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15. Supplementary note – The 20 market depth or level 3 data (https://zerodha.com/varsity/chapter/supplementary-note-the-20-market-depth/) The 20 Market Depth (level 3 data) Window I’ve driven a car for many years and I’ve even changed my car a few times now. Each time I changed my car, the engine remained more or less the same, but the features within the vehicle and its aesthetics continuously changed. Air conditioner, power steering, and power windows were all luxury features in the car at one point, but today, I guess no one buys a car without these essential features. The game-changer for me though was parking assist. The little camera at the back of the car gave me complete visibility of the parking space available. I was no longer required to pop and twist my head out and struggle to park the car, nor did I have to bug my co-passenger to get down and help me navigate my way into a parking spot. The parking assist feature did everything and helped me execute a perfect parallel park. The parking assist feature was my edge for hassle-free car parking. I feel the same edge while trading the markets with the level 3 data 🙂 Level 3 or the 20 market depth feature is unique and has multiple uses. You’ll probably appreciate the level 3 market window if you have traded at an institutional desk. A regular retail trader would not understand this feature anytime soon, simply because this feature was unavailable all these years until we introduced it for the very first time to the Indian retail traders. The purpose of this chapter is to help you understand how useful this feature is and get you started on building trading strategies around this feature. If you are entirely new to this, I’d suggest you read this blog (https://zerodha.com/z-connect/featured/introducing-20-depth-or-level-3-data-beta-on-kite) to understand what the level 3 data is all about. Assuming you know what it is, this chapter will help you understand the multiple uses of this feature. Contract availability For the option traders, the 20-depth order book gives great visibility into the availability of contracts to trade and help identify better price points to execute these trade. Without this visibility, it becomes really hard to trade illiquid contracts. While I’m specifically talking about options here, you can extend this to Futures contracts as well, especially the illiquid ones. Let us put this in context, have a look at the regular market depth (i.e. the top 5 bid-ask) of the 13000 CE expiring in Jan 2020. We can see narrow bids on the left and a notch better offer on the right. You’d probably hesitate to trade this contract if you are someone looking at trading a few lots of Nifty. But check what’s hiding under the hood here by opening the level 3 data –  As you can see, there are many contracts available, but they are not visible in the regular market depth. In fact, the bid and offer quantities are heavily concentrated below the 8 th row respectively. Given the availability of the contracts in this strike, the perspective to trade or not completely changes and will now depend upon your trading strategy. Execution control Level 3 data gives you full visibility of the approximate execution price for your trade. This is particularly useful when you decide to scalp the market. When you scalp the market — Let us say you want to buy and sell 5000 shares of Hindustan Zinc; the regular market depth window gives you the following information —  As you can see, there is no visibility on how these 5000 shares will get filled. Now, take a look at the 20 depth window —  The 20 depth window paints an entirely different picture. It not only tells me that I’ll get the 5000 shares, but it also gives me information about the approximate buy price. If I were to place a market order for 5000 shares, I’d be buying this order book from 210.5 to 211.25. I also see at 211; there are 2425 shares available, so I can expect the average price is at or around 211. Now, my decision to scalp the stock should depend on the pop I’d expect over and above 211. Maybe 211.5 or so. Of course, you’ll get the exact breakeven (post charges) if you were to use a brokerage calculator. Position sizing Level 3 market window plays a critical role in ‘guesstimating’ the number of shares to trade, given the liquidity of the stock. For the sake of this discussion, we will assume that the availability of capital is not an issue. Now, have a look at the regular market depth — You expect Siemens to move from 1675 to about 1690 over the next hour. So, given the fact that you are not constrained by capital, how many shares will you buy for this intraday trade? The regular market depth window suggests that you can buy close to 175 shares. However, the 20 depth opens up a different perspective altogether — In fact, the liquidity in this stock lies below the best five bid and ask, and the impact cost is reasonable. The regular market depth window fails to capture this information. Assuming you intend to buy about 1500 shares, the buy price will lie somewhere within 1675.5 to 1678, which is spread of 0.149%. In this case, assuming you are sure about the target price (1690), you can go all in and buy through whatever is available at that moment. Order placement You can extend the position sizing concept and use the 20 depth market watch to place a stop loss or a limit order. Assume you have an intraday buy position in VST Tillers at 1313.8. The question is, where you would place the stop loss for this trade? Can the 20 market depth help us with this? Of course. Have a look at the 20 depth window for VST Tillers. As you can see, there is a concentration of bids in 1290. The good part is that the number of order count is also the highest (35) in 1290. This implies that several traders have placed an order at 1290, indicating some sort of price action at that level. This perhaps builds a case for placing the stop-loss. A prudent trader would probably place a stoploss not at 1290, but maybe at a price just below it. So I was a buyer in this stock, then purely based on 20 depth I’d probably place my SL at 1290 or below, maybe at 1287 and by the same logic, set my target at 1340 or at 1338.8. Validate the support and resistance level I find this extremely interesting. In the example above, we identified 1290 as the stoploss price, simply because there was a concentration of bids. In other words, we expect 1290 as a support price. If this is indeed true, then it should show up on the charts as well, right? Have a look at the chart below – Clearly, there is some price action around 1296. Remember, support and resistance is not one price point, but rather a range. Therefore 1290 – 1300 marks as an intraday support for this stock. This is a perfect example of seeing the price action concept play out in the market. Another way to look at this is first to identify the S&R level and then check the 20 depth to figure if there is a concentration of bids/offers in that zone.  Hopefully, by now you’ve started to appreciate the immeasurable value 20 depth order book brings to you while trading. Remember, irrespective of which technique you use to develop a point of view (technical or quantitative analysis), things boil down to price, and the action trades take at that price. The 20 depth market window is essentially your ticket to validate the truth of this price action. Make sure you use your card wisely! Do post your comments and tell us how differently you will use the 20 depth window for identifying trading opportunities. Good luck!   608 comments cannot see market depth You need to have generated at least 100 Rupees in brokerage to see the 20 depth. Please check this – https://zerodha.com/z-connect/featured/introducing-20-depth-or-level-3-data-beta-on-kite (https://zerodha.com/z-connect/featured/introducing-20-depth-or-level-3-data-beta-on-kite) Very nicely written, thank you for your incredible insight. Salman, thank you 🙂 Sir, how will the market depth data be relied upon? When clients or trading systems use the disclosed quantity feature, not the entire quantity is shown. In such a case, isn’t there a chance that the wrong assumptions are made looking at just the market depth? Valid point, but there is no way one can identify disclosed quantity. By the way, level 3 helps you identify contract availability. Given this, the disclosed quantity, if any, will only make the liquidity situation better. Hi Karthik! Newbie here, under the ‘The 20 Market Depth (level 3 data) Window’ section, you’ve said – If you are entirely new to this, I’d suggest you read this blog to understand what the level 3 data is all about. Are you referring to this chapter as the blog or have a separate blog elsewhere, in which case I do not see a link to it. Can you help? ‘Read this blog’ is hyperlinked 🙂 Amazing featute for the reatil traders. Way to go team for bringing such innovative and pro Tools to the world at such decent costs. Happy learning and trading 🙂  Name (required)    Mail (will not be published) (required)      Post comment    Δ Varsity by Zerodha © 2015 – 2024. All rights reserved. Reproduction of the Varsity materials, text and images, is not permitted. For media queries, contact [email protected] (mailto:[email protected])

12. Key Events and Their Impact on Markets (https://zerodha.com/varsity/chapter/key-events-and-their-impact-on-markets/) 12.1 – Events Trading or investing based on just company-specific information may not be sufficient. Outside events, both economic and/or non-economic, impact stocks and the market’s performance in general. It is also important to understand the events that influence the markets. In this chapter, we will try to understand some common events and how the stock market reacts to these events. 