Sunday, 15 July 2007

'CORN'y Connection

A common theme in investing is that, in the long-term, asset prices adhere to fundamentals. The road to adherence is often an irregular one, prices overshoot and undershoot along the way...but ultimately, they behave like obedient children.

Sometimes though, the relationships between asset prices are hidden from the eye. Peer through the layers and one might just be able to come up with a relationship that could form the basis of a trading strategy. 'Corn'y Connection, is one such linkage...

The Craze for Maize
Lot of factors have driven corn (maize) prices of late. The rush of demand for ethanol has ensured that corn finally got its due. Apart from the fundamental factors of demand and supply, speculative demand for the commodity has served to increase the volatility in corn prices. Not surprisingly, corn prices have surged quite a bit (refer adjoining figure).

Along with the rise in corn prices, the 200-day historic volatility has increased significantly. Corn, and indeed other agri-commodity prices, tend to be influenced by acreage reports. A higher than expe
cted acreage, tends to be bearish for prices and vice versa. The drop in corn prices towards end-June of this year was one such occurrence.

The Implied Volatility - an indicator that reflects among other things, the uncertainty in the human mind - tends to pick up just before the acreage reports and drops off once there is 'clarity' in the direction of prices. Another obedient adherence to fundamentals.

So good. What about the trading strategy? And...did someone mention Soybean (Soy for short)?

LOSHing the two...and the 'Linkage'
LOSH stands for 'LOng' and 'SHort'. The trading strategy is simple. You go Long on one commodity and Short the other. So where does the profit come from? Here is where the unseen linkage comes into play. A chart is in place to help us.

Corn and Soybean prices have probably little in common when seen in isolation. But combining the two throws up a potentially profitable combination. Dividing the Soybean price with the Corn price yields a rather queer combination. The chart depicts the Soybean/Corn price ratio over a two-year period. The horizontal line is the historical average of the ratio (about 2.23).

There isn't anything special about 2.23. The trading strategy is based on the concept of 'reversion to mean'. If the ratio overshoots the mean for a while, it will eventually fall back to its historical average. The same holds true for undershoots as well. To be sure, there is nothing to prevent the mean itself from fluctuating over time.

The circles in the chart show possible trading opportunities to exploit any discrepancies from the 'normal' condition. Whenever the blue line crawls above the brown, the trader can Short Soy and Long Corn. Eventually as the ratio reverts back to the mean, profits get realized. Conversely, when the blue line sinks below the brown, Long Soy and Short Corn is the solution.

The circles also show the return that could have been realized by executing the strategy. One wouldn't have done too badly in my opinion...
Why does it work? One possible reason is linked to the limited cultivable area available to a farmer. As crop area is limited, a farmer would choose to cultivate one of many crops available, based on likely future prices. Sowing corn over soy in one year will lead to an excess supply of corn relative to soy the next, thereby leading to a favourable demand-supply situation in soy versus corn. As supply keeps fluctuating, so do prices, which may be posited, in general, to move in opposite directions.

What does the chart say now?
The ratios is far above the historical average, and, more importantly, it has broken the historic high as well. This could indicate two things. One, probably the Golden number is on its way up, in which case, one would want to wait to see further price development before entering into a trade, or, two, its a fantastic opportunity to play the LOSH strategy. If the reversion to mean holds true, then there is good money to be made along the way. I am betting on the latter.

Wednesday, 4 July 2007

Is India Over-priced?

That is a question that is on everyone's minds, after the bellwether index, BSE Sensex hit its all-time high. A euphoric rise is followed by a 'correction'. And so everyone believes.

I believe that an investor with an eye on the long-term, should spend his time and energy in understanding the big-picture numbers, rather than short-term gyrations that is never under his control. The markets may be foolish in the short run...but it has the good habit of correcting itself in the long run. And numbers get their due.

In this post, I will take a look at the question from a fundamental perspective. I will not predict the Sensex level, which is something best left to the TV channels and the 'experts'. I shall present my perspective of the numbers as they stand today.

The table juxtaposes and compares major Asian countries on key fundamental parameters like EPS growth, the P/E multiple, Return on Equity and Return on Capital Employed. Finally, I have added the Price-to-Earnings-to-Growth (PEG) ratio to get a sense of where the respective equity markets stand in relation to their expected growth.

First on the EPS growth. India is expected to post the highest growth rate in the pack. Consistently high growth rates have been a key factor in the re-rating of the Indian markets over the past 3/4 years. The high double digit growth rate is expected to continue going forward too. Structurally the economy is on sound footing. Increasing capacity utilization across industries, increased investment, favorable demographics and emergence of the middle class have all contributed to the upturn in the Indian economy. Increasing openness in the economy has attracted foreign investment (portfolio and FDI). With these factors expected to remain in place over the foreseeable future, it doesn't seem outlandish for India to achieve the expected EPS numbers.

Next on the Return Ratios. India again emerges at the top of the pack on ROE and ROCE. High ROE and ROCE characterize strong businesses with a reasonably strong moat and sustainable competitive advantage. All the 'Buffet' factors seems loaded in favor of India. While there might be some moderation in growth due to the high base effect, the fundamental drivers of ROE are firmly in place.

Third on P/E multiples. India - which is expected to post the strongest growth rate - is valued lower than Malaysia, which is expected to grow modestly. While this points to the possible over-valuation in Malaysia, its still relatively easy to see India's relative attractiveness on the P/E metric. Only Korea and Thailand trade at lower multiples, but they are also expected to grow slower than India.

Finally, on the PEG metric, India is the most attractive in the lot. A PEG of 0.53 is very attractive especially considering the fact that India has the best fundamentals of the lot. India ranks very highly on corporate governance too.

A mixture of high corporate governance standards, strong fundamentals, and attractive valuations leads me to believe that the Indian markets are not over-priced, as much as people would like to think. The rise in the Sensex has been accompanied by EPS growth, which in turn is driven by strong Sales growth. In fact, given its fundamentals, I wouldn't be too surprised if the Indian markets eventually trade at a premium to its Asian peers. While there is still some way to go before reaching that point, I think that India is well on its way to get there.

So what can a small investor expect from the equity markets going forward? FIIs will come and go. There will be fears of the 'Yen Carry Trade' and the disastrous effects that the unwinding of these positions have on financial markets. The eventual direction of the market is up...but this will most definitely be interspersed with corrections every now and then. People will get scared and sell, thinking that the world has come to an end at every fall in the markets.

But the intelligent investor stays on...evaluating the macro scenario periodically to ensure that the fundamentals haven't changed for the worse. As long as the fundamentals are intact, the investor should stay put...but once the underlying premise on which the decision was made changes...well...the investor would do well to remember the adage..

"When the conditions change...I change my opinion. What do you do Sir?"