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The rise of commodities

The revival of the world economy and industrial demand have boosted commodity prices. This trend will continue in the coming years, say experts.

R. Sree Ram        Print Edition: November, 2009

There are many lessons to be learnt from the 2008 crash. Equity markets went into a tailspin. Even the less volatile real estate prices came under pressure as there were few buyers left in the market. Sales plummeted because the uncertainty made consumers jittery.

Amid the gloom, one asset class weathered the downturn better than others. The prices of agricultural commodities did not fall with the same intensity as equity markets and real estate. The MCX Agri Index, which has items such as potato and gram as its constituents, lost only 18% in 2008 against a 52% drop in the Sensex.

This huge difference in losses highlights the benefits of diversification. The value of Rs 100 invested in the Sensex stocks in January 2008 would have dropped to Rs 47.50 by the end of the year. If this investment had been split equally between equities and agri commodities (Rs 50 each in the Sensex and the MCX Agri Index), its value at the end of the year would have been Rs 64.60.

The diversification helped curtail the losses by spreading the risk across asset classes that are inherently different in nature. The prices of agricultural commodities are driven by the demand and supply equation and are completely unconnected to the broader financial markets. A bumper harvest of a certain crop will lead to lower prices, while a shortfall in production will cause prices to shoot up.

For instance, while the Sensex lost 52% in 2008, turmeric prices shot up 44% due to lower production. Ditto for sugar, where prices rose 35% last year following a drop in cane acreage. The same goes for other commodities such as metals and cement.

Cyclical Movement
Commodity prices are usually cyclical and follow a certain trend over a period. The length of the cycle differs depending on the production dynamic of that commodity. For instance, researchers at the Domestic and Export Market Intelligence Cell of Tamil Nadu Agricultural University have found that turmeric prices move in fiveyear cycles. Meanwhile, analysts at Prabhudas Lilladher say that sugar prices move in 2-3-year cycles. According to a study conducted by ING Asset Management Company, commodities typically follow 13-14-year cycles. “The latest growth started around 1999 and could see higher demand growth till around 2013,” says the report.

The recent data on commodity prices buttresses this argument. The prices of major commodities such as crude oil, steel, sponge iron, zinc and copper bounced back as demand from industries and consumers picked up. Crude oil has risen 55.58%, zinc by 75.05% and copper by 93.19% so far this year. This is a welcome sign because just a year ago, analysts were contending that there would be a prolonged downtrend and a slow recovery in prices. “Most businesses are definitely on the revival path. Commodities may go up in the medium term,” says Saurav Arora, senior vice-president, Jaypee Capital Service. The revival in business environment has pushed up the MCX Spot Metal Index by 41% since 1 January 2009.

Investing in Commodities
However, when it comes to benefiting from such a rise, the Indian investor has limited options. For one, an individual cannot invest directly in commodities for the long term because there are no such products for retail investors. Commodity markets only offer short-term forward contracts. These leveraged products require an in-depth research and can be risky for small investors.

If you are looking to invest in commodities for the long term, you could buy mutual funds that invest primarily in companies in this space. Some of these funds include Birla Sun Life CEF-Global Multi Commodity Fund, Mirae Asset Global Commodity Stock and the ING Optimix Global Commodities Fund. You could also buy commodity stocks directly. In an economic upturn, commodity stocks perform better than the broader equity markets. According to research by ING AMC, between June 1995 and June 2008, a basket of diversified commodity stocks earned annualised returns of 18.4%, while the Nifty yielded 11.7% during the same period.

Should you Buy Now?
Is this a good time to buy commodity stocks? No. It isn’t due to the gloomy outlook, but because valuations are stretched right now. Experts are advising against buying at current levels as they believe the commodity stocks have run ahead of their fundamentals. Sensing the recovery in metal prices, the BSE Metals Index has surged 226% since mid-March this year. The 103% rise in the Sensex appears muted in comparison.

Analysts suggest that investors wait for the market to correct. “Many commodity stocks have run up too fast, discounting a lot of positives that may happen in the future. Some correction in the near term can be expected in commodities. One should wait for a correction before going long on commodities,” says Saurav Arora of Jaypee Capital Services. “On any correction of over 20%, one can look to buy them again,” says D.D. Sharma, senior vice-president, research, Anand Rathi Financial Services.

If it were not for the stretched valuations, commodity stocks would be a good buy because all fundamental factors point to a rosy future. The Chinese economy is consuming more commodities, improving the outlook for metals. Back home, the industries that use metals such as auto, consumer durables and real estate, have bounced back, leading to a strong demand for metal products.

Economic Revival
There’s good news flowing in from other parts of the world as well. Economic indicators from the developed and emerging countries (major consumers of commodities) are pointing towards revival in business activity. “The global economy appears to be expanding again, pulled up by the strong performance of Asian economies and stabilisation or modest recovery elsewhere. As prospects have improved, commodity prices have staged a comeback from the lows reached earlier this year, and world trade is beginning to pick up,” says the IMF’s World Economic Outlook report.