12.2 – Monetary Policy The monetary policy is a tool through which the Reserve Bank of India (RBI) controls the money supply by controlling the interest rates. RBI is India’s central bank. Likewise, every country’s central bank is responsible for setting interest rates. For example, the European Central Bank in Europe and Federal Reserves in the US. Central Banks tweak the interest rates to control the money supply in the mainstream economy. While setting the interest rates, the RBI has to strike a balance between growth and inflation. In a nutshell – if the interest rates are high, the borrowing rates are high (particularly for corporations). If corporate can’t borrow easily, they cannot grow. If corporations don’t grow, the economy slows down. On the other hand, borrowing becomes easier when the interest rates are low. This translates to more money in the hands of corporations and consumers. With more money, there is increased spending which means the sellers tend to increase the prices of goods and services, leading to inflation. I’d encourage you to watch this YouTube video where I’ve tried to explain what causes inflation and the means through which RBI controls inflation. To strike a balance, the RBI has to consider all economic factors and carefully set the key rates. Any imbalance in these rates can lead to economic chaos. The key RBI rates that you need to track are as follows: Repo Rate – Banks can borrow from the RBI. The rate at which RBI lends money to other banks is called the Repo Rate. If the repo rate is high, the cost of borrowing is high, leading to slow economic growth. You can check the latest repo rate (And other rates, too) on RBI’s website (https://www.rbi.org.in/) . Markets don’t like the RBI increasing the repo rates because it slows down economic growth. Reverse repo rate – Reverse Repo rate is the rate at which RBI borrows money from banks. Or in other words, Reverse Repo is the deposit rate RBI offers to other banks when the banks park funds with RBI. When banks deposit money to RBI, they are certain that RBI will not default, so the rate RBI offers is relatively low. However, the banking system’s money supply reduces when banks deposit money with RBI (at a lower rate) instead of the corporate entity. An increase in the reverse repo rate is not great for the economy as it tightens the money supply. Sometimes via the central bank’s policy, the central bank mandates higher deposits by banks; again, this is a way to curtail excess money supply in the mainstream economy. Cash reserve ratio (CRR) – Every bank must maintain funds with RBI. The amount that they maintain is dependent on the CRR. If CRR increases, more money is sucked out of the mainstream economy, which is not good for the economy. The monetary policy committee members meet regularly to review the economic situation and decide upon these key rates; hence keeping track of the monetary policy event is a must for any active trader. The first to react to rate decisions would be interest-rate sensitive stocks across various sectors such as – banks, automobiles, housing finance, real estate, metals, etc. 12.3 – Inflation Inflation is a sustained increase in the general prices of goods and services. Increasing inflation erodes the purchasing power of money. All things being equal, if the cost of 1 KG of onion has increased from Rs.15 to Rs.20, this price increase is attributed to inflation. Inflation is inevitable, but a high inflation rate is not desirable as it could lead to economic uneasiness. A high level of inflation tends to send a bad signal to markets. Both the Government and RBI work towards reducing inflation to a manageable level. Inflation is generally measured using an index. If the inflation index increases by certain percentage points, it indicates rising inflation. Likewise, an index falling indicates inflation cooling off. There are two inflation indices – The Wholesale Price Index (WPI) and Consumer Price Index (CPI). Wholesale Price Index (WPI) – The WPI indicates the movement in prices at the wholesale level. It captures the price change when goods are bought and sold wholesale. WPI is an easy and convenient method to calculate inflation. The inflation measured here is at an institutional level and does not necessarily capture the consumer’s inflation. Consumer Price Index  (CPI) – The CPI, on the other hand, captures the effect of the change in prices at a retail level. As a consumer, CPI inflation is what matters. The calculation of CPI is quite detailed as it involves classifying consumption into various categories and subcategories across urban and rural regions. Each of these categories is made into an index, the final CPI index is a composition of several internal indices. The CPI captures the effect of inflation on daily household consumables like fruits, vegetables, cereals, and even fuels like petrol and diesel. The computation of CPI is quite rigorous and detailed. It is one of the most critical metrics for studying the economy.  A national statistical agency, the Ministry of Statistics and Programme Implementation (MOSPI), publishes the CPI numbers around the 2 nd week of every month. The RBI’s challenge is to strike a balance between inflation and interest rates. Usually, a low-interest rate tends to increase inflation, and a high-interest rate tends to arrest inflation. 12.4 – Index of Industrial Production (IIP) The Index of Industrial Production (IIP)  is a short-term indicator of the country’s industrial sector’s progress. The data is released every month (along with inflation data) by the Ministry of Statistics and Programme Implementation (MOSPI). As the name suggests, the IIP measures the Indian industrial sectors’ production, keeping a fixed reference point. As of today, India uses the reference point of 2004-05. The reference point is also called the base year. Roughly about 15 different industries submit their production data to the ministry, which collates the data and releases it as an index number. If the IIP increases, it indicates a vibrant industrial environment (as the production is going up) and hence a positive sign for the economy and markets. A decreasing IIP indicates a sluggish production environment, hence a negative sign for the economy and markets. To sum up, an upswing in industrial production is good for the economy, and a downswing rings an alarm. As India is getting more industrialized, the relative importance of the Index of Industrial Production is increasing. A lower IIP number puts pressure on the RBI to lower the interest rates and aid industrial credit with cheaper credit. 12.5 – Purchasing Managers Index (PMI) The Purchasing managers’ index (PMI) is an economic indicator that tries to capture business activity across the country’s manufacturing and service sectors. This is a survey-based indicator where the respondents – usually the purchasing managers- indicate their business perception change concerning the previous month. A separate survey is conducted for the service and manufacturing sectors. The data from the survey are consolidated on a single index. Typical areas covered in the survey include new orders, output, business expectations, and employment. The PMI number usually oscillates around 50. A reading above 50 indicates expansion, and below 50 indicates a contraction in the economy. And reading at 50 indicates no change in the economy. 12.6 – Budget A Budget is an event during which the Ministry of Finance discusses the country’s finance in detail. The Finance Minister, on behalf of the ministry, makes a budget presentation to the entire country. During the budget, major policy announcements and economic reforms are announced, which impacts various industries across the markets. Therefore the budget plays a vital role in the economy. To illustrate this further, in one of the recent budgets, the expectation was to increase the duties on a cigarette. As expected, during the budget, the Finance Minister raised the duties on a cigarette, so the prices increased. An increased cigarette price has a few implications: In reaction to the budget announcement, ITC traded 3.5% lower for this precise reason. A budget is an annual event, and it is announced during the last week of February. However, the budget announcement could be delayed under certain special circumstances, such as a new government formation. 12.7 – Corporate Earnings Announcement Corporate earning season is perhaps one of the important events to which the stocks react. The listed companies (trading on the stock exchange) must declare their earnings once every quarter, also called the quarterly earnings numbers. During an earnings announcement, the corporate gives out details on various operational activities, including: Besides, some companies give an overview of what to expect from the upcoming quarters. This forecast is called ‘corporate guidance.’ Invariably every quarter, the first blue-chip company to make the quarterly announcement is Infosys Limited. They also give out guidance regularly. Market participants follow what Infosys has to say regarding guidance as it impacts the markets. The table below gives you an overview of the earning season in India: Do note that the 1st of April in India marks the beginning of the financial year. In the US, the financial year starts on 1st Jan, so the first quarter starts from January through March, and so forth. Every quarter when the company declares its earnings, the market participants match the earnings with their expectations of how much the company should have earned. The market participant’s expectation is called the ‘street expectation.’ The stock price will react positively if the company’s earnings are better than the street expectations. The stock price will react negatively if the actual numbers are lower than the street expectation. If the street expectation and actual numbers match, the stock price tends to trade flat with a negative bias more often than not. This is mainly because the company could not give any positive surprises. 12.8 – Non Financial events Apart from the events we discussed above, it would be best to watch out for other non-financial events to understand their impact on markets. For example, the Covid crisis of 2020 had a significant effect on economies around the world, disrupting the world economic order. The supply chain took a hit across the globe leading to an inflation spike. That said, there were select pockets of the economy that did very well, mainly the online services industry. Events like the Russia – Ukraine war or the tension between China and Taiwan have impacted world markets. Geo-political affairs such as these impact various connected economies. For instance, the war between Russia and Ukraine affects the supply of natural gas and crude oil, which significantly impacts the energy costs in Europe. As an active trader or a market participant, you need to watch out for these events and understand how these events can impact the markets. While the world economies are interconnected, isolated events (Country specific) impact the local economy. For example, the elections in India impact only the Indian economy. So, keep an eye on these non-financial events and how they can impact the stock markets or sometimes specific industries. Key takeaways from this chapter 329 comments 1. From the close of a quarter/financial year, what are the time limits within which companies must declare the results? 2. In case of insider trading (SAST), what is the time limit to inform the exchanges about it ? 3. Is there any rule/law making it mandatory for companies to report events with financial significance? Answers in the same order – 1) If I’m not wrong companies must declare results  within 30 days 2) In order to make it a level playing field SEBI mandates the companies to disclose insider trading ‘at the earliest’, which pretty much means the company has to declare this information within the same trading day 3) Yes companies have to declare this information. Hi, What is insider trading and SAST ? How it works? Is their any facility into Versity to get notification once get solution of query? You should get an email notification when this gets answered. Anyway, insider trading is basically trading on information not known to the public. For example, an employee of TCS can buy the shares of TCS based on his knowledge of the quarterly results yet to be announced. Thanks Karthik 🙂 Cheers! By 8% & 7% in Repo and Reverse repo rate, do you mean it is same as we borrow from banks at 11 % ? No, repo & reverse repo rate are rate at which banks transact with RBI. The lending rates to us are different. Sir, i am not able to understand “Purchasing managers index(PMI)” PMI or the Purchasing Manager’s Index is an index which measures the activity of a purchasing manager (PM) of a company. This is measured by running a survey across many PM’s across sectors and industries. If the PM is sheen to be purchasing things for the company then the perception of growth and industrial activity is created, which is good for the markets. Else its considered not so good. Thank you sir Welcome 🙂 Important & better for new trader You bet, it is.  Name (required)    Mail (will not be published) (required)      Post comment    Δ Varsity by Zerodha © 2015 – 2024. All rights reserved. Reproduction of the Varsity materials, text and images, is not permitted. For media queries, contact [email protected] (mailto:[email protected])

