February 08, 2016

are companies passing on raw material cost savings to consumers?

Something I wrote on higher operating margins during times of falling raw material costs by listed companies in today's FC Invest issue:

Take high operating margins in a falling raw material cost scenario with a pinch of salt

One of the very investment themes which has not been hit adversely by the global economic slowdown and the Chinese mini-meltdown has been the domestic consumption theme. The Indian consumer has been fairly insulated from the external factors.

Given this, the crash in crude oil prices and the prices of most commodities has posed a strategic challenge to many listed companies in the fast moving consumer goods and consumer durables sectors, as well as in other consumer-centric sectors.

Companies’ raw material (RM) costs have come down drastically in the past one year. Cost of transportation is down. Should a company use this a golden opportunity to cut prices for its consumers and boost it sales? How much of the savings arising from these cost declines should a company pass on to its end customer? Or, should the company pocket all savings to itself considering the justification that any price cuts made by the company to increase sales will invite similar cuts from competition? And, if a company pockets all or much of the cost savings and then goes on to show a jump in its operating margins, is that necessarily a show of great and sound fundamentals as far as investors are concerned?

In the process of such companies addressing these questions, investors in these companies get a golden chance to gauge the thought process of the company management on this important strategic challenge and sense whether they are dealing with it in the best and long-term interests of the business or not.

Take a look at the latest 9-month period of April to December of the current financial year, 2015-16 (9M-FY16). FC Research Bureau analysed the financials of five select consumption-driven companies whose latest third-quarter (December 2015) results were out, and which were large-cap companies belonging to the Nifty 100 index, to understand what was going on in a falling RM cost scenario.

These five companies were Asian Paints, Colgate-Palmolive (India), Godrej Consumer Products, Hindustan Unilever (HUL), and Marico. Four of them saw their operating profit (earnings before interest, depreciation, tax and amortisation or Ebidta) growth in 9M-FY16 as compared to the year-ago period, outpace their net sales growth by a wide margin.

Lets take the case of Asian Paints first. Its net sales in the latest  9-month period grew by just 8.5 per cent, while its operating profit jumped up by 24.8 per cent, on a yoy basis. This came on the back of a 3.0 per cent reduction in RM costs. The same company, in 9M-FY15 (the previous year), had recorded a 12.9 per cent rise in net sales against which operating profit grew by a smaller margin of 10.1 per cent. The RM cost had risen by 12.2 per cent.

Asian Paints is currently running high operating margin on the back of cost savings in RM which it has not passed on to the consumers. Without price cuts, it has not been able to boost its net sales whose growth was one-third to that in its operating profit.

But the company management was clearly aware of the implications. In a conference call with analysts on January 18, after it had announced its Q3 results, the company management acknowledged that there was no change in the pricing of its products, and further categorically said that  the high level of gross margins was clearly not sustainable going forward.

According to Prashant Mittal, investment analyst at Ambit Capital, companies typically follow three approaches to make use of the fall in their input prices for increasing their sales:
1) Passing on the benefit to the end consumer through price cut
2) Indulging in promotions, that is, increasing the volume sold (for example, 5 per cent extra or buy 2 get 1 free) but keeping SKU price same
3) Additional spending on advertising
Net sales of Marico, another company in our analysis, rose by 7.2 per cent and its RM cost fell by 7.2 per cent, while its Ebidta shot up by 23.4 per cent, in 9M-FY16, on a yoy basis. The previous year’s corresponding period (9M-FY15) had seen net sales shoot up by 24.7 per cent, RM cost flare up by 44.4 per cent and Ebidta trail with a rise of just 15.9 per cent.

Clearly, Asian Paints, Marico and also Colgate (see chart), represent potential examples of companies choosing, for their own strategic reasons, not to pass on RM cost reductions to their consumers.

