Vijay Kumar Gaba

 The traders and investors, who directly access the trading platforms of brokers, are reminded and forced to acknowledge, every time they log in to the trading system, “9 out of 10 individual traders in the Equity Futures and Options Segment, incurred net losses”. This is in fact one of the conclusions of a study conducted by the Securities and Exchange Board of India (SEBI) (published in January 2023). From my study of the Indian stock markets in the past three decades, I understand that this conclusion is no exaggeration.

This state of affairs raises two pertinent questions:

(i)      How sustainable a market is where 90% of participants are losing money consistently?

(ii)     Does not this pose a material systemic risk for our markets, especially under the present circumstances where the global financial and geopolitical conditions are worsening every day, and the probability of an eight-sigma event like 9/11 attack and Lehman Collapse etc. is increasing?

Sustainability of market

In my view, the fact that about 90% of the participants are losing money consistently does not pose any risk whatsoever to the sustainability of the markets.

(a)   There is strong empirical evidence to suggest that a large number of traders on the losing side may have actually aided the market growth in the past twenty-three years.

·         The derivative segment turnover at the National Stock Exchange of India (NSE) has grown from Rs2365cr in FY01 to a staggering Rs3,82,22,86,018cr in FY23 – a CAGR of 91.4%. In simple terms almost doubling every year from the previous year for 23 years.

·         The transaction cost incurred by the ever-rising derivative traders has evidently contributed materially to the development of the capital markets. Brokers have been able to invest significant capital in technology and trading infrastructure, The regulator has also earned a tremendous amount of fees, enabling it to invest in technology and investor protection & education programs; the National Stock Exchange has become one of the most valuable financial service corporations.

(b)   This 10:90 ratio has been true ever since the financial markets came into existence in India. While doing research for my PhD during the early 2000s, I discovered that about 90% of the Indian households participating in the stock markets were actually not serious investors. They would “bet” some money on some random stock to test their luck. They seldom differentiated between buying a lottery ticket, a roll of dice in a casino, and buying stock of a company. However, since the amount of ‘bet” is usually very small in relation to their networth, a loss of 100% of their bet never deters them from testing their luck repeatedly.

(c)    Moreover, over the years the “investment” part of their exposure to the securities market has become increasingly institutionalized. In the past 10 years, the share of retail investors in the total NSE turnover has reduced from over 55% to close to 40% now.

Systemic risk

The rise in derivative turnover and a large number of traders losing money may not be contributing much to the systemic risk of the Indian stock markets. In the past two decades, the Indian markets have been best regulated and safest amongst the global peers. In fact, the Indian market was perhaps the only major market globally that did not impose any trading restrictions, or face any closure or trading halt, during the global financial crisis or during Covid-19 pandemic.

We have hardly seen moves of more than 3% on a daily closing basis in the past 5 years. Despite all the global noise and domestic issues, the implied volatility index (VIX) is persisting at its lowest level.

There are two key reasons for this remarkable stability in our markets.

(i)    Indian markets follow one of the strictest margining systems in the world. The chances of a contagion, in case any market participant defaults, are negligible. Besides, the regulators have also implemented a very extensive surveillance mechanism to identify and control unusual movements in stocks.

(ii)  
The composition of market activity has materially changed since the global financial crisis days when 3-5% daily moves in the index were not uncommon. In FY08 prior to the global financial crisis, the single stock futures (inarguably the most risky derivative product) comprised 58% of the total derivative segment turnover, where the safest product index options were just 10%. In FY23 Index options were 97.7% of the derivative segment turnover, while stock futures were just 0.5%. Obviously, the systemic risk is now minimal. The potential losses are very well defined and adequately provided for through margins.

To conclude, I am not worried about any systemic or sustainability risk to Indian markets. However, I am also not sure about the utility of the warning flashed on trading screens at every login. To deter people from stretching their luck too much and losing money consistently, much more serious efforts and paradigm shifts would be needed. 

