Commodities are back in the news and metals are clamouring for attention. It's hardly a surprise, what with the BSE Metal Index delivering a return of 54 per cent between June 2009 and June 2010. It's a stupendous rise since 2008, when the index lost almost 75 per cent of its value due to the downturn. Compare this with the measly 2 per cent return delivered by the BSE Sensex during the same period.
If we consider specific metals, the best performer in 2009 was copper, which saw its price increase by 120 per cent, followed by zinc, with a 99 per cent appreciation, and aluminium, with a 56 per cent rise. As for the Indian companies, the price of Sterlite Industries rose from a low of Rs 275 to Rs 850, while Hindustan Zinc gained 2.5 times its value during this period.
Although this is good news for investors, they must remember that the metal sector is far more volatile than the broader market. "Metals have a high beta correlation with the markets and upside or downside movements are volatile," says Mayank Shah, CEO, Anagram Capital Ltd.
In fact, the index's performance has been nothing short of a rollercoaster ride this year. After its value increased thrice in 2009, metal stocks halted their rally in January 2010 owing to a major sell-off in the commodity markets. At the same time, US President Barack Obama's proposed reform on limiting investment by US banks affected the commodity prices. However, the prices continued their upward journey till April 2010 due to the excise duty hike on steel products, substantial increase in prices of raw materials and supply constraints.
In the past few months, there has been scepticism about the demand for metals. There has also been speculation about how companies will deal with the new economic environment—stronger dollar, tightened global monetary measures and the uncertainty in Europe. The prices of most base metals, such as zinc, aluminium and copper, have fallen by 20-40 per cent, says Paresh Jain, analyst, metals & mining, Angel Broking. According to Shah, metals were a proxy for dollar, but now that the latter is appreciating, there is likely to be a shift back to the currency and the reduced weightage could keep the upside capped. Steel prices have already fallen by Rs 3,000-4,000 per tonne in the domestic market.
"The European crisis has had a major impact on investors in base metals, not so much on steel players," says Tarang Bhanushali, metal analyst at IIFL. This is because the profitability of base metal companies is proportional to the London Metal Exchange prices, which is driven by liquidity rather than fundamentals, he adds. Due to the liquidity crunch and an increase in lending rates, there has been some sell-off in this space. The impact on steel companies is lesser as India is a net importer and the domestic demand is adequate. The only concern is China, which dictates the prices because it consumes and produces 50 per cent of the steel.
Future for metal stocks
Typically, metal prices are driven by capacity utilisation among producers, that is, the demand for the metal. There is no doubt that the global economy has improved, given the GDP and the Index of Industrial Production (IIP) figures. In fact, the demand for steel and aluminium is strongly correlated to the IIP growth, which will support the demand for metals globally. Further, the short-term effects of a weak monsoon and the rollback of stimulus could be offset by the thrust on infrastructure development and the structural rise in domestic savings.
The domestic demand for steel and aluminium, which grew by 8.9 per cent and 4.8 per cent, respectively, in 2009, is expected to accelerate by 12.1 per cent and 11.3 per cent, respectively. Jain is particularly positive about Indian steel companies, such as JSW Steel, as they do not have to rely on imports owing to their strong domestic operations and captive iron ore units.
Jain also expects the surplus in zinc to decrease in the domestic market, which augurs well for Indian companies. The global usage of zinc is expected to grow by 11.9 per cent and the global surplus to decline by 40 per cent in 2010. Bhanushali favours copper due to its advantageous demand-supply economics compared with its peers, which allows the price of copper to bounce back early. But as there are no copper producers, he advises investing directly in the commodity. However, it may not be such a good move for long-term investors as it requires a lot of money and the price movement could be huge in either direction.
Though the sector provides good investment opportunities, these should be considered only if you are willing to stay and ride the volatility. Considering the high beta correlation, Shah recommends an allocation of not more than 10-15 per cent of one's portfolio. In fact, most of these stocks bear the risk of weak metal prices and adverse exchange rate movements. Specifically, Hindalco faces the risk of delay in completion of expansion projects. The biggest risk for Tata Steel is a slowdown in economic activity. Since 75 per cent of its revenue is from overseas operations, the European economy governs it. Thus, the stock may not be ideal for a short-term investment, says Jain. Although the management had indicated that steel consumption in Europe was expected to grow by 15-20 per cent in 2010, construction activity in Europe is currently weak.
Analysts believe the correction is mostly over and that metal stocks could be on an upside, especially as they are cheap on valuations. However, Europe is a big risk. A double dip recession and a slowdown in China could pressure metal prices in the second half, leading to lower earnings on a year-on-year basis and a price correction. Watch out for PMI, the leading indicator for investment in Chinese infrastructure. Also, one should keep tabs on the bailout packages in Europe. Ideally, you should allocate 25 per cent of your investment to metal stocks at current levels and the rest based on calculated dips, says Bhanushali.