Cost-sales-margin matrix

How four major consumption-driven stocks have fared in the last two financial years

9M-FY16* 9M-FY15**

Net sales RM cost Ebidta Ebitda margin (%) Net sales RM cost Ebidta Ebitda margin (%)
Asian Paints 11411 5617 2219 19.5 10515 5793 1778 16.1
YoY change (%) 8.5 -3.0 24.8 --- 12.9 12.2 10.1 ---
Colgate-Palmolive (I) 3041 836 687 23.0 2933 885 601 20.0
YoY change (%) 3.7 -5.5 14.3 --- 11.8 3.5 3.8 ---
Godrej Consumer Products 6691 2579 1219 18.2 6160 2569 1033 16.8
YoY change (%) 8.6 0.4 17.9 --- 8.9 14.7 20.6 ---
Hindustan Unilever 23616 8430 4599 19 22615 8938 4895 22.0
YoY change (%) 4.4 -5.7 -6.0 --- 10.5 8.3 21.4 ---
Marico 4820 2273 912 19 4497 2373 739 16.4
YoY change (%) 7.2 -4.2 23.4 --- 24.7 44.4 15.9 ---

* Apr-Dec 2015

** Apr-Dec 2014

Figures in Rs crore, unless specified  otherwise

Financials are consolidated, unless not available or not applicable

RM: raw material, Ebidta is operating profit

Source: Capitaline. Analysed by FCRB.

HUL, on the other hand, appeared to have gone a long way to boost sales by passing on the RM cost fall benefit to its consumers. HUL’s latest period net sales was up by 4.4 per cent while its Ebidta actually fell by 6.0 per  cent. RM cost was down 5.7 per cent. In the year-ago period, net sales had risen by 10.5 per cent and although Ebidta had shot up by 21.4 per cent the RM cost had also gone up by 8.3 per cent.
According to Anand Rathi Securities’ investment analyst, Ajay Thakur, “HUL has proactively made a 12 per cent price cut in its products in Q3 and first month of Q4 largely to maintain their market share and partly to gain market share.”
Ambit’s Mittal thinks companies can only take limited price cuts considering the risk of brand dilution in case of an excessive cut. “Similarly, given law of diminishing marginal utility, the companies have limited leeway with respect to promotional offers. They are unlikely to end up making consumers consume a whole lot more than the usual amount through promotions. What they can do is either pre-pone the demand or premiumize (tempting consumer to try a higher value brand by reducing its price),” said Mittal.
He further said that once the three approaches (or a combination) is met, the rest of the benefit becomes a part of operating margin. “Hence, whilst some of the additional demand might stick, the investor should take both higher sales and higher operating margins in a falling raw material cost scenario with a pinch of salt,” Mittal said.
Investors, therefore, need to go beyond healthy operating margin figures and look at their primary cause. In quite many product lines in the Indian consumer markets, the consumers are un-aware that the cost of making the products has come down. “Unless there is a competing product that is priced lower, a consumer does not know,” said Anand Rathi’s Thakur.
Savvy FMCG companies might just take undue advantage of them by not passing on cost savings and at the same try to impress the investors with high operating margins. Be wary of their tactics and not get carried away by the strong operating margins they throw around to lull you.


January 30, 2016

what good is our equity f&o market up to?

A story, I wrote a week ago, on whether our equity derivatives story is up to providing depth, liquidity, breadth and innovative products to investors for hedging and other uses during times of stress in the markets:


The very beginning of the new calendar year has seen stock markets worldwide, including our own, grappling with a host of factors causing fear and pain. Under these difficult circumstances there is one equity market which tends to play the valuable role of a shock absorber: the equity derivatives market or the equity futures and options (F&O) market as it popularly known here.

To be sure, the domestic equity derivatives market is likely to play an important role as a shock absorber in case the Indian stock market keeps getting hit by the raised risk levels of global economic slowdown and the consequences of sustained currency devaluation by China. It plays the role of a buffer for foreign portfolio investors (FPIs), as well as domestic investors, where they can come to and execute their portfolio hedging strategies and other protection measures (see box: The most basic hedging strategy).

And, that role, being an ongoing role, is already being played out in the current month which has already seen two major bouts of market shocks involving sharp fall in global equity indices, including our Nifty 50 index and S&P BSE Sensex index.

The one which took place on Wednesday this week was the latest. According to Chandan Taparia, a senior technical analyst at Anand Rathi Broking’s retail research desk, FPIs were quick to take note of the heightened market volatility. He said the kind of buying in index options contracts which FPIs have done in the current month has not been seen in the past couple of years. “Since the start of the new month series this month, FPIs have been buying and selling in index options which we have not seen in the last few years. This indicates that the FPIs are doing two things – they are hedging in a big way and they are playing the volatility in he market,” he added.