 It was summer of the year 1997. The equity markets in India were struggling to come out of a four year long directionless phase. Though globally the technology sector had started to excite the investors, nothing much was happening in India. It was arguably the most dreary phase in the Indian stock markets in a decade.

A random walk through the settlement statistic of NSE for past two decade and half decades provided some interesting insights into the market evolution over past two decades. It is interesting to note the things that have changed and the things that have not. Regardless, it is comforting to note that Indian markets are maturing well and the systemic risk appears to have subsided materially. The best part was to observe that our markets have become more democratic with deeper and wider participation.

(All data is sourced from www.nseindia.com)

Indian market maturing well

The latest bull market has shown that the Indian investors and traders are maturing very well. The tendency to recklessly over trade that was witnessed during dotcom bubble, and to some lesser extent during credit bubble of 2007-08, seems to have been reigned well now.

To give it some perspective, at the peak of the dotcom bubble, the average daily turnover of NSE was close to 0.8% of the total market capitalization in FY01. In FY08-FY09 it remained in the range of 0.3-0.4% of the total market cap. However, in the latest bull market, it peaked close to 0.3% in FY20-FY21.

In fact FY21 average daily turnover (ADT) as percentage of market cap has seen marginal decline over FY20, despite a 60% rise in the value of ADT.

Definitely, the changes in ownership pattern of Indian equity may have been at play in this. The institutional and promoter ownership is now much higher as compared to FY01. Nonetheless, there are clear signs of sensibility in day trading patterns, as depicted by the tremendous rise in the option volumes in past 10years. The traders now definitely prefer options more than the stocks, where they can better control their exposure in accordance with their risk tolerance.

A reliable evidence of the rationalization of speculative tendencies over past 20years is available in the form of lower interest in low value (penny) stocks.

In FY01, at peak of the dotcom bubble, in value terms only 8.4% of the traded value resulted into delivery of shares, while 91.6% value was intraday trading. Moreover, when we see the total number of shares traded resulting in delivery, it was 16.5%. This implies that traders were not only overtrading, they were trading more in low priced (penny) stocks.

The share of delivery in the value of trades increased to 27.6% in FY08, and this time the almost 25% of shares traded resulted in delivery; implying that the trading in penny stocks was much lower in FY08.

In FY21, the percentage of delivery has reduced materially to ~17% both in terms of value trade and number of shares traded; implying that traders continue to be cautious about penny stocks and focusing more on mid and large cap stocks for taking delivery.

Another evidence of market maturity comes from the share of smaller companies in the overall market activity.

In FY01, at the peak of dotcom bubble, numerous small, hitherto unknown and often unsustainable businesses were the top traded shares on the stock exchanges. In top 10 most active securities, 7 had market cap of 1% or less of the total market cap of NSE, with 4 having a market cap that was less than 0.1% of the total market cap.

In that year, on NSE the top 10 most active securities accounted for an insane 73% of the total traded value; whereas these securities accounted for just 13% of the total market cap. Himachal Futuristic (HFCL) with just 0.17% of the total market cap was the most active security accounting for over 15% of the total market turnover. Two other small cap companies Global Telesystem (0.11% of total market cap) and DSQ Software (0.05% of total market cap) accounted for 9% and 6.5% of total turnover respectively. To put this in perspective, the company with the largest market cap (Reliance Industries, 6.25% of total market cap) accounted for just 4% of the total turnover; and IT bellwether Infosys with 4.1% of total market cap, accounted for 8.1% of the total market turnover.

In FY08 also, 4 companies accounting for less than 1% of total market cap of NSE figured in the top 10 most active securities. The 6 top most active securities were Reliance group companies. But, the top 10 most active securities accounted for just 27% of the total turnover. Reliance Industries with 6.8% of total market cap contributed just 5% to the total turnover. IFCI was the only microcap stock in top 10 most active securities list.

Things improved significantly in FY20, when top 10 most active securities accounted for 20% of the market cap and 26% of the total turnover. Though this year also 4 companies with less than 1% of the total market cap figured in the list, the skew of share in total turnover was much smoother. Reliance Industries was again the top traded stock, but now accounting for just 3.6% of total turnover.