16. Momentum Portfolios (https://zerodha.com/varsity/chapter/momentum-portfolios/) 16.1 – Defining Momentum If you have spent some time in the market, then I’m certain you’ve been bombarded with market jargon of all sorts. Most of us get used to these jargon and start using them without actually understanding what they mean. I’m guilty of using a few jargon without understanding the true meaning of it, and I get a feeling that some of you reading this may have experienced the same. One such jargon is – momentum. I’m sure we have used momentum in our daily conversations related to the markets, but what exactly is momentum, and how is it measured? When asked, traders loosely define momentum as the speed at which the markets move. This is correct to some extent, but that’s not all, and we should certainly not limit our understanding to just that. ‘Momentum’ is a physics term. It refers to the quantity of motion an object has. If you look at this definition in the context of stock markets, everything remains the same, except that you will have to replace ‘object’ with stocks or the index. Momentum is the rate of change of stock returns or the index. If the rate of change of returns is high, then the momentum is considered high; if the rate of change of returns is low, the momentum is considered low. This leads us to the next obvious question i.e. what is the rate of change of returns? The rate of change of return, as it states the return generated  (or eroded) between two reference periods. For the sake of this discussion, let’s stick to the rate of change of return on an end-of-day basis. So in this context, the rate of change of returns means the speed at which the daily return of the stock varies. To understand this better, consider this example – The table above shows an arbitrary stock’s daily closing price for six days. Two things to note here – Consider another example – Two things need to note – Given the behavior of these two stocks, I have two questions for you – To answer these questions, you can look at either the absolute change in the Rupee value or the percentage change from a close-to-close perspective. If you look at the absolute Rupee change, the change in Stock A is higher than in Stock B. However, this is not the right way to look at the change in daily return. For instance, in absolute Rupee terms, stocks in the range of, say, 2000 or 3000 will always have a higher change compared to stocks in the range of 1000 or lower. Hence, evaluating absolute Rupee change will not suffice, and therefore we need to look at the percentage change. In terms of percentage change, Stock B’s daily change is higher, and therefore we can conclude that Stock B has a higher momentum. Here is another situation, consider this – Stock A has trended up consistently daily, while stock B has been quite a dud all along except for the last two days. On an overall basis, if you check the percentage change over the 7 days, then both have delivered similar results. Given this, which of these two stocks is considered to have good momentum? Well, Stock A is consistent in terms of daily returns, exhibits a good uptrend, and, therefore, can be considered to have continuity in showcasing momentum. Now, what if I decide to measure momentum slightly differently? Instead of daily returns, what if we were to look at the return on a 7 days basis? If we do that, stocks A and B qualify as momentum stocks. The point I’m trying to make here is that traders generally look at momentum in terms of daily returns, which is perfectly valid, but this is not necessarily the only way to look at momentum. The momentum strategy we will discuss later in this chapter looks at momentum on a larger time frame, not daily. More on this later. I hope by now; you do have a sense of what momentum means and understand that momentum can be measured not just in terms of daily returns but also in terms of larger time frames. High-frequency traders measure momentum on a minute-to-minute or hourly basis. 16.2 – Momentum Strategy Among the many trading strategies traders use, momentum is one of the most popular strategies. Traders measure momentum in many different ways to identify opportunity pockets. The core idea across all these strategies remains the same, i.e., to identify momentum and ride the wave. Momentum strategies can be developed on a single-stock basis. The idea is to measure momentum across all the stocks in the tracking universe and trade the ones that showcase the highest momentum. Remember, momentum can be either long or short, so a trader following a single stock momentum strategy will get both long and short trading opportunities. Traders also develop momentum strategies on a sector-specific basis and set up sector-specific trades. The idea here is to identify a sector that exhibits strong momentum; this can be done by checking momentum in sector-specific indices. Once the sector is identified, look for the stocks that display maximum strength in terms of momentum. Momentum can also be applied on a portfolio basis. This involves portfolio creation with, say ‘n’ number of stocks, with each stock showcasing momentum. In my opinion, this is an excellent strategy as it is not just a plain vanilla momentum strategy but also offers safety in diversification. We will discuss one such strategy wherein the idea is to create a stock basket, aka a portfolio of 10 momentum stocks. Once created, the portfolio is held until the momentum lasts and then re-balanced. 16.3 – Momentum Portfolio Before we discuss this strategy, I want you to note a few things – Given the above, here is a systematic guide to building a ‘Momentum Portfolio’. Step 1  – Define your stock universe As you may know, there are close to 4000 stocks on BSE and about 1800 on NSE. This includes highly valuable companies like TCS and absolute thuds such as almost all the Z category stocks on BSE. Companies such as these form the two extreme ends of the spectrum.  Do you have to track all these stocks to build a momentum portfolio? Not really. Doing so would be a waste of time. One has to filter out the stocks and create the ‘tracking universe.’ The tracking universe will consist of a large basket of stocks within which we will pick stocks to constitute the momentum portfolio. The momentum portfolio will always be a subset of the tracking universe. Think of the tracking universe as a collection of your favorite shopping malls. Maybe out of the 100s of malls in your city, you may go to 2-3 shopping malls repeatedly. Clothes bought from these 2-3 malls comprise your entire wardrobe (read portfolio). Hence, these 2-3 malls form your tracking universe out of the 100s available in your city. The tracking universe can be pretty straightforward – the Nifty 50 or BSE 500 stocks. Therefore, the momentum portfolio will always be a subset of the Nifty 50 or BSE 500 stocks. Keeping the BSE 500 stocks as your tracking universe is an excellent way to start. However, if you feel adventurous, you can custom-create your tracking universe. Custom creation can be on any parameter – for example, out of the entire 1800 stocks on NSE, I could use a filter to weed out stocks that have a market cap of at least 1000 Crs. This filter alone will shrink the list to a much smaller, manageable set. Further, I may add other criteria, such as the stock price should be less than 2000. So on and so forth. I have randomly shared a few filter ideas, but you get the point. Using custom creation techniques helps you filter out and build a tracking universe that matches your requirement. Lastly, from my personal experience, I would suggest you have at least 150-200 stocks in your tracking universe if you wish to build a momentum portfolio of 12-15 stocks. Step 2  – Set up the data Assuming your tracking universe is set up, you can proceed to the 2 nd step. In this step, you must ensure you get the closing prices of all the stocks in your tracking universe. Ensure your data set is clean and adjusted for corporate actions like the bonus issue, splits, special dividends, and other corporate actions. Clean data is the crucial building block to any trading strategy. There are plenty of data sources from where you can download the data for free, including the NSE/BSE websites. The question is – what is the lookback period? How many historical data points are required? To run this strategy, you only need 1-year data point. For example, today is 2 nd March 2019; then I’d need data points from 1 st March 2018 to 2 nd March 2019. Please note once you have the data points for the last one-year set, you can update this daily, which means the daily closing prices are recorded. Step 3  – Calculate returns This is a crucial part of the strategy; in this step, we calculate the returns of all the stocks in the tracking universe. As you may have already guessed, we calculate the return to get a sense of the momentum in each stock. As discussed earlier in this chapter, one can calculate the returns on any frequency, be it daily/weekly/monthly, or even yearly returns. We will stick to yearly returns for the sake of this discussion; however, please note; you can add your own twist to the entire strategy and calculate the returns for any time frame you wish. Instead of yearly, you could calculate the half-yearly, monthly, or even fortnightly returns. So, you should have a tracking universe of about 150-200 stocks at this stage. All these stocks should have historical data for at least 1 year. Further, you need to calculate the yearly return for each stock in your tracking universe. To help you understand this better, I’ve created a sample tracking universe with just about ten stocks in it. The tracking universe contains the data for the last 365 days. The 1-year returns are calculated as well – If you are wondering how the returns are calculated, then this is quite straightforward, let us take the example of ABB – Return = [ending value/starting value]-1 = [1244.55/1435.55]-1 = -13.31% Relatively straightforward, I guess. Step 4 – Rank the returns Once the returns are calculated, you need to rank the returns from the highest to the lowest returns. For example, Asian paints has generated a return of 25.87%, the highest in the list. Hence, the rank of Asian paints is 1. The second highest is HDFC Bank, which will get the 2 nd rank.  