But the F&O volumes are much higher. So is there some other explanation?

Some structural issues exist in the cash markets. And the derivatives bazaar, specifically stock futures, solve these issues.

1. If you buy in cash, you have to put the full money down. So buying a 100 shares of Reliance costs you Rs. 100,000 out of your bank account.

2. You get the settlement after two days. Cash flows out of your account tomorrow, if you purchase today; you get the shares in your account in two days. If the seller did not own the shares, there is then an auction – you get the shares in your account five to six days after your purchase. The interim period is weird – if your stock hits a stop loss then, you can’t even exit.

3. Institutions like mutual funds are not allowed to do margin trading in stocks. So switches are a mess. A purchase has to go into the demat first before it can be sold, and full money has to be available before a purchase. Why is this painful? Imagine you are a mutual fund manager who has 10 crores worth stock which you decide to sell and buy something else. What do you need to do?

• Sell today. The money will reach your account after two days (T+2), the stock leaves your account tomorrow. 
• Once you receive the money, place the buy order (on T+2). You can’t place it earlier – the broker and exchange needs the money upfront and if you’re a mutual fund you gotta wait till the money comes in.
• On T+3, the money goes out, and on T+4 you get the stocks in your account

It takes four days to sell and then buy. Meanwhile, whatever you wanted to buy could have run away!

4. Stocks have low liquidity. Of the top 50 stocks in India – the Nifty 50 – the least liquid trades just 8 crores in the cash market, per day. A 1000 cr. fund, if it chose to allocate just 1% of its portfolio per stock, can’t even buy 10 crores worth of that stock – it will move the market so much that the impact cost can be 4-5%! And buying it slowly, piece by piece, is not fun at all; you never know what price you will get in future days.

5. Regulation does not allow funds to own than x% of a certain stock, or require disclosure if the percentages go greater than 1%. Some stocks have a market cap of just 1000 cr. and funds or HNIs like to expose themselves to beyond 10 cr. but don’t want to report.

6. Can’t go short a stock. The SLBS is dead.

If you buy a future instead of a stock, you pay only 50-60% as margin – the remaining money can sit in your account and earn interest; in fact, even the margin money can be given as a fixed deposit which earns interest. There is no settlement wait period – you buy a future, it is immediately in your account. No problem in intraday switching – you can sell one future and buy another right away, margins are released immediately on selling and is available to buy something else. Futures markets are a lot more liquid: for example today, the notional value of cash market trades was 13,000 cr. versus 66,000 cr. in F&O. Individual stocks too show 2x to 3x more volume in their futures trades than in the cash market. Regulation only provides for an upper limit of all F&O on each stock, but there are no disclosure requirements. And of course, you can go short as easily as you can go long.

Still, the futures markets have challenges.

• Futures earn no dividend.This would be an issue if the average Indian large cap stock was yielding higher than the ridiculously low 2.5% per year they currently do.
• Rollovers could be a problem.Since futures expire often – typically the most liquid expire each month – the rolling over of a position may involve a cost. For example, on March 25, the recent expiry, HDFC’s March future closed at Rs. 2586 while the April future closed at 2601. If you were long March, you had to sell March and buy April to stay long. The process would cost you Rs. 15, a 0.57% “cost”. If you incurred that every month, you pay about 6.85% a year to use the futures market.
• Sometimes rollovers work in your favour. For example, on 26 Nov 2009, HDFC’s Nov future closed at 2756 while the December future was at 2748; a long rollover would be Rs. 8 profitable! In the last two years, average rollover costs of HDFC have been Rs. 1.3 – an insignificant number. And NSE has introduced a feature in NEAT
• Both the above costs have to be made up by interest that is received on the margined amount + whatever else is in the bank. Funds can’t lever portfolios so whatever is not margined stays in cash. And the interest seems to do it. Let’s say they get something like 7% on a fixed deposit – it needs to cover the loss of dividend (2.5%) and the average rollover cost (say 4%), which it just about does.
• Futures have a daily mark-to-market potential outflow. If you buy a future worth 2 lakhs, you may only need to give Rs. 50,000 as margin. But let’s say the stock falls 20% – you then need to put Rs. 40,000 (20% of the 2 lakhs) as mark-to-market loss, which is paid to the exchange and won’t earn you any interest. But then, if your shares go up, you receive cash instead.
• Not every stock is listed in the F&O segment, which has only 250 stocks or so, versus a few thousand stocks overall.
• Market Wide Position Limits curtail F&O use.The MWPL on a stock is 20% of the free float, which tends to create crazy short squeezes like in Akruti.
• Mutual funds, Pensions and Insurance corpuses can’t currently only trade derivatives. They need an equity component in their portfolio, and derivatives can only be a small percentage of that. No such restrictions on Portfolio Management Services (PMS) or FIIs or proprietary accounts, which continue to participate through futures.