 

Systemic risks lower now

The stricter compliance norms, improved surveillance and disclosure practice and wisdom gained through hindsight have resulted in materially lower systemic risks in the markets.

Though the common man had started to participate in the stock markets from early 1990s as the economy was opened up, the development of Information Technology industry in late 1990s provided the real impetus. A large number of IT workers came from middle and lower middle strata of the society and had an opportunity to work in global companies. Young professionals from the smaller towns migrated to metropolis and foreign countries. ESOPs became popular and that laid foundation for a deeper and wider participation in the stock markets. The understanding about the financial investments however did not grew in tandem with the understanding of complex IT algorithms.

Besides, a large number of new entities, dealing in new economy businesses and services, came into existence. Many of these companies did not survive the test of solvency for long. Consequently, about one third of the companies listed on NSE in March 2000 had vanished by March 2004.

This was not repeated in 2008-09 and 2020 market crashes. The number of companies available for trading on NSE increased by 25% during the period from March 2007 to March 2010. During the period between March 2020 and March 2021 also the number of companies available for trading has increased by 1.5%.

Democratization of Indian markets

A key development in the stock market has been the democratization of the markets. Not long ago in the history of Indian stock market, the market participants were a small privileged group of people, mostly from established industrial families or senior corporate executives.

Common household investors had begun meaningful investment in listed equity in late 70’s at the time of forced dilution of foreign owned companies operating in India, under the provisions of a stricter Foreign Exchange Regulation Act (FERA). These companies now known as MNCs were then referred to as FERA companies in common market parlance.

Reliance in 80’s and PSU disinvestment and capital market reforms in early 90’s drew the 2^nd lot of household investors. IT boom of late 90’s drew the 3^rd and the largest set of new investors to the listed equity. However, the participants were mostly concentrated in the few larger cities of some industrialized states. The four top cities accounted for more than 80% of investment amount and investors.

Anecdotal evidence point to the fact that Covid19 enforced lockdown has drawn the latest set of investors to the equity markets. 2020 was the period when many businesses were either locked down or their workers were operating from home, whereas equity markets were functioning uninterrupted. This was one trading business that could be done from the comfort of homes and without any additional investment in infrastructure or facility building.

Since, traders and small business owner had no work to do; and bank deposit and bond returns were falling; many of them deployed their working capital in the equity trading. Many small and micro businesses which were declining since demonetization and GST implementation also shut down during this period, with their owner shifting their focus on financial investments.

Thanks to the significantly improved accessibility due to the financial inclusion efforts, technology and Fintech popularity, the participation in stock market is now much deeper and wider. People from across the country and wider spectrum of socio-economic background are participating in the equity investing.

One glimpse of this democratization process could be seen from the average trade size on the stock exchanges. In mid 1990s the average trade size on NSE was in excess of Rs1,00,000. This fell below Rs20,000 by FY12. In FY21 it has increased to above Rs 33,000, (higher than the past five year average of Rs26,000), but has again declined to around Rs29000 in past couple of months.

In a market with total market cap of Rs250trn, where the delivery percentage is just 17% of the total value and number of share traded on daily basis, an average trade size of Rs29000 is a stronger indication of democratization of market than the number of trading & depository accounts opened or mutual fund portfolios created.

The principle and overriding function of the securities market regulator, The Securities and Exchange Board of India (SEBI) is to protect the interests of the investors in the securities market. The other functions, viz., orderly development and regulation of securities markets are secondary, in my view. However, there is overwhelming anecdotal evidence to indicate that the regulators have given precedence to market development and regulation over the principle objective of investor protection. There are many instances in past 3-4years alone to indicate this. In the episodes of IL&FS, Franklin Templeton, Yes Bank, Jet Airways, Karvy etc., the interests of the investors in these entities were compromised. Moreover, little efforts were made to ensure that prospective investors are given full disclosures about the risk and reward of investing in the securities of these entities.