Infosys’s return, on the other hand, is -35.98%, the lowest in the list; hence the rank is 10. So on and so forth. Here is the ‘return ranking’ for this portfolio – If you are wondering why the returns are negative for most of the stocks, that’s how stocks behave when deep corrections hit the market. I wish I had opted to discuss this strategy at a better point. So what does this ranking tell us? If you think about it, the ranking reorders our tracking universe to give us a list of stocks from the highest return stock to the lowest. For example, from this list, I know that Asian Paints has been the best performer (in terms of returns) over the last 12 months. Likewise, Infy has been the worst. Step 5 – Create the portfolio A typical tracking universe will have about 150-200 stocks, and with the help of the previous step, we would have reordered the tracking universe. Now, we can create a momentum portfolio with the reordered tracking universe. Remember, momentum is the rate of change of return, and the return itself is measured yearly. A good momentum portfolio contains about 10-12 stocks. I’m comfortable with up to 15 stocks in the portfolio, not more than that. For the sake of this discussion, let us assume that we are building a 12 stocks momentum portfolio. The momentum portfolio is now the top 12 stocks in the reordered tracking universe. In other words, we buy all the stocks starting from rank 1 to rank 12. In the example we were dealing with, if I were to build a 5-stock momentum portfolio, then it would contain – The rest of the stocks would not constitute the portfolio but will remain in the tracking universe. You may ask what is the logic of selecting this subset of stocks within the tracking universe? Well, read this carefully – if the stock has done well (in terms of returns generated) for the last 12 months, it implies that it has good momentum for the defined time frame. The expectation is that this momentum will continue onto the 13 th month, and therefore the stock will continue to generate higher returns.  So if you were to buy such stocks, you are to benefit from the expected momentum in the stock. This is a claim. I do not have data to back this up, but I have successfully used this technique for several years. It is easy to back-test this strategy, and I encourage you to do so. Back in the day, my trading partner and I were encouraged to build this momentum portfolio after reading this ‘Economist’ article. You need to read this article before implementing this strategy. Once the momentum portfolio stocks are identified, the idea is to buy all the momentum stocks in equal proportion. So if the capital available is Rs.200,000/- and there are 12 stocks, the idea is to buy Rs.16,666/- worth of each stock (200,000/12). By doing so, you create an equally weighted momentum portfolio. Of course, you can tweak the weights to create a skewed portfolio, there is no problem with it, but then you need a solid reason for doing so.  This reason should come from backtested results. If you like to experiment with skewed portfolios, here are few ideas – So on and so forth. Ideally, the approach to capital allocation should come from your backtesting process, this also means you will have to backtest various capital allocation techniques to figure out which works well for you. Step 6 – Rebalance the portfolio So far, we have created a tracking universe, calculated the 12-month returns, ranked the stocks in terms of the 12-month returns, and created a momentum portfolio by buying the top 12 stocks. The momentum portfolio was built based on the 12-month performance, hoping to continue to showcase the same performance for the 13 th month. There are a few assumptions here – Now the question is, what happens at the end of the month? At the end of the month, you re-run the ranking engine and figure out the top 10 or 12 stocks which have performed well over the last 12 months. Do note at any point, we consider the latest 12 months of data. So, we now buy the stocks from rank 1 to 12, just like we did in the previous month. From my experience, chances are that out of the initial portfolio, only a hand full of stocks would have changed positions. So based on the list, you sell the stocks that no longer belong in the portfolio and buy the new stocks featured in the latest momentum portfolio. In essence, you rebalance the portfolio and you do this at the end of every month. So on and so forth. 16.4 – Momentum Portfolio variations Before we close this chapter (and this module), I’d like to touch upon a few variations to this strategy. The returns have been calculated on a 12-month portfolio and the stocks are held for a month. However, you don’t have to stick to this. You can try out various options, like – As you can see, the options are plenty, and your imagination only restricts it. If you think about what we have discussed so far, the momentum portfolio is price based. However, you can build a fundamental-based momentum strategy as well. Here are a few ideas – You can do this on any fundamental parameter – EPS growth, profit margin, EBITDA margin etc. The beauty of these strategies is that the data is available, hence backtesting gets a lot easier. 16.5 – Word of caution As good as it may seem, the price-based momentum strategy works well only when the market is trending up. When the markets turn choppy, the momentum strategy performs poorly, and when the markets go down, the momentum portfolio bleeds heavier than the markets itself. Understanding the strategy’s behavior with respect to the market cycle is crucial to this portfolio’s eventual success. I learned it the hard way. I had a great run with this strategy in 2009 and ’10 but took a bad hit in 2011. So before you execute this strategy, do your homework (backtesting) right. Having said all of that, let me reassure you – a price-based momentum strategy, if implemented in the proper market cycle can give you great returns, in fact, better more often than not, better than the market returns. Good luck and happy trading. Key takeaways from this chapter 240 comments Dear sir,What about volatility based delta hedging strategy? Kehav, perhaps I’ll add that sometime as an addendum. Moving forward onto the next module. When will Varsity Android app launch.. waiting for it.. Here you go, Ankit – https://play.google.com/store/apps/details?id=com.zerodha.varsity&showAllReviews=true (https://play.google.com/store/apps/details?id=com.zerodha.varsity&showAllReviews=true) , please don’t forget to rate us on play store 🙂 Hey thanks sir.. app is awsum.. hopeing for all the modules to be added soon.. and even the new app of kite 3 is awsum.. thanks alot… I’m happy to note that, Ankit! Lots of efforts towards building these apps 🙂 Yes, eventually all the modules will be added to the app. Did you check out the wall feature? h1 Sir, Thanks for an this topic was waiting for it to be covered.. According to you which is the best source to get eod data which is adjusted of splits and bonus for bse 500 stocks apart from nse/bse websites. And secondly you said u need a coder to get a this strategy working can u share excel sheets to calculate momentum score as you did for pair trading chapter Thanks Nick, there are plenty of data vendors who provide you clean data. I’d suggest you subscribe to any of them. Unfortunately, I was unable to produce the excel, hence I took up the example of 10 stocks. At present I am investing on long-term basis and good results and very much Happy with the returns. I want to start trading shortly and watching articles related… thanks… waiting further. Good luck, Shakeel! Sir correct me if I’m wrong but this is one of the longest chapters in varsity and I enjoyed reading it in one sitting. I’m currently in the process of back testing the portfolio based on momentum. What would the next chapter be about sir? I’m glad you could read through it in one sitting, do share the backtested results if you are comfortable with it 🙂 This module ends with this chapter. We are moving ahead with the next one.  Name (required)    Mail (will not be published) (required)      Post comment    Δ Varsity by Zerodha © 2015 – 2024. All rights reserved. Reproduction of the Varsity materials, text and images, is not permitted. 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1. Sector analysis overview (https://zerodha.com/varsity/chapter/sector-analysis-overview/) 1.1 – Introduction Welcome to another Varsity Module! This module on Varsity explores sectors as an investment avenue. We all know that a well-diversified portfolio is the key to building a successful stock portfolio. The diversification should be across sectors and market capitalizations. If we are looking at picking stocks from different sectors, we need to understand sectors from a stock-picking perspective. The objective of this module is just that, i.e., to help you understand what to look for in each sector as a stock picker or an equity investor. Each chapter will focus on one sector. So after reading this chapter, you can jump across to any sector you are curious to learn about without worrying about losing the chain of thought. By the way, my name is Vineet Rajani; I hold a CFA charter and have four years of experience in researching equities. I recently joined the Zerodha Varsity team to help Karthik develop content, and the sector analysis module is the first module I’ll be working on. I hope you all will like this module as much as you’ve liked all the previous modules 🙂 1.2 – What is a sector, and what is an industry? A sector is a set of companies engaged in similar business activities. For example, Infosys, TCS, and HCL are similar businesses, forming the Information Technology sector. HDFC Bank, ICIC Bank, and SBI are banks, and these companies belong to the banking sector. Sun Pharmaceuticals, Apollo Hospitals, and Dr. Lal Path Labs are all companies belonging to the healthcare sector. Sectors can have sub-sectors or industries. Sectors and industries are often used interchangeably. Each industry has a distinct business at a granular level, but at a broader level, many industries can make one sector. While banking, insurance, and mutual funds are all distinct industries, collectively, they are financial services and make up the financial services sector. Similarly, the healthcare sector comprises sub-sectors such as hospitals, diagnostics, pharmaceuticals, pharmacies, preventive healthcare, and wellness. The following table classifies various industries in a limited set of sectors. There are about 3-4 globally accepted standards for industry classification. This table shows how Refinitiv (https://www.refinitiv.com/content/dam/marketing/en_us/documents/quick-reference-guides/trbc-business-classification-quick-guide.pdf) classifies the sectors and industries. An investor would want to analyze a particular sector when they see a factor or phenomenon influencing it. For instance, an investor investing in the fertilizer or packaged foods sector would want to take note of the monsoon season’s data as it tends to impact those sectors as a whole. Or an investor in the IT sector may want to keep an eye on the USD-INR exchange rate as the sector makes a significant part of revenues in USD. Investors also take an interest in the sector of their occupation – a doctor might want to invest in healthcare stocks, or a software engineer might be confident about their understanding of the technology sector. Investor frenzy in a particular sector also stimulates the interest of other investors in that sector. 