are these:

ONE: There was a rumor of a clandestine Fed Meeting scheduled for yesterday evening. In that meeting, the fed was expected to cut interest rates. Why would Fed in its sane do that? when the FOMC meeting is just three weeks away on 11th Dec. The markets were not so bad for a quick intervention like they did in August. Infact, no one is even talking about the gumming of commercial paper. When Fed had made it clear that they were giving 'additional insurance' on 31st Oct but cutting rates by 25 bps, why would they give additional 'additional insurance' again? Or is it that somebody mis-understood the release of minutes of meeting of last FOMC as a secret meeting and smsed everyone that led to the chaos. This, I hear, has spread to the European markets as well. I cannot figure out why this happened and would leave it for the wisdom of the market.

TWO: There is a talk that some brokers have decided to short the market (as a cartel). I undertand that there was profit looking going on in the market market due to impending negative global cues and no real triggers to watch out for. But this theory of a broker cartel deciding in which way to turn the markets is scary. If it is real, they could do it any time with any stock. So, this could just be a baloney.

THREE: The FII figures indicate huge selling of over Rs 4200 crores in F&O. Some say that it was the hedge funds that could have wound up their positions. This is not a surprise as they guys have been selling equities, commodities and currencies across the globe. Look at how Yen breached 110 mark due to yen carry trade. Apparently, the investors met their profit target and want to get away from risky assets. I am surprised to see no one talking about the redemption numbers for this quarter of hedge funds. If they are under pressure to redeem, they certainly would have booked their profit. Nevertheless, the argument about FIIs protecting their profits has some merit.

FOUR: The next argument I hear is that the Indian markets have run up steeply. The argument further goes to mention that every T,D & H is making money in mid and small caps which is a clear sign of complacency. Well, this might have some merit. However, the other Asian markets have also fallen steeply. Infact, India has so far outperformed other Asian markets (thanks to PNotes). We outperformed Hang Seng by 10% in the recent past. So, the selling is not only in India but all across.

Whatever may be the reason, the global clues are weak and there are no event triggers on the horizon. Some bloodshed would happen as it happened today with Sensex losing more than 600 points (third largest point loss) and Nifty losing more than 200 points.

Investors who entered recently could get out and enter at low levels. I hope they are in good quality stocks. Those who are sitting on cash could wait a bit to reenter. This market will give an opportunity to nibble which has been the best strategy over the last couple of years. Those sitting on good amount of profits may hit the beaches of Goa to celebrate festivities.

Your investments will work for you. Keep an eye on Oil exploration, Pipe, Iron ore, Shipping, Ship building, Logistics and Engineering companies.

Are tier-I hotel companies good to Invest?

Last week, the performance of Hotel stocks has been out of the ordinary. Hotel Leela was up 14%, EIH was up 10% and India Hotels was up 8%. The primary reason for the frontline hotel stocks to go up is a speculation that some PE firms are eyeing a stake in Hotel Leela. That set me thinking to research on what the PE firms are doing in the hospitality sector.

This year, thus far, about $250mn dollars found way into the hospitality sector. Due to the excesses in valuation in tier-I cities based companies, they are eyeing at companies that are active in tier-2 & 3 cities. Here are a few deals that have been done:
1. Credit Suisse invested $55 mn in Apeejay Surrendra Hotels
2. Morgan Stanley invested $37.7 mn in Bharat Hotels
3. Lehman Bros invested $100 mn in Future Capital Holdings
4. Kotak Mahindra invested $8 mn in Lemon Tree
5. Kotak Mahindra invested $11 mn in Pride
6. Reliance Capital invested $8 mn in Oriental Hotels

Is this a right time to invest in these tier-I companies? The answer is NO.
If you look at the stock performance of the last one month, Hotel Leela gained as much as 51% while EIH & India Hotels gained 8%. If you look at the YTD performance, EIH gained 36% while Hotel Leel gained 8% while India Hotels lost 4%. During the same time, Sensex gained 43%. So, the short term performance has been pathetic. Even the rights issue of India Hotels has not pumped life into the stock.

The valuations indicate that the stocks are over valued. Historically, the stocks traded at a PE band of 16-20 one year forward earnings. Currently, EIH has PE FY08E of 26, Hotel Leela has 21 and India Hotels has 18. Clearly, valuations look stretched.

The financials of the companies has been choppy. Unless they show consistence performance, they will not be rerated to the level of their peers in other Asian markets where average PE FY08E is 30.

Fundamentally also, the companies are slow to increase capacities. Moreover, their expansion plans are in tier-1 cities. Though I believe Federation of Hotel and Restaurant Association when they say that 30,000 rooms are need in next three years to the current capacity of 97,000, I would not bet on these top tier hotel companies. I would wait for the PE firms to make their money in smaller hotel companies and list them in the market.

India overtakes China in Valuation in MSCI Asia portfolio

For the first time (possibly), Indian has over taken China in terms of valuation in the MSCI Asia portfolio. On 16th Nov 2007, FY08E PE of India is 25.4 compared to 23.9 of that of China.

Lets take a look at two other snap shots. On 14th Nov 2007, FY08E PE of India was 24.4 compared to 25.9 of that of China, India closing in. On 30th Oct 2007, no one expected that this would happen as the valuation was wide. It was 24.8 for India compared to 29.7 of that of China. This has been possible because the Chinese markets have given away considerably while Indian markets held on.

Infact, the one month returns indicate that India has given a return of +4.3% with Malaysia at +0.7%. These are the only two Asian markets with one month returns positive.

Third observation is that the YTD returns in MSCI Asia portfolio are lcosing into that of Chinese. Indian portfoli has given 62% return while Chinese stocks have given 65%. Indonesia is third at 45%.

This shows the focus India is drawing for global investors.

Essar group does have the history of delisting

There is a huge hue and cry about the stocks Essar Steel and Essar Shipping going much above the discovered price. The discovered price for Essar Steel is Rs 48. The floor price for Essar Shipping is Rs 36.

The rule book says that once the promoters cross 90% of holding after open offer, they have to give six months window for others to tender in at the discovered price. The price discovery is done by seeing the price at which the company received maximum number of bids. Ideally, the investors who did not participate in the open offer should tender their shares during this open window if the open offer is successful. If they do not tender it, they are still eligible for the dividends paid by the company. This is at the cost of illiquidity of the stock. Essar Steel promoters seems to have managed to garner shares to take their holding above 90% and hence the others will get Rs 48 if they tender their shares. So, there is no reason why the stock must have gone up.

It is a different story for Essar Shipping. The open offer failed as only 6 cr shares were tendered when 7 cr were required. Even then there is no reason why the scrip should move from Rs 40 to Rs 64 in four trading days.

Essar group was successful with delisting of Essar Teleholdings. They seemed to have paid a hefty price for that. Here are some details that could be useful.
Name: Essar Teleholdings
Bankers: Edelweiss
Issue size: 1.68 lakh shares
Total number of shares: 50 lakh
Floor Price: Rs 4949
Discovered Price: Rs 4990
Amount Paid: 84.1 Cr
Offer announcement: 16th Sep
Offer Start Date: 25th Sep 2006
Offer End Date: 27th Sep 2006
Delisting Date: 22nd Jan 2007