As many of you know, L&T got hammered yesterday for no reason at all. It all started with a brokerage house leaking a discussion with the L&T CFO, who mentioned that one of L&T’s subsidiaries is likely to face a 150 to 200 crore hedging loss this year. The market blindly hammered L&T shares yesterday without properly analysing the effects of this hedging loss. This is the sequence of events that happened
L&T, as a business practice, hedged against currency fluctuations in the forex derivatives market and also certain commodities which are essential for its business through the commodities derivatives market. Lets say L&T hedged Steel, which is an important raw material used for construction purposes. The purpose of hedging was to prevent its core business margins from taking a hit in case prices of steel went up drastically or there was an unfavourable movement in the currency market. L&T has been doing this for the past 3 years.
For the past 2 years, the prices of steel were on the rise and hence L&T would have taken a hit on its margins which would have been compensated by the profits made by buying steel forward in the commodities market.
This year metal prices including steel prices have taken a hit and hence obviously L&T and for that matter, all other companies which have hedged, would make a hedging loss. The market was short-sighted and only saw this hedging loss.
What the market ignored is the fact that this loss would be compensated in terms of increase in margins in their core business (which is construction and not commodity trading). Today the market realised that and the shares prices of larsen and toubro have bounced back today.
How I made Money
Yesterday 30 minutes before the closing bell, I checked the performance of my portfolio of which L&T has a weightage of about 45%. I was shocked to see the share prices of L&T down over 7% especially when the broader market was in the positive territory. When searching for the reason for this steep fall, I saw a news report saying L&T was likely to make 200 crore hedging loss this year. Since I’ve well researched L&T, I knew that it had been hedging for the pass 3 years and the reason for hedging. I knew the market would realise this fact in a short while and the share prices of L&T would bounce back soon. Since I was short of cash, I bought 5 lots L&T futures yesterday. I sold all the 5 lots today for a profit of close to Rs 40,000 which I’ve used to buy L&T shares in the spot (cash) market. My target (fair price) for L&T is Rs. 4600 per share which I’ve arrived at using a combination of DCF, SOTP and book value (investments) valuation methods.
Note : L&T has recently issued a clarification that the hedging loss has been through forex derivatives and not commodity derivatives. But the concept is similar. You hedge to protect your profit margins. So, if there is a hedging loss, higher business margins will offset it. Similarly if there is a hedging profit, lower business margins will offset this hedging profit.