Indeed, the domestic equity market ecosystem has had a robust equity derivatives (futures and options) market for most part of the last 16 years after it went live in June 2000 with initially only index futures trading. But given its current contours is the equity derivatives market micro-structure well placed to be an effective shock absorber?

FPIs have been selling in the equity cash market and in January their net outflows, as of January 20, was Rs 8,340 crore. They have been net sellers for the most part since May last year, monthly FPI net investment data put up by the National Securities Depository (under direction from the Securities and Exchange Board of India) shows. Barring July and November of 2015 the domestic equity market has witnessed FPI net outflows.

Have a look at the net outflow figures: Rs 5,770 crore in May, Rs 3,340 crore in June, Rs 16,880 crore in August, Rs 6,480 crore in September, Rs 7,070 crore in November and Rs 2,820 crore in December.

Clearly, therefore, the January (till 20) FPI net outflow level of Rs 8,340 crore, if it sustains around that level at the end of the month, would be the second-highest since May 2015 when the FPI net outflows in equities began.

While future forecasts, of whether global equity jitters will continue and whether it will lead to a meltdown in equity markets worldwide, may or may not get it right eventually. But what can help enormously is the ability of large investors such as the FPIs to be able to execute multiple trading strategies in the equity derivatives market to play out, temporarily, their portfolio protection strategies as well as any other which they want to execute to optimise their returns from the Indian equity market.

So, it that happening? “Yes,” says Siddharth Bhamre, head of derivatives and technical at Angel Broking, “No matter how large your portfolio is you can hedge in our equity derivatives market. There is enough liquidity in the Nifty F&O contracts as well as in 30-40 large-cap stocks in the stock F&O contracts.”

A FC Research Bureau analysis of Capitaline data on FPI investments in different types of equity F&O contracts revealed the exact numbers behind the assertion by Anand Rathi’s Taparia that FPIs were buying and selling in very large quantities in the current month as a response to the global market crash in the first week of January.

Our analysis shows that in the first 13 days of the new month series which began from January 1, and till January 19, the net buying action by FPIs in index options on the National Stock Exchange’s equity F&O segment was Rs 11,800 crore.

While this high level of net buying has been seen 3-4 times in the last 24 months, as per our analysis, what is unprecedented is the aggregate level of buying and selling by FPIs which was to the tune of Rs 3,84,100 crore in purchases and Rs 3,72,200 crore in sales.

It added up to a very large gross FPI trading value in index options of Rs 7,56,300 crore. The last biggest level in the last two years was in March last year, when the first 13 days of the new month series saw total FPI trades in index options to the tune of Rs 3,83,900 crore. The average monthly figure, in the analysed period, was Rs 2,75,700 crore.

FPIs dabbling in equity derivatives
FPIs increased their use of three of the four
derivatives instruments in CY15 over CY14

CY14 CY15
Index Futures - Buy 2480 2575
Index Futures - Sell 2444 2601
Index Options - Buy 14451 16840
Index Options - Sell 14035 16290
Stock Futures - Buy 4879 5213
Stock Futures - Sell 5013 5188
Stock Options - Buy 2004 1869
Stock Options - Sell 2026 1888

Figures in Rs crore, represent daily average
CY: calendar year

Source: Capitaline (source:Sebi).
Analysed by FCRB.

The average daily traded value (including notional value for options contracts) in the entire equity F&O segment of NSE in January, till 21, was Rs 2,63,030 crore, which represented a jump of 25 per cent over the previous month’s average daily figure of Rs 2,10,500 crore. Index options notional turnover made up for 75 per cent of total turnover in the current month, till January 21, and averaged Rs 1,98,700 crore per day, which was 28 per cent more than the previous month’s average daily level.

This brings us to the mix of derivatives products available to large and small investors, institutional and retail, foreign or domestic. There are five equity F&O products available to investors, namely index futures, index options, stock futures, stock options, and volatility futures.

In the current financial year 2015-16 (FY16), till mid-January, 75 per cent of all equity F&O turnover on the NSE has been in index options, while stock futures’ share was 13 per cent, and those of index futures and stock options were 7 per cent and 5 per cent respectively.

