Category Archives: Equities

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Apr 06

Discovering Opening Price through Pre-Open Session

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Note: One of our students preparing for NCFM Capital Markets (Dealers) Module Exam raised the query in the class about price discovery mechanism in pre-open session at exchanges. Since the subject-matter is not very much clear in the relevant study material, we at Intelivisto thought it to elaborate upon and make it easily comprehendible by the NCFM exam aspirants as well as anyone interested and dealing in the market. So, here we unfold the complicacy of pre-open session for you all. Enjoy learning…..

Discovering Opening Price through Pre-Open Session
In order to discover correct opening price and eliminate/minimize opening volatility in opening prices of securities, SEBI advised the exchanges to formulate a Pre-Open Session of 15 minutes ahead of the normal market using Call Auction mechanism. Earlier, price of first trade in any security used to be ascertained as its opening price, but this practice was manipulated and maligned by forming a cartel to open the prices at one’s desired level.

What is a Call Auction market?
In a Call Auction market, orders are pooled in the order book but remain unexecuted till the end of the order entry period, when the orders will get matched and get executed at the single call auction price that is so determined. At the call, all buy orders are aggregated into a downward sloping demand function and all sell orders are aggregated in an upward sloping supply function. The market opening price and quantity traded are derived based on aggregated supply and demand for the underlying. The orders that trade and the price and quantity at which they trade, are set by multilateral matching, rather than by the sequence of bilateral matching used to determine trades in earlier system of normal market.

Pre-Open Session
Pre-Open Session is a new innovation on exchange side to arrive at the ideal opening price of scrips for the current trading session. The session intends to reduce the volatility that accompanies during the beginning of the day and facilitates better price discovery.
The duration of Pre-Opening Session is of 15 minutes – from 9:00 A.M. to 9:15 A.M. The session has three phases–

Under this new arrangement, the exchange collects the orders for the first few minutes of this session. On the basis of orders received, the exchange arrives at an Equilibrium Opening Price and trades matchable orders on that price. Remaining orders are moved to normal trading session.

Equilibrium/discovery price
An equilibrium/discovery price is the price which is discovered in the pre-open session and all matching orders during pre-open session are executed at this price. Further, the normal market opens at this discovered price.

The equilibrium price is the price at which the maximum volume is executable. In case more than one price meets the said criteria, the equilibrium price shall be the price at which there is minimum order unmatched quantity. The absolute value of the minimum order unmatched quantity shall be taken into consideration. Further, in case more than one price has same minimum order unmatched quantity, the equilibrium price shall be the price closest to the previous day’s closing price. In case the previous day’s closing price is the mid-value of a price or prices which are closest to it, then the previous day’s closing price itself shall be taken as the equilibrium price.
Example 1: Let’s suppose, we have the following Order Book on a scrip:

The system will now calculate the cumulative tradable quantity @ each price

The maximum Tradable Quantity is @ Rs. 95, so the system will mark Rs. 95 as Opening Price and execute the tradable quantity at that price.
If you create a demand – supply curve based on the price and cumulative values, it would look like this.

The intersection of this curve is the price at which maximum transactions can be conducted and that’s the equilibrium price that comes out from this pre-open call auction.

Example 2: Another example of more than one price having minimum unmatched quantity–In the above example 103 and 96 are the prices wherein, the volume tradable and unmatched quantity is the same. To derive the equilibrium price only one price, which is closest to the previous day’s closing price of the said prices i.e. 103 and 96, will be considered. If previous day’s closing price is 95, then 96 may be considered as the equilibrium price. In case the previous day’s closing price is 105, then, 103 may be considered as the equilibrium price. In case the previous day’s closing price 99.5 which is the mid-value of 103 and 96, then the equilibrium price shall be the previous day’s closing price i.e. 99.5.

What happens to the pending unexecuted orders in pre-open session?
Pending unexecuted orders in pre-open session are shifted to the order book of the normal market session. All the unmatched market orders are converted to the limit orders at the discovery price as discovered in the pre-open session and carried forward to the normal trading session. All unmatched limit orders of pre-open session remain at the limit price as specified and carried forward to normal trading session.

In case the equilibrium price is not discovered in the pre-open session, wherein there are only market orders, the market orders shall be matched at previous day’s close price. All unmatched market orders shall be shifted to the order book of the normal market at previous day’s close price following time priority. Previous day’s close price shall be the opening price.

In case of equilibrium price is not discovered in the pre-open session and there are no market orders to be matched, all unmatched market orders (at previous day’s close price) and limit orders shall be shifted to the order book of the normal market following price time priority.

Jul 05

Diversification

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Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio of several stocks. When this is the case, a portion of an individual stock’s risk can be eliminated, i.e. diversified away. This principle is called as Diversification and it is possibly the best way to reduce the risk in a portfolio.