The cost differential, if you test back the last two years, is very little for the benefits one gets. And in the two years, we have fallen a lot and risen a lot and futures have been a better way to invest. Prior to 2007 liquidity wasn’t all that great in the futures market (for individual stocks) so it’s difficult to test and conclude.

Net of the above, if markets remain volatile a long-only kind of fund is likely to see substantial  benefits using futures instead of buying in the cash markets. For going short, F&O is the only choice. It may just be that the smartest money is moving into the futures markets and cash markets are following through largely because of arbitrageurs.

This post is written by Deepak Shenoy, at Capital Mind.

From April 1 2011, all capital gains booked will be added to your income and taxed appropriately in your tax slabs. (Upto 1.6 lakhs – no tax, 1.6 to 10 lakhs – 10%, 10-25 lakhs – 20% and above that, 30%).

Then why is capital gains any different from other income? Answer: Long term gains are “indexed” – meaning, the government understands that when you sell an asset, you should consider inflation. If you bought something for Rs. 100 three years ago, and inflation was an average of 6% in the last three years, then the Rs. 100 is actually worth Rs. 118 today – three years of simple 6% inflation. (Note: the actual number will be slightly higher due to compounding effects). So if you were to sell that asset for Rs. 140 today, your gain isn’t Rs. 40 – it’s only Rs. 22; since you are only taxed on gains, it lowers your tax incidence by 50%!

For more details on indexing read: http://blog.investraction.com/2006/12/long-term-capital-gains-ltcg-applies.html.

The wider slabs, too, give you a lower tax payout. Yet, some of us have held stocks for a LONG time. Maybe 5 or more years. The gains are probably huge – some of them above 50%. If we sold them anytime after April 1, 2011, then we’d pay tax on the entire gain! This is of course unacceptable, given there is a cheaper way out.

You can sell all these shares today and buy them right back. Then, the gains will be assumed to be booked today – on which there is a capital gains tax of ZERO. That sorts the past gains. From here onwards, only the gains from the NEW purchase price to whenever-you-sell will count for taxation post April 1, 2011.

Example: In my family we own some shares of Hero Honda bought in the nineties. The effective cost price today, after all their bonuses, is about Rs. 12 per share. The share is at Rs. 1750+. Even if I indexed everything like crazy, my cost price won’t go beyond Rs. 100 per share – we have to pay taxes on about Rs. 1600 per share if we decide to sell after April 1, 2011!

The right thing to do then is to sell shares, get the money and buy them right back, because we want to be invested in Hero Honda. That takes care of the full gain till now – no tax on the 1600 rupees – and if Hero Honda goes to 2000 when we sell, we’ll only pay tax on Rs. 250.

And there’s another thing: if we sell now, before March 31, 2011 and buy shares back, we will get TWO years of indexation; indexing laws work such that each financial year of purchase is counted for indexing, which means a purchase tomorrow and a sale in April 2011 gives me two years of indexing – 2009-10 and 2010-11 – so I can get the advantage of two year’s inflation before my gains are counted.