Recently, we have seen repeat of this tendency. On Monday, the 7^th June 2021, evening, DHFL informed stock exchanges about the resolution plan approved by the Mumbai bench of NCLT. It was clear from the resolution plan that in the successful bid of Piramal Group “No value was attributable to the equity shares as per the liquidation value of the Company estimated by registered valuers”. Besides it was also made clear in the communication to the exchanges that equity shares of DHFL shall be delisted upon completion of the resolution.

Clearly, the resolution plan envisaged zero value for the shares of DHFL Limited. Despite this the stock was allowed to be traded on Tuesday, the 8^th June 2021. To make the matter worse, it was allowed to rise 10% (the maximum permitted as per the applicable price band). Over 14cr shares were traded on NSE alone and investors took delivery of over 9crore shares valued close to Rs200cr. All this money will be lost. No broker warned the investors on Tuesday. The exchanges did not advised the brokers to caution their clients. SEBI did not asked the exchanges to suspend the trading. To compound the mistake, the stocks continues to be traded on both the exchanges despite the company formally informing the exchanges that the worth of equity shares is Zero. About 5 million shares were traded on Wednesday also. To be fair, many brokers did advise their clients on Wednesday.

Many “knowledgeable” investors in DHFL have been allowed to unfairly transfer their risk to unsuspecting gullible investors in past two days.

In this context it is pertinent to note that the model bye laws prescribed for the exchanges require that—

“The Exchange shall provide adequate and effective surveillance and monitoring mechanism for the purpose of initiating timely and pro-active measures to facilitate checking and detecting suspected or alleged market manipulation, price rigging or insider trading to ensure the market integrity and fairness in trading. For this purpose, the Exchange may, from time to time, apply, adopt, determine and implement various measures, mechanisms and requirements, as may be provided in the relevant Regulations and as may be decided by the Relevant Authority from time to time.”

It is therefore also the duty of the exchanges to act proactively to ensure fairness in trading. In this case the exchanges could have easily anticipated that some people have advantage of knowing the details of the resolution plan. An analysis of trading data for Tuesday will clearly show that the trading in DHFL was not fair. Not suspending the trading this stock is even more unfair to “unaware” investors and traders.

 Trends in cost of capital in India

A recent survey done by the consulting firm Ernst & Young (EY) and National Stock Exchange (NSE) highlights some interesting data about the cost of capital of Indian businesses. “The Cost of Capital Survey” is an “attempt to understand the threshold cost of equity that India Inc. used for its capital allocation and investment decisions, and the process by which practicing finance professionals in the industry make capital costing decisions.”

The key findings of the Survey are as follows:

·         India’s average cost of equity is ~14%. This has declined by ~100 basis points since our last cost of capital survey, over a period in which interest rates have declined by ~50 basis points.

·         Real estate, healthcare (including pharmaceuticals and life sciences) and renewables command the highest cost of equity, whereas chemicals, media and entertainment and FMCG are at the lowest. ARCs and Startups recorded higher cost of equity on an average than all the other sectors. If ARCs and start-ups are excluded, then the average cost of equity drops further to ~13.5%.

·         The results confirm that the Discounted Cash Flow (DCF) methodology is one of the key approaches for valuation analysis used by corporates, usually in combination with other methods such as peer company multiples or transaction multiples.

·         It was observed that most companies that use the DCF approach typically consider a horizon of five years.

·         The survey emphasizes our learning from the previous survey that “rule of thumb” or an organizational hurdle rate is preferred over objective models such as the Capital Asset Pricing Model (CAPM) to estimate cost of capital.

·         The quantum of subjective company-specific adjustments made to arrive at the cost of capital has remained at similar levels as assessed in 2017. The top factors necessitating such adjustments as suggested by respondents are company/project specific risk factors and uncertainty around projections along with company size and gestation project also forming important considerations.

·         Most respondents acknowledged that an additional risk premium is justifiable when considering strategic investments in start-ups and provided their views on the quantum. The quantum of premium varied across industries, with most sectors capping it at 10%.