According to Bhamre, for the institutional investor the futures contract is a better hedge than the options contracts. “Today, more than 80 per cent of trading is in options—index and stocks. The ideal mix would have been to have 60-65 per cent trades in options and the balance in futures.” Bhamre has a point if one looks at the historical mix on the NSE.

Index options had a share of just around 10 per cent during FY07 and FY08. This was, in fact, the last time when the domestic equity market had undergone a large fall on the back of global meltdown in financial markets following the global financial crisis. At that time stock futures was the pre-dominant traded derivatives instrument with a 50 per cent share, followed by about 30 per cent share of index futures.

The historical mix

Stock-based derivatives' share fell from 30% to 20% in last few years

Share in total equity F&O turnover:

Index futures Index options Stock futures Stock options

FY03 10 2 65 23 100
FY04 26 2 61 10 100
FY05 30 5 58 7 100
FY06 31 7 58 4 100
FY07 35 11 52 3 100
FY08 29 10 58 3 100
FY09 32 34 32 2 100
FY10 22 45 29 3 100
FY11 15 63 19 4 100
FY12 11 72 13 3 100
FY13 8 72 14 6 100
FY14 8 73 13 6 100
FY15 7 72 15 6 100
FY16 7 75 13 5 100

Figures in per cent, represent share in total equity equity F&O turnover
Put a * in FY16, and say the following in the footnote *till mid-January

Source: National Stock Exchange. Analysed by FC Research Bureau

Bhamre thinks the Indian investor psyche of not paying a higher rate of down-payment in the form of margins or any other means when entering into a forward contract is the reason why options has taken off in a big way. A futures trade attracts 10-15 per cent initial margin and also attracts a marked to market margin every day. In case of options, the buyer just pays a premium, which varies from 0.5 per cent to 3.0 per cent of the notional value of the trade. This is perceived by the lay investor as being cheaper by 5-10 times. The seller of options, of course, is subject to rigorous margins, including the marked-to-market options.

Another indicator of the action in equity F&O comes from the Sebi data giving investor category-wise share of turnover in equity derivatives. As per the latest monthly bulletin of Sebi, in the January-November 2015 period, the FPI share in NSE’s equity derivatives segment ranged from a low of 9.1 per cent in July to a high of 13.8 per cent in April. Proprietary account share of F&O brokers ranged from 47.7 per cent to 51.5 per cent, while individual (and other non-institutional investors) investor share ranged from 13.5 per cent to 15.9 per cent.

Mutual funds accounted for just 0.2 per cent to 0.7 per cent of the equity F&O turnover. Ideally, point out several market analysts, MFs should have been heavy users of the equity F&O market providing more depth and liquidity to it. But they have not taken to using the equity F&O market because a majority of the equity schemes of mutual funds have seen that they can get alpha returns from their cash market investments alone, and so they do not feel the need to protect their equity portfolios using F&O or to implement other investment strategies using F&O which can optimise their returns further.

The stock market regulator, Sebi, plays a major role as an active fiddler in the regulations governing the domestic equity F&O market. In the middle of last year, Sebi ordered that all new equity derivatives contracts getting introduced from the end of August-expiry contracts be subject to a new minimum trading lot size condition of Rs 5 lakh. Earlier, this was Rs 2 lakh.

This had the effect the tripling the minimum lot size in Nifty futures and Nifty options contracts, and turnover in the equity F&O volume fell in the last quarter of calendar 2015. “There were many investors who would take trading positions in just one or two trading lots,” said Bhamre. He said he advised his firm’s clients who still wanted to trade in the higher minimum lot sizes to take their trading to the cash market, they took to trading in options where the premiums cost 1-2 per cent even though they may been trading in futures in the earlier regime.

This has had the effect of pushing the options trading attractiveness still higher, and increasing their notional exposure to the market leading to higher risks from adverse fluctuations. Bhamre and other analysts believe the access to the equity F&O market should not be so restricted.