To put it simply: If I sell now and buy back before March 31, I will save 12% of future gains as well. If Hero Honda went to 1960 and I sold it in April 2011, I will pay ZERO tax. Not bad at all, in a thirteen month scenario.

Another thing to think about: if you want to buy stocks for the long term, buy them before March 31. No matter when you sell them you get an additional year of inflation adjustment and saves you tax.

Downside notes:

• Selling and buying back involves payment of commissions and STT. That, for me adds up to less than 1% of the entire transaction value  (not just the gains). Considering the huge gains we have, we are better off than the potential tax of 10% on the whole deal. But to you it may be huge if the gains are not quite as much.  For example if you own 100 shares of Reliance at Rs. 800 for two years and it’s at 1000 today; your indexed gain if you sell now is just Rs. 100 per share, assuming 6% inflation. If you’re in the 20% bracket next year that would only result in a tax of Rs. 2,000. But a 1.5% transaction cost on selling and buying back 100 shares (@ Rs. 1000) today will cost you Rs. 3000. So do the calculations carefully before logging on to your broker’s web site.
• You need a two day break before you can buy again. The T+2 settlement system ensures that if you sell today you only get money after two working days. That means a “buy again” can only happen then. In the meantime the share could fluctuate in value, so there’s a risk.

The sell and buy back makes sense if you have very high gains and don’t want to pay tax on them.

This post is written by Deepak Shenoy, at Capital Mind.

Treasury stock is when a company owns it’s own shares – not usually permitted, but in this case, Reliance got them when it merged with Reliance Petroleum I in 2002 (as opposed to RPL II in 2009). Investors remember that Reliance sold a good chunk of what it owned of the RPL II shares at 214 or so, a few weeks before the big crash in 2008. That shows they knew a little bit of timing. Of course, if the RIL management was that smart, they would have sold the treasury stock too at those rates – when RIL quoted at a bonus adjusted price of Rs. 1650.

It’s tough to read anything into treasury sales. If anything it’s good to have cash, one would think, especially when they have quite a lot of debt in a potentially rising-interest-rate scenario.

This post is written by Deepak Shenoy, at The Indian Investor's Blog.

(Click for a larger image)

• Revenues have flattened since Jan 2008, and aren't recovering much at all.
• "Other Income" forms a substantial part of their profits even today. The most recent quarter had 14.74 cr. of net profit, and they had "other income" of 8.35 cr. The business literally hinges on the other income figure!
• They have around 320 cr. in the bank, going from their recent financial statements. That is generating most of the other income - at 8% yield you'll get about 6 cr. per quarter of income.
• Other income is useful, but paying 35 P/E for a company whose biggest contributor to the bottom line has been other income for the past four quarters is, in my opinion, crazy. They might as well return the money to investors if they aren't using it. (The cash comes to Rs. 115 per share)
• Look at the EPS - it's flat throughout. The last two quarters add up to a measly Rs. 10.27, and the earlier financial year was Rs. 21.87. No serious growth in EPS since last year.
• But as you see the stock price and went up beyond 800 and a P/E ratio of nearly 40 - it has since dipped to 770 and p/e of 35. But such a high P/E for a stock which has barely grown in the last two years - very surprising.
• Like in 2007-08, the annual report for 2008-09 also contains a scary piece of information: If option grants were calculated using "fair value" versus "intrinsic value", profit would have been lower by Rs. 10.8 crores and the EPS would have been Rs. 17.91, nearly 1/5th lower than the 21.67 they reported.
• Insiders have been consistently selling over the last year. Some Info Edge insiders seem to have sold between 5-20% of their holding over the last year, but note that usually insider sells don't mean much to stock prices.

(Related: All Info Edge Posts)

This post is written by Deepak Shenoy, at The Indian Investor's Blog.