The goose that once laid golden eggs has since derated into a regular goose. Asia’s oldest stock exchange BSE and its benchmark Sensex make for excellent cocktail chatter, but over the past three years the exchange’s stock has delivered -9% annual return compared to Sensex’s 15% (See: Chasing the benchmark). After hitting an intra-day high of ₹1,200 on its listing day, the stock has been on a steady roll downhill. Shareholders who have held on since its IPO, priced at ₹806, have not seen any capital appreciation.
Will the BSE remain a regular goose forever?
The BSE has history, legacy, controversy, and longevity on its side. It was one of the worst monopolies pre-1993. Since then, after the advent of the NSE, it is on the backfoot. As of last count, 3,913 stocks traded on the BSE with total market cap of $2.8 trillion. Yet, the exchange itself is valued at $350 million. If you look at how online brokers or other fintech start-ups are valued, it seems ironic that the underlying beneficiary of the market expansion – the exchange – is valued at a fraction of that. There is clear dichotomy in how the frontend is getting valued versus the backend.
Within the exchange space itself, the gulf is very wide. At one end, there is NSE which is being valued at $7 billion versus the BSE’s $350 million. That chasm is an outcome of NSE’s overwhelming market share both in cash and F&O trading. Point to ponder though is whether BSE’s valuation of $350 million is justified.
A prominent fund manager, on condition of anonymity, says, “Whether you like it or not, where it is efficient or not, trading on an exchange is a matter of habit. The number one player has a stranglehold on the market and the number two player has the odds stacked against them unless the number one player loses all credibility.”
If you look at just the past trajectory of its earnings growth, it is tough to justify a bump up in valuation for BSE. More so, it is an exchange where listing fees are a bigger contributor than trading income (See: High non-core). But investing is not just about what has but what can be. Question is if the BSE can deliver from here on.
Second fiddle
When the NSE shut down for four hours on February 24, that was supposed to be the BSE’s moment in the sun. However, volume did not move as much to the BSE on that day. Instinctively or by force of habit, people trade on the NSE since it is more liquid and impact cost is lower, and a lot of large players decided to back off till there was clarity. For BSE, which has been trying hard to increase its trading volume, this response to NSE’s shutdown must have added insult to injury, especially since it has not had the glitches NSE has seen over the years.
BSE CFO Nayan Mehta says their system has suffered no glitches or errors since 2010 as compared to NSE, which has suffered about 10 glitches since 2015. BSE can process 500,000 orders per second, using the Deutsche Börse trading system but will its glitch free track record hold up when volume picks up? NSE handles a much higher load as of now, as it hogs almost the entire volume in derivatives as well as the cash market.
We are still in the dark about what exactly caused the NSE glitch. In its initial disclosure, NSE had mentioned that trading was halted due to “issues with the links with telecom service providers.” The exchange’s spokesperson declined to share the timeline given by Sebi to submit the root cause analysis report. Even Sebi did not respond to the questions sent.
On whether communication during the shutdown could have been better on part of NSE, the spokesperson repeated the same defence stated in an earlier press release: “NSE was continuously working on resolution of the problem and once the same was resolved, NSE made an announcement with respect to re-opening of the markets to its members at 3:17 PM. This communication was done only after there was visibility and clarity on resumption of services and any prior communication would not have been appropriate.”
This lack of communication has certainly cost brokers and their clients. With brokers clueless until the last-minute announcement, many including Zerodha Broking squared off intra-day equity positions on the BSE around 3:10 PM on that day, as a risk mitigation measure. Their clients clearly weren’t happy given the large impact cost or accompanying loss that they had to bear. Zerodha co-founder Nithin Kamath says, “When you don’t know exactly what the tech issue is, it is very tough to even communicate. What could have possibly been better is there was a SOP in place that if the exchange is shut, then trading will probably get extended till 5 PM. Then, we would not have to hurry and square up.”
Interoperability being fully implemented would have certainly helped both traders and the BSE, and would have seen even more cash trades flowing in. But that did not happen. For one, the February glitch happened due to problems at NSE’s clearing house. “At the same time that NSE halted trading, the primary server at NSE Clearing (NCL), which clears the trades for NSE, BSE and MSEI on an interoperable basis, was also shut down. This was one of the two major issues arising out of the trading glitch at NSE, the second being non-availability of NSE indices for trading on BSE. Trades at BSE are cleared through NCL and Indian Clearing Corporation (ICC), with around 85-90% of BSE’s trades now being cleared by NCL. While the slave server of NCL at BSE premises was operational, members were not able to increase their collateral at NCL and continue trading at BSE seamlessly as was envisaged as one of the key reasons for implementing interoperability,” says Mehta.