According to the IMF, the rebound in manufacturing is due to the stabilising retail sales, return of consumer confidence, firmer housing markets and a turnaround in the inventory cycle. The agency is projecting the global economy to grow at 3% in 2010 as against the 1% contraction in 2009. It forecasts a 4% plus growth rate from 2010 onwards. China, the world’s leading consumer of commodities, is expected to grow at 9% in 2010. For India, growth projections are pegged at 6.4%. “There will be a revival in global metal prices in tandem with the economic recovery that is under way,” says Hitesh Agrawal, head of research, Angel Broking.

As mentioned earlier, cyclical stocks tend to outperform in an economic upcycle. So if the IMF’s projections of 4% plus growth during 2010-14 come true, commodity stocks, if bought at low prices, will turn out to be multibaggers. “The increase in cost of production is very low when compared with the increase in product prices, leading to exponential gains for companies,” says Arora.

Steel and aluminium are the only two metals that have a significant representation on the Indian stock exchanges. There are 33 iron and steel companies and 18 aluminium companies listed on the Indian bourses. Cement is another commodity having a sizeable presence, with 66 cement companies listed on exchanges. However, investors don’t have too many options when it comes to other commodities because there are very few public companies in these sectors.

Steel has a bright future in a flourishing economy. In 2008 and early 2009, steel producers across the globe aggressively cut capacities and inventories to cope with falling prices and demand. The World Steel Association (WSA) had, in April 2009, forecast a 14% fall in steel demand this year. However, sustained demand from China and the user industries has reversed the trend in the second half of 2009.

As a result, the WSA has now revised its forecast and expects the demand for steel to fall by 8.6%. Analysts say that steel production in 2009 will be close to 1,136 million tonnes, while consumption will be 1,171 million tonnes. The small shortfall will be met by inventories that were piled up last year. The industry is expected to gather pace from 2010 onwards, when consumption is estimated to grow by 5% to 1,229 million tonnes. This increased demand will allow the industry to hike production by 8% next year. “The Indian steel sector has been one of the best performers due to a lack of surplus capacity and a strong rebound in demand,” according to a report by Macquarie Research.

Among steel stocks, Tata Steel is the most preferred by analysts. The company is in the midst of restructuring and expects to reduce fixed costs and improve realisations by closing down high-cost facilities. Apart from this, Corus is expected to improve utilisation rates due to a rise in sales volumes in key markets. Volumes in the UK and the Netherlands increased 23% in July. Due to its low valuations and high leverage, Tata Steel is expected to benefit the most from the rebound in prices and volumes. “Tata Steel is restructuring while JSW is growing fast. They remain our top picks. SAIL remains an underperformer due to its high cost structure and possible negative surprises,” say analysts at Macquarie Research, who have set a target price of Rs 584 for Tata Steel.

Aluminium too has seen a sharp revival in demand from user industries and aluminium manufacturers are poised to resume the high growth path from next year. Globally, key aluminium consumers such as the auto, construction and packing industries, have witnessed a growth of 2.5-4% during the past three-four months. Analysts expect the global demand for aluminium to grow by 13% in 2010. This bodes well for an industry which was forced to cut back on production due to the depressed demand last year. Global production of aluminium is expected to fall this year too, from 39.5 million tonnes in 2008 to 37 million tonnes. However, growing demand and falling inventories will make companies increase production levels to 40.7 million tonnes in 2010 and 43.5 million tonnes in 2011. “We estimate a long-term aluminium demand growth rate at a conservative 4.5% per annum. We expect the 2010 global demand to grow 13% year on year, and yet remain around 9% below the longterm potential,” say Prasad Baji and Manan Tolat, analysts at Edelweiss Research.

Hindalco and Sterlite Industries are the most preferred stocks in the aluminium space. Hindalco will be the biggest beneficiary of the rebound in aluminium prices. Triggered by the strong demand in China, aluminium prices have seen a sharp rise of 45% from their lows. Hindalco’s low-cost production and its leadership in downstream products will help improve its realisations substantially. Analysts at Antique Stock Broking expect Hindalco’s domestic operations to post a 23% average annual growth over 2010-12. Also, Novelis is expected to turnaround in 2010-11 on the back of cost-cutting measures, improved demand environment and stable metal prices. “Cost competitiveness and high leverage to metal prices make Hindalco an attractive proposition in the current environment. Novelis’ short-term risk in terms of earnings and cash flow offers a favourable earnings proposition in 2010-11,” says Sumeet Singhania, analyst at Antique Stock Broking. Singhania has arrived at a sum-of-the-parts valuation of Rs 127 per share while Kotak Securities has valued Hindalco at Rs 135.

Sterlite Industries is another beneficiary of the rebound in metal prices. According to analysts, the company has multiple triggers, including volume growth in the zinc and aluminium businesses, and commencement and scaling up of the power business. “Led by our revised aluminium and copper price forecasts, we upgrade our 2010-11 financial years’ EBITDA and EPS by 13.7% and 13.9%, respectively,” say Baji and Tolat. They have arrived at a target price of Rs 849 per share.

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