1.3 –  What is sector analysis? Sector analysis involves looking for factors, features, events, and metrics that impact the businesses in a given sector. A factor might positively impact one sector while a negative impact on another. The idea of sector analysis hinges on the fact that certain aspects or events are specific to sectors and do not impact the overall market. Sector analysis is a part of fundamental analysis. While our module on fundamental analysis explains the approach to researching a particular company, sector analysis focuses on the features and operational or performance metrics unique to a sector. The exercise becomes meaningful when several companies within a sector are compared based on these metrics. 1.4 -Different Approaches for Different Sectors No two sectors are the same; therefore, no two sectors can be analyzed the same way. Banks, for instance, are analyzed using key performance indicators such as NPAs, capital adequacy ratios, and interest margins. Insurance companies are analyzed for solvency ratio, claims settlement ratio, expense ratio, persistence ratio, etc. Airlines look at revenue per seat kilometer, cost per seat kilometer, fuel costs, and occupancy rates to understand performance. These metrics depict the operational efficiency of the players in an industry and how those players stack against each other. For industries in the heavy manufacturing space – cement, steel, aluminum, and the like – production capacity, production volume, and sales volume are important comparables. Volume metrics are significant for automobiles and electronics too. Companies in FMCG, or Fast Moving Consumer Goods, focus significantly on distribution, brand awareness, packaging, etc. When an investor begins studying a sector, understanding the value chain could be a good starting point (I will explain the concept of “value chain” soon). A study of the value chain provides more insights into a particular sector’s unique dynamics. The exercise could also unearth certain industry players’ competitive advantages or disadvantages. 1.5 – What is a value chain? Simply put, a value chain begins with the sourcing of raw materials and goes up to the point of end consumption. For example, the textile industry’s value chain would include fiber production, spinning yarn, fabric production, dying and printing, garment manufacturing, packaging, distribution, and retail. Cement’s value chain starts with limestone mining, followed by clinkerization, blending, grinding, packaging, and distribution. This value chain might be extended if the cement manufacturer processes it further into ready-mix concrete (RMC) before selling it in the market. Dissecting the value chain in this manner enables an investor to identify which steps drive costs or improve or hamper productivity. A value chain typically has many steps. Here, the investor must put on a business owner’s hat to understand what steps along the value chain add value to the business and what do not. Cement companies generally own the limestone mines and all the processes up to distribution. The cement industry is predominantly vertically integrated. Let me introduce three new concepts: Vertical Integration, Backward Integration, and Forward Integration. Although a rare phenomenon, a fully vertically integrated company owns all the processes from raw material production to end consumer retail sales. Samsung, a global leader in consumer electronics, is essentially a vertically integrated business. It produces semiconductors, memory chips, and screens that go into making mobile phones, then assembles mobile phones at its plants and even sells them through its own retail stores. While Samsung also sells through other retailers and e-commerce channels, its retail stores symbolize some level of vertical integration. Most companies within an industry exhibit similar business structures across the value chain. FMCG companies in India can hardly be backward integrated. Palm oil, a key ingredient in many food products, personal care, and cosmetic goods, is primarily sourced from Malaysia and Indonesia. Packaging for these products uses petroleum derivatives which have their source in oil-producing countries. It does not make business sense for an FMCG company to own supply-side processes. The case of the FMCG sector suggests that the geography of the value chain also influences a business’ vertical integration, costs, and material availability. Automobile companies are mostly assembly companies. The thousands of parts that go into making a car are all sourced from vendors that may be geographically located far apart. The significance of packaging in a value chain depends on the nature of a product, its application, size, shape, and perishability. It also depends on where the end consumer is located and what modes of transport will be used to deliver the product. Regulatory requirements must also be met concerning packaging material, dimensions, eco-friendliness, etc. 1.6 – Framework  These concepts above can be put into a framework for an investor researching a particular sector. This framework can act as a checklist for the investor to ensure that adequate efforts have been dedicated to comprehensively understanding a sector. Political Factors: The political will of the ruling government can influence the overall business sentiment in an economy as a whole. Businesses engaged in sin goods such as liquor and tobacco and necessities such as grains and oil often carry large political overhangs. Economic Factors : The strength of an economy and the stage of economic development can present different opportunities for different sectors. High-interest rates could limit corporate growth, while low-interest rates could enable easy borrowing and faster growth. However, low-interest rates could encourage excessive retail borrowing and spur inflation. The ability of the economic authorities to balance growth and control inflation is of the essence here. Economic factors such as inflation, exchange rates, FDI, and money supply play along with interest rates to influence the business environment. Socio-cultural Factors : Festivals can stimulate seasonal buying for specific sectors. Socio-cultural shifts can create long-term trend growth for certain products while a decline in others. The gradual move from coal-fired stoves to gas stoves results from economic development and social acceptance of a new cooking method. Demographic features and changes are a major influence on demand creation. The vast size of India’s youth population, in both absolute and percentage terms, has led to the creation of various products and brands meant to attract the young crowd. A decline in the average fertility rate suggests a decline in population growth. The aging of today’s young population could boost the demand for old-age products after three-four decades. Technological Factors : The stories of Nokia and Blackberry losing market share to Apple and Samsung have been discussed every time the impact of technological change has to be depicted. Innovations in technology can create new sectors and even wipe out some. All industries related to e-commerce were built upon the Internet. The Internet was a technological breakthrough. On the other hand, typewriters and Telegram are technologies that died as better ones replaced them. Legal Factors : The duties, tariffs, quotas, and other restrictions have an impact on the import-export trade of a country. Legal factors often create entry barriers for new players to enter a particular industry. For example, the heavy licensing requirements and different state-wise laws make liquor manufacturing a capital-intensive and difficult industry to get into. Pollution control, labor laws, and regulators like SEBI, RBI, and IRDAI constitute an economy’s legal machinery. Environmental Factors : The natural environment of a country can present opportunities for some sectors while discouraging others. Mining businesses are possible only if a country has minerals under its earth. Pollution and environmental deterioration result in imposing restrictions and requirements on industries. Water and effluent treatment plants have become a regulatory mandate for various chemical and industrial goods companies. Natural calamities could purge industries while displacing civilizations. Insurance companies carry a huge risk on account of natural disasters. These factors also influence each other. Economic development could lead to social development and shifts in culture. Issues related to society and the environment could be behind the development of certain legal barriers. Some legal factors can also be politically influenced. These factors make the PESTLE (https://pestleanalysis.com/what-is-pestle-analysis/) Analysis (Political-Economic-Social-Technological- Legal-Environmental), a framework commonly taught in colleges and business schools. 