A good portfolio cannot be formed by investing only in one type of security or sector, but by diversifying across various avenues. Diversification largely means investing in a variety of assets instead of just one type of asset. Due to this, potential of losses gets reduced because every instrument or industry would react differently to the same event. Although it does not guarantee against loss, diversification is the most important component of achieving long-term financial goals.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

Consider holding two stocks that have the same expected returns, instead of one stock. Because stock returns will not be perfectly correlated with each other, it is unlikely that both stocks will experience extreme movements (positive or negative) simultaneously, effectively reducing volatility of the overall portfolio. As long as assets do not move in lock step with one another (are less than perfectly positively correlated), overall volatility can be reduced, without lowering expected returns, by spreading the same amount of money across the multiple assets.

Imperfect correlation is the key reason why diversification reduces portfolio risk as measured by the portfolio standard deviation. This concept of diversification is one of the main tenets of modern portfolio theory – volatility is reduced through the addition of more assets to a portfolio.

Diversification, by putting stocks of various sectors that reflect the economy, is used to cancel out stock noise which is essentially the individual stock fluctuations and to reduce investor’s risks. Diversification is a strategy in which investor’s money is not invested in one place rather it is invested in different securities. It is assumed that if one category fails the loss can be made good by return from other categories.

Below mentioned are the few types of diversification:

  1. Diversification by asset class: A group of securities that show similar characteristics and behave similarly in the marketplace is called an asset class. The three main asset classes are stocks, fixed-income (bonds) and cash equivalents (money market instruments). Real estate and commodities such as gold are also considered as asset classes. A well-diversified portfolio invested across various asset classes can be an ideal strategy to participate in the top performing assets. e.g., Gold prices are traditionally inversely correlated to stock prices. So, gold can help minimize losses in a portfolio that includes stocks.
  2. Diversification by sector: A sector is one of a few general segments in the economy within which, a large group of companies can be categorized. To give an example: the financial services sector includes banking, insurance, NBFC, etc. An investor can invest across these broad sectors in order to minimize sector-specific risks. e.g., a spike in crude oil prices may boost prices of exploration & refinery sector stocks but aviation sector stocks may fall in reaction.
  3. Diversification by market capitalization: Mid and small-capitalization stocks have the potential to deliver higher returns than the Large-cap stocks, but they tend to be volatile in nature, which means, if the market goes down, small-cap stocks would lose maximum value followed by mid-cap stocks. On the other hand, large-cap companies provide support and stability to a portfolio as they may reduce risk in a downturn. An investor can reduce the risks faced by the mid and small-cap segment by diversifying investments into large-cap cap companies.

In this way, investors should develop a diversified portfolio that helps them limit downside risks while participating in the growth of asset classes or sectors or industries that are expected to do well. The portfolio should also be rebalanced from time to time taking into consideration the economic, business and/or policy environment. The latter two aspects are especially influential for India because our’s is still a developing nation on the path of growth. The opportunity to participate in India’s growth exists for us all but a simple tool like diversification can make our journey safer.

Apr 11

Buying Back the Shares

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SHARE BUYBACK
Share buyback means a company buying back its shares from shareholders other than promoters. Company does it to increase the shares’ prices or delist, and this is done by either buying in the stock market directly, or asking shareholders to tender their shares.

A buyback offer is when a company buys some of its shares from its shareholders and extinguishes them. This is usually done from shareholders other than the promoters themselves, and is most often a testament from the management and promoters on the strength of the company, and their commitment to increase the returns for the shareholders. Market experts say it usually shows the confidence of promoters in the future of the company.

THE RATIONALE BEHIND SHARE BUYBACK
There are a number of reasons companies go for buybacks. The intentions could be to reward investors, improve financial ratios (such as price to earnings, return on assets and return on equity), increase promoter holding, reduce public float and check the falling stock price, reduce volatility and build investor confidence.

The following are the 6 main reasons why company offers share buyback:

  1. To stop the fall in stock price.
  2. In some situation company may want to bring down the public holding and increase promoters holding.
  3. If the company sees there is no better opportunity to deploy its cash reserves then it may decide to buy back its shares.
  4. The buyback may improve companies return ratios. If they reduce the total number of outstanding shares then the EPS (Earnings per Share) increases because EPS is PAT (Profit after Tax) divided by total outstanding shares. If the EPS increases then the P/E multiple decreases, and when P/E decreases, the share price increases to bring the P/E back to the higher levels. Other ratios like Return on Equity and Return on Networth also improve due to this.
  5. When a company thinks its share price is undervalued.
  6. In case of eventual delisting, some companies, especially foreign owned companies get into buybacks because they want to eventually delist from the Indian stock exchange. Usually, they don’t buy their entire outstanding shares at one go, but conduct these buybacks over a period of time and buy in tranches of 5% or 10%.

MODES OF BUYBACK
First of all a buyback is proposed in general meeting of the company which is then voted on and approved by the board of directors. Then they announce the buyback in a newspaper with all the details. There are two types of common buyback routes companies take, open market purchase and tender offer, i.e. one is done through open market purchase from the stock exchanges, and the second is done through a tender form.

  •  When a company carries out buy back from the open market through stock exchange, there is nothing that you have to do except hope for a probable gain in stock’s market price. Company decides to acquire the certaisn number of shares to be bought back and fixes a price cap and can buy for any price up to that.
  • When company makes an offer to buy shares through the tender route, it has to declare the number of shares and the specific price, at which shares have to be bought back directly from shareholders. Company sends a tender form to all its shareholders with instructions on how to fill the form and where they can mail or drop the form. This route ensures all shareholders are treated equally, however small they are.