·         In using the DCF method for non-finite projects, another key area apart from cost of capital is the terminal value. Respondents were equally divided between using the Gordon Growth Model vs. an Exit • Multiple to arrive at terminal value; the popular long-term stable growth rate used was ~4%, down about 50bps since our last survey.

·         Most of the respondents indicated that they did not make any temporary adjustments to discount rate and the inherent uncertainty arising out of the situation was met by businesses by adjusting their projections or evaluating multiple scenarios instead.

(Source: The Cost of Capital Survey, 2021, EY-NSE)

A web series on the infamous Harshad Mehta scam of early 1990s seems to have triggered a debate on the present state of the financial regulation and risk management practices in India. The key point of interest is whether a scam similar to Harshad Mehta scam could recur!

During late 1989-1992, a Mumbai (then Bombay) based stock broker Harshad Mehta used the inefficiency and lacunae in the banking and stock market systems to create massive pseudo credit. The credit so created was used to manipulate stocks prices, causing the first major bubble in Indian stock markets. This was the time when Indian economy was struggling with unprecedented balance of payment crisis, political uncertainty and higher energy prices due to war between Iraq and US (an ally of Kuwait) in the Persian gulf. Given the despondent economic situation huge short positions were built by traders in Indian equities. In the summer of 1991 the Congress government led by P. V. Narsimha Rao assumed office and unleashed a slew of radical reforms. Using this pretext, Harshad Mehta squeezed the short sellers by using the pseudo credit he could manage by defrauding the nationalized banks. The bubble finally burst in April 1992 when the modus operandi of Harshad Mehta was exposed.

The immediate fall out the bubble burst were (i) promulgation of the Securities and Exchange Board of India (SEBI) Ordinance 1992 to establish an autonomous regulator for regulation of securities market in India; and (ii) up-gradation and modernization of interbank settlement system of government securities. SEBI immediately issued a slew of rules and regulation to regulate the operations of stocks exchanges and market intermediaries. The first fully electronic stock exchange (OTC Exchange of India) modelled on NASDAQ of US was established in 1992. A National Stock Exchange (NSE) was established in 1994, as a nationwide fully electronic trading platform. Establishment of NSE eventually led to elimination of floor based trading and closure of 27 of the 28 regional stocks exchanges. India thus became the first country in the world to have 100% electronic trading in equities. Later Depositories Act was passed to enable establishment of depositories, dematerialization of securities and settlement of trades in electronic form.

The improvement in trading and settlement systems; tightening of margining norms; tightening of compliance procedures to protect the interests of investors etc. have been a continuous process since then. Each instance of fraud & manipulation, accident, unethical behavior has resulted in some improvement in the regulatory process in past 28 years.

However, the continuous strengthening and tightening of regulatory has not deterred the manipulators, fraudsters, and unethical promoters & intermediaries from indulging in fraud and malpractices. The IPO and plantation companies frauds of 1994-1996, dotcom fraud (Ketan Parekh) of 1999-2001, Sahara public Deposit scam, PACL Chit Fund Scam, LTCG Scam, numerous cases of insider trading and front running by mutual funds and corporate officials, act of impropriety by mutual funds (e.g., Franklin Templeton, Kotak MF, Birla MF) etc kept rocking the market intermittently. In fact it has been a 28yrs long episode of Tom (SEBI) and Jerry (Manipulators) where both are consistently trying to dodge each other. Hence, there is no assurance that a Harshad Mehta like scam will not recur in Indian markets.

The best thing however is that Indian markets have remained amongst the safest in world in past two decades. We were perhaps the only market in India that did not impose any trading restrictions during global financial crisis.

The recent measures taken by SEBI and Stock Exchanges to tighten the margining norms to dissuade excessive speculation have been severely criticized by market participants. However, in my view, COVID-19 has warranted SEBI to consider Negative Commodity price and Act of Gods as White Swans for risk management system for securities market. I therefore expect even further tightening of margining and compliance norms.