1.7 – How companies within a sector can differ? Beyond the PESTLE framework, as an investor, you must also study how a particular company competes with its peers. By the way, competition is much more than just outselling each other. A company also competes during the sourcing of raw materials. Two dairy companies, for example, will compete with each other to source milk from farmers. Companies also compete with new players in the industry. New players can disrupt the industry. A large influx of new players can change the industry’s competitive landscape. Industries also have to worry about being replaced by substitutes. A company’s ability to outrun its competition and negotiate with external factors depends on what differentiates it from its peers. Let us look at a few differentiating factors. Size : Size is essentially about the capital of the company. Being big or small comes with its advantages and disadvantages. Larger companies managed to stay afloat through the Covid-related lockdowns while many smaller companies shut down. Why did this happen? Business activity was mostly dull through the lockdowns. So regular operations were not yielding profit. Larger companies survived by using capital reserves. Remember how large retailers survived while many smaller retailers closed shops? Huge capital reserves also open opportunities that are otherwise out of reach. For example, the huge capital and licensing requirements to set up a telecom business are a barrier. Smaller businesses or individuals with small capital do not even consider starting a telecom business. But the deep pockets of Reliance Industries enabled it to pump in loads of capital to set up Jio. Its war chest was huge enough to wipe out some existing players (remember Aircel, Uninor) while others were forced to merge (Vodafone and Idea). Larger companies also enjoy economies of scale . Ever wonder why a readymade shirt generally costs lower than a tailor-made one? Makers of readymade shirts source everything in bulk to get deep discounts. These discounts can be passed down to customers in the form of lower prices. Conversely, a tailor cannot compete with the quick turnaround of automated sewing machines. A tailor charges a higher price to make up for the hours dedicated to a single shirt. Being small also has its advantages and disadvantages. A newly set-up business generally has limited funds, workers, and resources. But the ability to disrupt is high mostly because larger companies do not consider smaller companies a threat, and smaller companies do not have legacy issues. Let me break this down. For example, the Brushless DC (BLDC) technology has been used for 50 years in electricals to save electricity. However, it was first used in ceiling fans in the US only in 2009. And a few years later, smaller players like Versa Drives and Atomberg (https://atomberg.com/blog/post/ceiling-fans-a-brief-history) adopted the technology and made it big. The incumbent players had been improving upon the existing technology but did not consider an alternative technology as an energy-saving solution. Once the smaller players disrupted the space, all larger players introduced the BLDC range of fans under their brand names. Why didn’t the larger players act first? Introducing a new technology could mean re-training the production staff and introducing new machinery. Existing skills and systems make the management averse to changes. These are known as legacy issues . Decision-making often slows down in larger organizations. So even if they were aware of better technology, its adoption took time. Small companies are not considered a threat because even if they have a superior product, their ability to sell it and scale it up is limited. A few that do manage to scale up become the disruptors. Age : With age comes experience. It is a commonly known concept. It is applicable to businesses too. Sometimes experience helps businesses avoid the same mistakes. Sometimes, experience makes them averse to trying new methods, techniques and technologies. Just by the virtue of being around for years, businesses have a network of suppliers, distributors, and allies that a new business will take some time to build. However, new businesses with huge capital can overcome this obstacle. Ola and Uber disrupted other cab services mainly due to the large venture capital that they spent on technology, networking, and marketing. Long-standing relationships with vendors are useful when the supply of inputs is limited. They could also allow easier payment terms. A long-standing distribution network can be used to launch new products. For example, Polycab used its wide network of wire distributors and retailers to launch its electrical goods. Tata Consumer Products has been launching several new products that it can distribute using the existing Tata Tea and Tata Salt network. These long-standing relationships can also become a hurdle in making objective business decisions. For example, HUL and Colgate-Palmolive had to face disputes (https://www.moneycontrol.com/news/business/companies/why-hul-colgate-palmolive-are-in-a-tussle-with-distributors-7897591.html) with their long term distributors for offering differential pricing to B2B e-commerce platforms. HUL also faced boycott threats (https://www.thehindubusinessline.com/companies/hul-faces-distributors-ire-for-exploring-new-distributors-in-mp/article65822837.ece) in Madhya Pradesh when it was looking for distributors in addition to the existing ones. Newer consumer brands established their online channels before exploring physical retailing. They do not have long-standing relationships with any distributor. Therefore, they are unlikely to face protests like HUL and Colgate-Palmolive did. Focus : Focus can be related to products, target market, costs, or pricing. The product focus sounds very basic. Every business is focused on its product. However, some businesses have multiple products. Some organizations have multiple businesses. Reliance Industries has three large businesses – oil, retail, and telecom. Its next bet is going to be on financial services. Similarly, ITC is a large FMCG company with a presence in hospitality, technology, packaging, and agri-exports. So when you study conglomerates like these as part of a sector, you must consider what drives the business and profitability. You might even want to consider each business as a separate organization to draw proper comparisons with relevant peers. A company operating in a single sector might be better equipped to innovate and scale up than a peer conglomerate with other business interests. The difference is mainly about focus. A conglomerate has diluted focus across divisions. This is also why some analysts assign a conglomerate discount when valuing a conglomerate business. The target market is the target customers. Both Maruti Suzuki and Mercedes are automobile companies but are incomparable because they focus on different markets. Maruti will not be able to charge as high for its cars as Mercedes does. Similarly, Mercedes will not be able to sell as many cars as Maruti does. Their different market focus is also visible in their marketing tools. Maruti uses TV commercials to spread the word about its car. It wants the maximum population to buy its cars. Mercedes understands that millions may watch TV commercials, but only some can afford their cars. Therefore, it does not spend on TV commercials. Some businesses focus on attaining cost leadership . Indigo Airlines has managed to stay afloat while so many airlines are struggling or have perished. Indigo’s flight tickets may be priced similarly to its competitors, but its focus on cost controls has led to profitability. Other businesses focus on pricing . FMCG companies often price their products competitively, meaning they keep the prices low to maintain and increase the customer base. Ever wondered why many biscuits and chocolates still sell in ₹5-packs despite all the inflation after so many decades? It is because a consumer with limited means finds the ₹5 price point psychologically comforting. Round figures such as ₹5 or ₹10 sell more than odd figures such ₹6 or ₹7. Also, they might not be willing to spend ₹10 or higher when their budget is ₹5. Price leadership is not always about the lowest prices. Apple has become the world’s most valuable smartphone brand by always pricing its phones at a premium. Such pricing power is achieved with a heavy focus on the product and branding. Regulations also impact a company or sector’s pricing power. One can argue that the healthcare sector has strong pricing power. But because of its essential nature, the government regulates medicine prices. Substitutes : Substitutes come in various forms. Tea and coffee are each other’s substitutes. Mobile phones have substituted personal cameras, computers, diaries, and watches. In the case of luxury goods, a vacation, watch, car, handbag, and chandelier are all substitutes for each other. So when I pointed out earlier that Mercedes and Maruti may not be comparable, Mercedes could compare with other luxury goods. Substitutes are a challenge because they can come from a different sector or even create a new one altogether. There can also be regulatory support for substitutes in certain industries – solar and wind energy getting favorable policies over coal. Electric vehicles are also getting incentives over combustion engine (conventional) vehicles. Certain businesses, mostly large ones, can identify substitutes and even own them. For example, petrol and diesel pumps are now setting up EV charging and gas stations. Since substitutes can render an industry obsolete, an analyst must try to ascertain the magnitude of the threat from substitutes. Competition from substitutes pushes businesses to expand into the substitute business as well. New entrants in a sector often increase the competitive intensity in the market. This causes businesses to sell at lower prices. The advent of e-commerce has forced physical stores to give comparable discounts. Competition from Jio forced telecom operators to offer 1 GB of data per day for a price point they would otherwise charge for a monthly limit of 1 GB. 1.8 – Conclusion Sector analysis could help you as an investor understand whether a sector appears attractive or not. Accordingly, you may bet on the whole sector or a few selected stocks. Either way, valuations must be justified. A good business at a high price is likely a bad investment. Therefore, you must combine sector analysis with a proper valuation analysis to improve the likelihood of investment returns. A comprehensive study would also include fundamental analysis. I shall delve into understanding each sector in depth in the subsequent chapters of this module. The first sector I will cover is Cement. Stay tuned! Key Takeaways: 66 comments Hello VIneet, Welcome to varsity. I have been a long-time reader of Varsity and I think Karthik would remember me. I was disheartened when there were no new write-ups in varsity for a long time. All that is over now and thank you for that. My question is, you have written about valuations, and I am searching for a good book on the topic. Could you suggest some apart from Damodaran? Thank you, Hi Sundeep, Thanks for the warm welcome! About your question on Valuations, I have learned only from Damodaran’s books. Wouldn’t be too sure of others. Regards, sectoral analysis of steel & metal are highly solicited.also explain the forthcoming changes in relation to C emmission we may seee in next decade. regards. Great read. Especially the value chain part is extremely important for an investor to understand. Thanks team. Akshat. Thank you 🙂  Name (required)    Mail (will not be published) (required)      Post comment    Δ Varsity by Zerodha © 2015 – 2024. All rights reserved. Reproduction of the Varsity materials, text and images, is not permitted. For media queries, contact [email protected] (mailto:[email protected])