Most companies prefer the open market route. Out of 19 buybacks offers received in 2011, 14 were made through open market mode and 5 were made through tender offer mode. The biggest difference between the two is that the price in the tender route is fixed.

CAN INVESTORS GET SOMETHING BENEFICIAL OUT OF IT?
A buyback usually improves the confidence of investors in the company because it sends signal to the market that the company believes the stock is trading below its intrinsic value and therefore its stock price rises.

However, past data reveal the stock can move in either direction after the buyback announcement, though it helps stocks in most cases.
Below mentioned are the few points, in what ways an investor can be benefitted from the buyback of shares:

  1. Buy back at good premium may increase the stock price in share market.
  2. As buy back of shares reduces outstanding shares, the EPS (EPS is calculated by dividing net profit by outstanding shares) may look good.
  3. The ROA (Return on Asset) and ROE (Return on Equity) may improve by fall in outstanding shares and assets (in this scenario, excess cash).

Generally shares react positively to such announcements because buyback reduces the number of shares outstanding, which increases investors’ claims on dividends and earnings of the company and as these claims increases, so do stock prices.

Hereunder are a few instances of buyback announcement and its impact on the market prices:

  • When this year in January, SEBI approved changes in rules to allow public sector units (PSUs) to buyback shares, as a result, shares of few PSUs soared 30-50% in the first 5 trading sessions.
  • On January 20th, Reliance Industries Limited approved buyback of up to 120 million shares at a price not exceeding Rs. 870 per share from open market. The stock has risen 4% since despite the fact that company had reported poor numbers for the 3rd quarter. It was at Rs. 830 at the commencement of the buyback on February 1st.
  • But the case is always not the same, Indiabulls Real Estate started moving southwards after the buyback announcement. The company announced a buyback on December 15th 2011, after which the stock fell 3% to Rs. 48.25 till 7 January 2012.

The price trend depends on various factors such as the market situation, the mode of the offer, i.e. tender or market purchase, the size of the offer, the difference between the offer price and the market price of the stock and the market’s confidence in the management’s intention to carry out the offer. The movement of a stock after the buyback announcement depends on valuations and the result can differ from company to company.

THINKING OF PARTICIPATING IN BUYBACK?
If you plan to invest in any such company which is going to buyback its shares, there are some guidelines and the few words of caution to be followed:

  • You should not buy shares just because the company is working out a buyback plan. In some scarce cases, buybacks are announced to trigger certain favourable movements in stock price.
  • It is important to consider the size of the buyback, buyback price and the duration of the offer, because if the buyback size is too small compared with the overall market capitalization of the company, the impact on the stock could be very small.
  • Equally important to know what buyback route the company will follow, because if they will buyback the shares from the stock market, then the share buyback price is irrelevant to you.
  • If the company is buying back from the shareholders then you have to look at offer size of the buyback, how much time is left for the buyback to take place, and what is the difference between the current market price and the offer price.
  • Generally, companies only buyback a certain percentage of outstanding shares from the public and to know this fact is really important; because a few people who are not familiar with the process end up buying shares with the hope of sure-shot profit and later stuck-up with the remaining shares as only a part of their holding has been bought back.

Whatever decision you take largely depends on these variables, and they can be entirely different with every single case. Generalization of these variables in context of buyback offers would certainly lead to a blunder; you will have to evaluate each offer on its merit only.

SOME CLARIFICATIONS WITH EXAMPLE
Consider the example of Monnet Ispat Limited; announced the buyback of equity shares on Dec. 22nd 2011 with the maximum offer price of Rs. 500, and the prevailing market price of the share was around Rs. 358.

What do you think of this offer? Is it an opportunity with entirely the win-win situation?

Monnet Ispat Limited will be buying the shares from the open market and not from the shareholders, and the price of Rs. 500 is only the maximum price at which they can buyback their shares. This is the upper limit beyond which the company can’t buy their shares from the share market.

So, when Monnet Ispat Limited has set up a maximum price of Rs. 500, it only means that they can’t buy shares at a price over Rs. 500, instead they can buy the shares at any price below Rs. 500, and can certainly buy it at the Rs. 358 or so at which it’s currently trading.

Had it been the offer where the company had opted to buy its shares back from the investors directly, the 500 number had more importance, but then they would not have even chosen such a high number.

Monnet Ispat Limited announced that buyback offer is for shares not exceeding Rs. 100 crores being maximum offer size representing 4.97% of the total paid-up equity capital and free reserves. At the time of announcement, maximum offer price was at 40% premium.

Now is it possible that someone buys the shares at lowest possible level and then sells them back at Rs. 500 in a few days, pocketing around 40% returns?

This simply won’t happen because usually there are more shares offered for a buyback than the company actually wants to buy. Therefore, in this case they buy back the shares in the proportion of the over subscription. So one will only get a part of his/her shares bought back, and if the price comes down below purchase price after buyback fiesta then for disposing of the remaining shares he/she might have to wait for long.