While there was some amount of interoperability with BSE allowing firms to transact using the last available info on collateral posted with NCL, and members being able to square off intra-day positions and trade on BSE for fresh equity purchases and sales, it was a lost opportunity for BSE. The earlier quoted fund manager says, “Given its market domination, NSE is now behaving like the BSE of yore. If incidents like the shutdown that happened on February 24 keep repeating, there is a chance for BSE to come back.”
The NSE has network effect on its side but seamless interoperability will definitely have a positive impact on BSE’s trading volume, believes Mehta. “As markets become more interoperable, liquidity on BSE too can rise significantly leading to higher trading volume and market share,” he explains.
Deep value or value trap
BSE’s cash market share and derivative market share is about 6% and 7%, respectively. Still, BSE has not thrown in the towel in the derivatives market and is experimenting with various indices. “S&P BSE Sensex 50 is a better index on which derivatives are offered in addition to Sensex 30. S&P BSE 50 has more than 99.97% correlation with Nifty and similar value. BSE’s value proposition for derivatives has increased even more in interoperability environment where the regulations permit cross margining in Sensex 50, Sensex 30 and Nifty,” elaborates Mehta.
Kamath feels the BSE would be better off focusing on the cash market than trying to capture share in F&O trading. “BSE has tried to push index contracts but it hasn’t picked up. It is tough to push an alternative when all the F&O trading is concentrated in Nifty and Bank Nifty. With the new rules and regulation on intra-day margin and leverage, my expectation is that volume will dip. So, BSE would be better off building the business around equity itself than F&O.” he reasons. Surely, beating the NSE at its own game will be far from a cakewalk, hence he adds, “If the same stock is more liquid on the NSE, why would someone trade on the BSE. It is for BSE to innovate, may be in terms of new indices or newer debt products or may be a newer order type.”
The lack of volume in its core business has also forced the BSE management to look for new avenues of growth. It has forayed into mutual fund distribution through the StAR MF platform and into insurance distribution through a JV with Ebix and has seen reasonable success. StAR MF is now the largest mutual fund distributor platform in India. “In FY21, so far, BSE StAR MF has processed close to 90 million transactions, compared to 57.5 million transactions in FY20. Within a short timeframe, it has become one of BSE’s key revenue vertical,” says Mehta. For the nine-months ended FY21, StAR MF has clocked revenue of ₹293 million (See: Rising Star). Though charge per transaction has now been reduced to ₹5, increase in transaction volume is expected to compensate for that shortfall.
This attempt by the BSE to diversify its revenue source has caught the eye of value hunters. A fund manager who has invested in the stock, justifies his rationale: “BSE is now transforming itself from a conventional stock exchange to a financial distribution platform. If one looks at the valuation of BSE, almost 2/3rd of its current value comes from its cash holdings (apart from settlement guarantee fund) and the remaining 1/3rd is from its 20% holding in CDSL. Hence, the core business of the company is available free.”
Zerodha Broking has also built up 2% stake and Kamath explains it thus: “We were seeing growth in our business and our call was that that value should reflect at the exchange level as well. If NSE was listed, we would have also bought NSE. We are very bullish on the growth that we are seeing in the capital market ecosystem."
Investors and analysts are also banking on the monetisation possibility of the new initiatives, primarily StAR MF. Amit Chandra, institutional research analyst, HDFC Securities, is optimistic about volume-led growth in the StAR platform as well as value unlocking through a stake sale. His Q3FY21 update estimates StAR MF revenue of ₹0.68/0.95 billion in FY22 and FY23, respectively.
Though his update states, “New initiatives like the Insurance platform, Power, and Spot exchange are promising, but currently there is less clarity,” he has a target price of ₹700 and his SOTP valuation has been arrived at, “by assigning 10x to core Dec-22 estimated profit after tax (₹123/share), ₹180/share for CDSL stake taking 25% discount, and adding net cash excluding settlement guarantee fund and clearing cash (₹397/share).