Cash vs derivatives in equity market
Lower margins and downpayment have inevitably meant higher
notional turnover in F&O

Total turnover (Rs crore)

Cash market Derivatives market Derivatives over cash (times)
FY13 3257000 38697000 11.9
FY14 3348000 47431000 14.2
FY15 5185000 75969000 14.7
FY16 (Apr-Dec) 3724923 50590399 13.6

Figures represent total traded value in the cash market and notional
turnover in the derivatives market
Data covers NSE and BSE

Source: Sebi, NSE, BSE. Analysed by FCRB

A few years back, in 2012, Sebi had tightened the criteria for a stock to be included in the stock F&O list which nearly halved the number of eligible stocks from around 182 to 130. In a research paper presented in December last year by four professors of Indian School Business and University of Southern California analysing the effect of the impact of the criteria change, it was concluded that prices of the excluded stocks, which did not meet the new critiera, were negatively impacted. The research paper argued that this was because when derivatives is allowed in a stock its price efficiency and liquidity increases. The study also concluded that contrary to the expectations of the regulators of cutting undue volatility in individual stocks, volatility largely remained unchanged after their exclusion from the F&O list.

In September last year, a finance ministry-appointed standing council had submitted its report on the international competitiveness of the Indian financial sector. It noted that Singapore’s SGX was the main competitor for Nifty index derivatives. It also said that foreign participation in the Indian equity derivatives markets is hampered by two elements of capital controls, (1) limitations on access and (2) fragmented markets.

India's equity F&O vs world's

Size of Indian equity derivatives market is formidable and compares well with the world total

NSE's share in world total (%) BSE's share in world total (%)

No. of contracts Notional turnover Number of contracts Notional turnover
Index futures 6.0 0.4 Negligible Negligible
Index options 48.7 5.5 4.2 0.9
Stock futures 26.1 27.4 Negligible Negligible
Stock options 3.1 10.6 0.2 0.7
For notional turnover, share is derived from US$ notional value of trades
Source: World Federation of Exchanges. Analysed by FCRB.

In comparing domestic equity derivatives market’s competitiveness with that of SGX the report argued that low position limits in the domestic market constrained participation, especially that of large institutional players. “Position limits in equity derivatives are the higher of USD 83 million or 15% of market OI for futures and options separately. This implies a limit of USD 300 million for index futures and index options each. In comparison, position limits on SGX are USD 345 million on the buy side and the sell side each. While current position limits on NSE are comparable with SGX, stronger participation from domestic institutions and greater investments by domestic financial firms would make the market more robust.”

Clearly, there is more scope for the domestic equity F&O microstructure to transform into a better one and enable it to play the critical role of more efficient risk-transfer and hedging and thereby acting as vital shock absorbers during times of global jitters.


There are innumberable strategies deployed by investors, institutional and retail, in the equity derivatives market. But the most basic and simple of them are just two.

The put options hedge.

In this, the investor protects her portfolio or her holdings in a stock by buying put options on an index or the stock. The idea is to insure against a drop in the price of the portfolio or the stock, and is primarily used when the investor is confident of the fundamental of her portfolio or stock, but feels external market jitters will pull down the value of her portfolio or stock.

She seeks the protection for that much time only when she expects the external market shocks to occur. Once the event passes by or fails to occur during that estimated time period she lets her options expire. But till then she keeps rolling over her put options position around the month-end expiry date to the next near-month put options contract.

The cost of the hedge for the investor is the premium she pays to buy the put options which is roughly around 1-2 per cent of the notional value. Other than this cost, and the cost of the brokerage charge, there is no other cost. She gets to keep the entire upside, in case the index or stock does not fall, as she simply lets the options expire un-exercised. Her loss is the 1-2 per cent premium she paid.

If the index or stock does fall or crash, she gets to profit at the rate of the fall by exercising her options, in addition to seeing her portfolio or stock rise in value.

The futures hedge

As in the case of the put options hedge, the basic idea to hedge is the same. But there is a difference in the cost and the impact of the hedge.

In this strategy, the investor sells the index—or stock—futures. On the Indian equity F&O market, she pays an initial margin of 10-15 per cent on the value of the trade and also pays marked-to-market losses on her position till the time it is kept open.

Other than the cost of interest loss on the margin payments and the brokerage fee, there is no other cost. If the spot price of the index or stock falls, she profits to the extent of the rate of fall. Thus, her portfolio or stock value is protected from the fall because she is getting reimbursed to the extent of the loss due to the fall in the spot price.

However, if the stock or the index goes up, then she loses to the extent of the rate of price increase. But since the prices have risen, the value of her portfolio or stock has also gone up. So, she is essentially locking in her portfolio or stock at the spot price prevailing at the time of her futures trade.