TIMING ELEMENT IN COMMODITY SECTOR STOCKS
(This appears in today’s Deccan Chronicle )
I have always held that commodity sector stocks do not do very well over a long term. Companies that are in the manufacturing sector in commodities (as opposed to trading) have to be asset heavy. For example, setting up a cement plant would cost around US $ 120 to 140 per tonne of installed capacity. In rupee terms, it is around Rs.8500 to 10.000 per tonne. Cement sells at approximately Rs.250 per bag of 50 kgs or around Rs.5000 per tonne. Thus, at the product level, even if they make ten percent as net profits, it just is a return of 5% on the capital cost. Cement is one industry that is still doing well in India and not so cyclical. We have not had instances of cement industry being in the red for prolonged periods, thanks to our economic growth. However, if we take commodities like steel, aluminum etc we have seen such cycles.
Let us take the example of Sugar. It could cost around Rs.15,000 per tonne of crushing capacity of cane. With a yield of around 10% as sugar, the cost of setting up a mill is approximately Rs.150 per kg of sugar produced. Again, the economics are not too good. I am not even talking about cane prices, power etc.
Every commodity sector has a similar story. The world cannot do without these companies or industries, but these do not get remunerative returns. This is because there is no great competitive advantage or technology edge. Thus, producers keep selling at marginal pricing, merely to survive.
This industry survives on marginal cost pricing. The manufacturing plants are quite robust and have a long life. Thus, older players have lower fixed costs to recover and they set the pricing in the market place. This means that some player or the other keeps getting in to financial problems leading to contraction of supplies at some point. Global capacities, demand, supply and government policies also impact prices and demand/supply changes. The fortunes of these industries swing like a yo-yo.
Stock prices of commodity companies move in anticipation of end product prices or key input prices. Plus there is a question of global demand factors. In most commodities, China has become the biggest consumer as well as producer. So their economy does impact global commodity prices in a big way.
Demand for commodities at consumer level is generally steady and rising in line with population growth. And global capacities for most commodities exceed demand. Each commodity may have some domestic regulatory factors also. For example, Indian sugar industry is still regulated by the government dictating a minimum support price for sugar cane. The availability of cane is dependent on our rain gods. Thus, given the capricious monsoons, the sugar industry swings between surplus and deficits. Surplus cane and sugar naturally result in bad times for the sugar industry. Earnings drop and share prices crack. Sometimes, the stocks fall in to a long period of depression.
Just take the long-term price chart of any sugar company and you will see. High stock prices in 2006, 2009 and 2016 and years of stagnating low prices in other years. I see that most sugar company prices have more than doubled in the last one-year or so. And now the sugar prices are moving up now. It is likely that the markets have anticipated firm sugar prices and stock prices moved up before the earnings did. If I scan the quarterly results, I see that the quarter ended June 2015 was particularly bad for the sugar companies. And most sugar stocks hit their recent lows in August of 2015. To buy then, one should have had the insight to predict that the worst was over. I, for one, had no clue.
The only way to take a call was to keep tracking the price to book value of the sugar company stocks. Taking a five to ten year history, there will be a trend in the Price to Book number. When it is near the lows, it is good to buy and exit when it is near to its historic high. Looking at the P/E ratios will put us away and make us buy at the wrong time. Share prices of commodity companies generally tend to turn lower from at round seven to ten times peak earnings. These are trading calls and can give great returns, if we follow a process and stick to it. I am using Price to Book simply because these businesses have universally available technology and there is almost no product differentiation.