Motilal Oswal Securities analyst Anmol Garg has a target price of ₹750 citing, “Our ‘Buy’ stance on BSE is centered on option value from new segments (Star MF, Commodities, and INX) over and above the SOTP value of its businesses.”
Garg is among the handful of analysts besides those at HDFC Securities, ICICI Securities and IIFL Securities who have the stock under coverage. Even for Garg, the core operations constitute a small part of the valuation. His report mentions, “Our SOTP fair valuation of BSE ascribes value to: (i) core operations excluding cash income (₹56/share), (ii) BSE operations, including cash and margin money income (₹301/share), (iii) the floating of encumbered cash (₹244/share), and (iv) implied value from CDSL’s market price at a holding company discount (₹147/share).
Regulatory trigger
BSE could get a further boost if it attracts a strategic investor, but the maximum shareholding allowed for institutions and trading members is a dampener. Broker members can hold 49% but an individual trading member cannot acquire more than 5%.
The first unnamed fund manager says trading members forming a consortium to buy 49% seems a stretch. “Members of the BSE are more active on the NSE. It is in their interest to trade more on the BSE as that increased trading volume will eventually reflect in a rising valuation for BSE. It is as if their own shareholders have given up on BSE,” he laments.
Trading members of the BSE seem to have missed the Atmanirbhar memo but financial entities such as a stock exchange, depository, bank, insurance company or public financial institution have more leeway as they can acquire either individually or together up to 15%.
And this is where space opens for regulatory arbitrage. While it may seem like conjecture at this point, it is not inconceivable that ownership rules might be relaxed either pre or post listing of NSE. Unlike BSE, NSE with its multibillion-dollar market cap post listing will attract huge interest (in addition to the foreign investors who have already bought in and might partially exit) not only from institutions but also from other stock exchanges. At present, NSE’s 490 million shares are distributed across 847 shareholders (700 public and 147 non-public).
As per NSE's December 31, 2020 shareholding, the non-public shareholding is 49.61 % against the prescribed limit of 49% and public holding is 50.39% against the minimum prescribed limit of 51%. Here, "public" includes any member or section of the public but does not include any trading member or clearing member or their associates and agents. Most of that "public" holding is with FPIs, FDI and venture capital funds. Under "non-public" are clubbed legacy shareholders, FDI, FPI, venture capital and individuals.
While NSE listing on the BSE may seem like an opportunity for the latter, Kamath is not so sure that it will lead to an increase in trading volume. “It depends on how much interest NSE creates among investors and traders. If it is going to be sparsely traded like CDSL or BSE, I don’t see a pop in trading volume on the BSE,” he says.
The first unnamed fund manager though feels listing of NSE presents a threat to BSE as large investors might just ignore BSE. “In India, stickiness of the market leader is a phenomenon that we have to accept. Market leaders in India have remained market leaders much more than anywhere in the world. BSE may seem cheap on global basis, but if NSE is available, then why would you waste your time on BSE?" he asks.
Even now, most domestic institutional investors are hardly wasting time on BSE. Mutual fund holding is less than 2% and the biggest institutional investor is Ruane, Cunniff & Goldfarb affiliate Acacia with 4.9% (See: Small-cap effect). At its current market cap of $350 million, BSE is unloved and under-owned. With yield of 3% and trading a little over 1x book, any further decline will make it even more undervalued. The ignominy of high contribution of listing fees vis-à-vis transaction income is also built into the valuation. “In BSE’s case, trading market share has been dropping and not contributing much. So, the risk of it reducing further and hampering valuation is lower because of diversification of income through other streams,” says the second unnamed fund manager.
As on December 31, 2020, BSE had free cash of ₹13.93 billion on its books. Besides investing in alternative revenue streams, the management is using cash for buyback and dividend payments. Over two rounds in FY19 and FY20, BSE has completed buyback of shares amounting to ₹6.44 billion, reducing the paid-up equity capital by 16.32% to ₹90 million.
Despite NSE’s formidable dominance, BSE’s structural story remains strong for Zerodha’s Kamath. “BSE will grow as long as the market grows but for BSE to catch up with NSE is a tough ask. Our call is that even if BSE keeps getting 10% of the volume and NSE 90%, overtime, even that 10% growth will be quite significant,” he emphasizes. The entrepreneur who bootstrapped an online broking unicorn is surely not taking Asia’s oldest stock exchange lightly.