2. Cement (https://zerodha.com/varsity/chapter/cement/) 2.1 – Cement – An Introduction We laid down a basic foundation for sector analysis in the previous chapter. In this chapter, we will discuss the Cement industry. I have picked cement as the first sector because cement is an inherent part of modern civilization. The concrete jungle, as we call our cities, is made of cement. India is the world’s second-largest cement producer, with a 7% global market share. Surprisingly, the largest producer, China , accounts for over half of the total global cement production. China produced 2.1 billion tonnes in 2022, while India produced ~370 million tonnes . The vast difference between China’s and India’s share in cement production perhaps shows the long runway ahead that India’s infrastructure has to cover and the opportunity for the cement sector. India has an installed capacity of over 570 million tonnes per annum (mtpa). Another ~150 mtpa in capacity is expected to be added by 2027. Owing to the housing and infrastructure boom in Eastern India, the region is expected to get a third of the total capacity additions. It also accounts for 80% of houses constructed under the PMAY-G scheme. Pradhan Mantri Awas Yojana (Gramin), or PMAY-G, is the central government’s scheme to subsidize the construction of pucca houses with basic amenities in villages. Generally speaking, there are two types of cement – Portland Cement and Non-Portland Cement. All cement we generally see being used around is Portland Cement and its various blended forms. Non-Portland cement is not commonly used due to its corrosive nature. Although a value-added product in itself, cement is essentially a commodity. Its all-pervasive use has made the cement an industry of its own, and its peculiarities warrant an analysis unique to the sector. 2.2 – How is cement manufactured? Let us have a glimpse of the Portland cement manufacturing process to identify the various sources or steps that could impact the cost of production, its selling price, and profitability. You can also understand cement production in this video by Vox . It is interesting for two reasons: One, it graphically explains the cement manufacturing process, and two, it discusses the possible solutions to the environmental concerns around cement manufacturing. But more on the environmental concerns later. As you can see, the process of manufacturing cement remains the same across companies. As an investor in the sector, you should analyze which steps in the manufacturing process consume more cash and where a company can save costs. Also, remember, although belonging to the same sector, no two companies are the same. You need to analyze if a factor impacts the whole sector or is specific to a company. In fact, this is the end objective of a typical sector analysis, i.e. to understand a sector and its nuances and eventually zero in on companies that thrive within the sector so that you can make wise investment decisions. It may sound complex at this stage, but eventually, you will realize this is a common sense approach without rocket science. 2.3 – The Three Major Cost Centres This is basically the Cost of Goods Sold, a concept we learned in the Fundamental Analysis module. Limestone is the most important ingredient in cement. Cement companies own limestone quarries to control costs. They mine limestone from their quarries and process it to make clinker at plants that are generally set up close to the quarries. Water is another major input in the process. Consistent water supply is also a major challenge in many parts of our country. Therefore, many cement companies have water recycling, rainwater harvesting, and groundwater recharging systems in place. This ensures regular water availability and better visibility of costs. Most cement manufacturers maintain captive power plants to bring down fuel costs. Let me introduce the concept of captive plants or units. If a manufacturing company can produce power for its own use, it is said to have a captive power plant. Another example would be a pizza chain owning a small tomato farm to produce fresh organic tomatoes for its pizzas. In this case, the tomato farm is called a captive farm. A captive unit’s product is not sold but used in-house for producing another product. Larger players like Ultratech Cement, Ambuja Cement, and ACC have captive thermal, wind, and solar power plants. Despite captive power plants, fuel costs for these major players can be as high as 25% of the revenues. Some cement makers even own coal mines to insulate from the impact of coal price fluctuations. Ultratech and Ambuja both have captive coal mines to support their requirements partially. Sourcing coal can often be a challenge. For instance, whenever there is a coal shortage, the government could ask domestic coal producers to sell coal only to power generation companies. Cement producers that own coal mines or other forms of captive power plants are at an advantage here. Others will have to import coal from international markets. Steel and aluminium industries are also heavy coal users and compete with cement in the international market to import coal, pushing prices up. This is not to say that coal mine owners are always better off. During a down cycle when the demand for cement is low, owned coal mines are a fixed cost that the manufacturer must bear amid slow production and sales. Or if there came a time when coal prices were abysmally low, buying coal from the market would become cheaper than mining at owned quarries. Given that coal is a dirty fuel, the possibility of a regulatory ban on its industrial use will only increase. Owned mines would become a dead cost if that were to happen. “ Controlling wastage and climate change All cement producers have waste heat recovery system (WHRS) plants in place. WHRS is good for two reasons – fuel cost savings and reducing carbon footprint. The tremendous heat generated in clinker production is channelled to generate steam. This steam is passed through turbines to generate electricity. This electricity can cater to 25-30% of the cement plant’s power requirements. The increasing focus on reducing fuel costs and carbon footprint has given rise to an interesting metric known as the Clinker factor. It represents the proportion of clinker in a cement recipe. The lower the clinker factor, the better. This may seem paradoxical – how can having less of the primary component be better? It is because clinker is also the most fuel-consuming step in the process of cement production. But wouldn’t that hurt the quality of cement? Manufacturers have been innovating recipes that augment the features of cement while retaining its strength. Fly ash, gypsum, silica fume, volcano ash, and other industrial by-products are common ingredients of blended cement. The Vox video after the manufacturing process above explains this well. Cement is a perishable product. It typically has a shelf-life of just 90 days. Therefore, the distribution of cement has to be fast and efficient. It is also perhaps why cement producers own the entire value chain beginning with limestone quarries. It enables them to be in control of the inventory and costs. Since perishability is a concern, cement companies might also own warehouses and trucks to monitor costs, time, and wastage. Another industry hack is to have grinding facilities closer to the market. According to Ultratech Cement’s Annual Report for 2021-22, it has 23 integrated plants, 27 grinding plants, and over 175 Ready-mix Concrete Plants. Let me break this down. An integrated plant crushes limestone, makes clinker, and grinds it into cement. Such plants are mostly close to the raw material source – the limestone quarries, in cement’s case. To solve the perishability problem, grinding units are set up closer to the market. The grinding unit will cater to a market which is more likely a state or comparable region. These facilities receive clinkers from the clinker plants that are set up near the quarries. Other components to be blended into the cement are procured directly at this grinding facility. The clinker with other components is ground to make the final cement. The grinding unit’s proximity to the market means a shorter time spent transporting the cement to the market. Further closer to the market are RMC plants. RMC, or ready-mix concrete, is a mixture of cement, sand, gravel, water, and other ingredients that make a paste used to bond the bricks in a wall. RMC has a very short shelf-life of a few hours. Therefore, RMC plants are smaller than grinding units and cater to small clusters of markets or just cities. Not all cement is sold in the form of RMC, but it is growing in popularity. As a business, cement companies would love to sell RMC; it is a value-added product and hence can improve margins. But it also adds capital expenditure. For construction companies, RMC is convenient because of the limited spaces available in cities and because it is one less job to do. 2.4 – Distribution of Cement Distribution of cement, or bringing it to the market, requires its own study. Cement is a “low value, high volume” product. As of this writing in May 2023, a 50 kg bag of cement costs roughly ₹400. Compare that with a bag of grains or cloth or cosmetics or gold. Transporting a unit of any of these items from one point to another will surely bring higher revenues than transporting the same unit of cement. Perishability, as discussed earlier, is a challenge too. An efficient distribution system is key to maintaining profitability in the cement business. At a time when urbanization has picked up pace, cement has become a necessity. If the market had only a small number of manufacturers, they could dictate prices, effectively impacting infrastructure growth and real estate prices. But the industry has several large players; over 25 are listed. However, the top five players account for almost half the national capacity. Huge capacity additions have been driving competition. Competition is also pushing the players to innovate and develop more ways of cutting costs and improving margins. Some are spending on branding and marketing to boost sales. 2.5 – Demand Drivers for Cement The next step is to understand the uses or users of cement. In other words, let us understand what drives the demand for cement. Cement is used in building houses, roads, dams, and other infrastructure. The cement users could be classified into three broad categories – housing, infrastructure, and industrial. Seasonality also impacts the demand for cement. All forms of construction activities usually slow down during the monsoon season, thereby impacting the demand for cement. Studying manufactured bulk commodities like cement requires a deeper focus on the entire value chain, from production to distribution and sales. The asset-heavy nature of the value chain also makes cement manufacturers prone to take on more debt. An investor studying the sector must also look at the debt levels of the companies and the sector at large. A structure to the above discussions to simplify studying the sector could be very useful. Let me suggest a checklist that you could use when studying the cement industry. 2.6 – The Checklist You can find these metrics in cement companies’ quarterly presentations and annual reports. Now why do metrics matter? These metrics are specific to the cement sector. If you are interested in investing in cement, combining these metrics with the regular company-based fundamental analysis can ensure complete sector research. Let us have a look at each metric one by one. Regional Presence : Diversification helps reduce risk. A company with its operations and market spread out across the country is more likely to continue operating despite any challenges. If one plant cannot operate for any reason, the others can fill in. Market Share: A larger market share usually results from a strong distribution network. Customers might want to buy a specific cement brand but will usually buy one easily available near their location. Production Capacity : The larger the production capacity, the larger orders the cement maker can serve. Cement makers want to add capacity if the economy is seeing a boom in infrastructure and real estate sectors. However, the cost of adding capacity must also be justified with the expected projected income from that capacity. Capacity Utilization : Let’s say a cement maker has an annual capacity of producing 100 mtpa worth of cement, but they produce only 70 mtpa. Effectively, they operate at a 70% capacity, or capacity utilization was 70%. As an investor, you must determine why the full capacity was not utilized. External factors such as natural calamities, pollution controls, and regulations could limit full utilization. For example, if heavy rains were to shut down production for three months, operating at 100% capacity for the remaining nine months would also mean only 75% utilization. Internal factors such as the unavailability of raw materials or labour could also hamper production. Sales Volume : Not all that is produced is sold. In fact, some cement makers sell more than what they produce. They may buy volumes from other cement makers to fulfil their commitments to customers. Realization ₹/MT : Realization is the average selling price per unit. Higher prices lead to higher revenues. Comparison of the realization numbers of cement players can lead to various insights. The one with the highest number could be commanding a solid premium in the market or must be servicing locations others have not been able to service. The highest number could also suggest a larger share of value-added products in the total sales volume.  This snapshot from Ultratech Cement’s Q4 presentation for FY23 shows that grey cement realizations have slightly moderated compared to the previous quarter. Input / Power and Fuel / Freight Cost Ratios : You can compute these ratios by dividing the cost item by revenues. The smaller these ratios, the better. Looking for each of these ratios separately can help identify what part of the business is driving costs and which one is improving margins. Cement companies typically try to control all these costs by having these activities in-house – captive quarries, power plants, and fleets. That is about it. This checklist should equip you well to comprehensively understand the cement industry and the companies operating in it. In the next chapter, we will discuss the highly regulated and frequently disrupted insurance industry. Key Takeaways 54 comments Very usefull information It’s very interesting and informative Thank you:) Thank you! Sir this kind of content is very unique and i have not seen it anywhere else. Could you please give me some pointers as to how to do my own sector analysis? What resources, books and websites do you use? Thanks again for the superb content. Thank you, Karthik! I mostly read the annual reports of a few players in any sector. Their “Management Discussion & Analysis” section gives a good perspective. If it is a highly regulated sector like banking or insurance, you can get a lot of information on the respective regulator’s website too. Good content, Excellent explanation, a non-finance/management persons can understand with this simpler explanation. Thank you so much:)  Name (required)    Mail (will not be published) (required)      Post comment    Δ Varsity by Zerodha © 2015 – 2024. All rights reserved. Reproduction of the Varsity materials, text and images, is not permitted. For media queries, contact [email protected] (mailto:[email protected])

77 comments VIDEO WAS QUITE FASCINATING MATCHING WITH MY CURRENT VILLAGE SITUATION. SAME BLACK AND WHITE 70’S VILLAGE AND COREOGRAPY WAS ALSO FASCINATING . Thanks! Glad you liked it 🙂 My son enjoyed this, when are the next episodes getting published, it adds a lot of value to childrens learning Glad your son liked it, we just published the 2nd episode, hope he likes it too 🙂 The content is amazing. You are making Finance concepts so much easy to understand by this interesting way. Thank you Karthik Sir and Team. Thanks for letting me know, Yatesh. Hope you continue to like all the videos 🙂 Hi Karthik You have highlighted the importance of compounding in education and finance. The characters are relatable, and the sprinkle of humor was well enjoyed by my child. Thank you for introducing Finance concepts for kids. I appreciate what you and your team at Zerodha are doing for the future generation. Best wishes, Bee. Thanks so much for letting me know, so happy that your kid enjoyed watching these vidoes 🙂 This is a beautiful piece of content for kids and grownups as well. Thank you, Varsity team, for making time and resources to simplify financial knowledge🙌🙌One small recommendation. It would be more engaging if the cartoon is in the color format. The next episode is in color – https://www.youtube.com/watch?v=D916Xq4Fbxg (https://www.youtube.com/watch?v=D916Xq4Fbxg) this one.  Name (required)    Mail (will not be published) (required)      Post comment    Δ Varsity by Zerodha © 2015 – 2024. All rights reserved. Reproduction of the Varsity materials, text and images, is not permitted. For media queries, contact [email protected] (mailto:[email protected])

We recommend reading this chapter (https://zerodha.com/varsity/chapter/the-stock-markets/) on Varsity to learn more and understand the concepts in-depth. Key takeaways from this chapter  Comments are closed. Varsity by Zerodha © 2015 – 2024. All rights reserved. Reproduction of the Varsity materials, text and images, is not permitted. For media queries, contact [email protected] (mailto:[email protected])

Download the excel here (https://docs.google.com/spreadsheets/d/1KgTubTr4Cq9YPbIFw9qqSnlqozCZs-JX/edit?usp=sharing&ouid=110974847305973492861&rtpof=true&sd=true) . We recommend reading this chapter (https://zerodha.com/varsity/chapter/the-need-to-invest/) on Varsity to learn more and understand the concepts in-depth. Key takeaways from this chapter 233 comments Love the way they care for their customers… And upgrading knowledge of customers is one of the best way .. proud member❤️ And we are equally happy to have you as a part of our family! Very excited to see zerodha  versity in  video series excellent effort from zerodha I am starting to see it from today I am in market from last 8 months.. and I have no doubt that it will add some more knowlege  in my market experiance We hope so too Anurag! Happy learning 🙂 Very well explained and useful Happy learning, Manjunath! MAKE ALL THE VIDEOS IN HINDI ALSO Such a excellent work knowledge sharing is the best for those who are new in share market.  Name (required)    Mail (will not be published) (required)      Post comment    Δ Varsity by Zerodha © 2015 – 2024. All rights reserved. Reproduction of the Varsity materials, text and images, is not permitted. For media queries, contact [email protected] (mailto:[email protected])

We recommend reading this chapter (https://zerodha.com/varsity/chapter/regulators/) on Varsity to learn more and understand the concepts in-depth. Key takeaways from this chapter  64 comments nice Very nicely explained. Just one suggestion, in the key takeaway slide (last 15 sec of the video), varsity logo (for subscribe button) in the middle and next video thumbnail in the Right hand corner is hindering some text. Can you please fix these? Or add extra 15 seconds blank space at the last so these thumbnails icons cover that blank space and key takeaway slides will cleared from any hinderance. Noted, will try and rectify this. Logo and Next Video disrupts the Key Takeaways thumbnail. Also Next video skips one video (eg. after watching Video 2 the next video they shows is Video 4 instead of Video 3). +1. Logo and next videos disrupt the takeaway slides in all the videos. please fix this. Working on it, Dhaval. Thank you so much sir for these wonderful lessons!! 🙂 Happy learning, Brianna!  Name (required)    Mail (will not be published) (required)      Post comment    Δ Varsity by Zerodha © 2015 – 2024. All rights reserved. Reproduction of the Varsity materials, text and images, is not permitted. For media queries, contact [email protected] (mailto:[email protected])

We recommend reading these Part 1 (https://zerodha.com/varsity/chapter/the-ipo-markets-part-1/) and Part 2 (https://zerodha.com/varsity/chapter/the-ipo-markets- part-2/) chapters of IPO Markets on Varsity to learn and understand the concepts in-depth. Key takeaways from this chapter  57 comments Hi Team Zerodha, Great work. Good Initiative. I like to personally congratulate Mr.Karthik and Mr.Prateek. I thought of sharing some content which I had prepared some 8 years back. If possible please share your contact email so that I can forward the same. Thank you, Dinakar. Please do share on Google dive with a link here itself. Brilliant explanation. Eagerly waiting for the day I might also join the Zerodha team as a Content Contributor. Coins tossed and fingers crossed. Glad you liked the content 🙂 Hi Team, Great learning. the way Mr Prateek is teaching is awesome, loved it . Happy learing! thank you so much for such great explanation of all the topics !! Happy learning! Brilliant content and presentation by Prateek. Precise and compact 8n a small capsule… Love this innovation at Varsity. Happy learning 🙂  Name (required)    Mail (will not be published) (required)      Post comment    Δ Varsity by Zerodha © 2015 – 2024. All rights reserved. Reproduction of the Varsity materials, text and images, is not permitted. For media queries, contact [email protected] (mailto:[email protected])