A goods way of investing

Commodities have outperformed stocks, their returns aren’t linked to other asset classes and they do well when inflation is high. R. Sree Ram assesses the potential of this avenue.

R. Sree Ram        Print Edition: October 16, 2008

A few months before his daughter’s marriage, 58-year-old R.K. Gupta liquidated some of his stock holdings and bought gold at Rs 10,000 per 10 gm. That was in December 2007 and by the time his daughter got married in February this year, the stock markets had crashed and the price of gold had shot up to Rs 12,000 per 10 gm.

This is not just a case of foresight and luck combining to give high returns. Gupta, a veteran equity investor, has systematically shifted a large chunk of his investments in stocks to the commodity markets after the equity markets hit a high in January this year. “Since the equity markets and commodity markets move in different directions, I not only managed to cushion my investments from the crash but also earned a decent return from commodities,” he says.

He is not alone. A growing number of investors is putting money in the commodities markets. The trend is clearly visible in the rising volumes on commodity exchanges. According to the Forward Markets Commission, the regulator of the commodities markets, the fortnightly trading volumes on commodity exchanges have more than doubled in the past year, from Rs 1,45,000 crore in August last year to Rs 3,01,000 crore in July 2008. “Though hedgers, traders and arbitrageurs are actively trading in commodities, a sizeable chunk of volumes is contributed by retail investors,” says Ashok Mittal, vice president and country head of Karvy Comtrade.

Srinivas M
Srinivas M., 32
Invests in commodities whenever he smells an opportunity

His research: A drop in turmeric cultivation in 2007 would lead to lower turmeric production and higher prices this year.

Investment: Bought two futures contracts of 10 tons each of turmeric at Rs 2,850 per 100 kg in January 2008.

Profit: Sold futures contracts at Rs 3,250 per 100 kg in April, pocketing Rs 80,000 in three months.

Madan Sabnavis
The factors that drive equities and commodities are different. One can invest in an agri-product even if the equities are down.

Madan Sabnavis, Chief Economist, NCDEX

Two crucial factors are driving retail investors to the commodities markets. Firstly, commodities are a standalone asset class. Their returns are not linked to the performance of other asset classes such as equities, debt and real estate. Experts advise investors to use commodities as a diversification tool. “Since it is impossible for an investor to time the market, the best way is to diversify his assets across investment categories. Commodities provide a good diversification option to reduce the investor’s overall portfolio risk,” says Anil Kumar, chief executive officer of the Birla Sun Life Asset Management Company.

It’s an asset class that is also not affected by macro-economic influences such as FII inflows. It’s the demand and supply of a particular commodity that define the investor returns. For instance, turmeric prices have shot up from Rs 2,850 per 100 kg in January to almost Rs 4,000 now, largely prompted by the fall in production this year due to reduced acreage. That’s a return of more than 40% in eight months. Sugar is another commodity that has given attractive returns of 34% in the same period. Compare this with the Sensex which fell by almost 30% during this time. “The factors that drive commodities and equity prices are different. One can invest in an agri-product even if the equity market is down,” says Madan Sabnavis, chief economist, NCDEX .

These stellar returns are no flash in the pan. Commodities have delivered decent returns even in the long term. In the past three years, gold and silver have generated a return of 20-30% per year, while commodities like pulses and oil seeds have earned annualised returns of 15-20%. That’s comparable with the 22.3% returns from the Nifty in the past three years.

Commodities also give superior returns in times of high inflation. Stocks do well when inflation is low because interest rates come down and fuel consumption demand. But when prices rise, the returns from stocks fall and commodities tend to give better returns. You can expect commodities to do exceptionally well when prices are high (see graphic, Hedge Against Inflation) or even when they are low and rising. Currently, in the Indian markets, the prices are high and rising, but commodities are doing well.

So, how do you go about buying commodities? It’s no different from buying stocks on the exchange. Only, instead of the BSE or the NSE, the trading happens on commodity exchanges like the National Commodities and Derivatives Exchange (NCDEX) and the Multi-Commodity Exchange (MCX ). “Trading in commodities is just like trading in stocks,” says Jayant Manglik, head of Religare Commodities. As in equities, commodity markets also offer spot deals as well as futures contracts.

For example, if you expect chilli prices to go up in November or December and want to profit from the rise, there are two options. You can either buy and horde chillis. That’s not very easy. Where will you store the stuff? What if it goes bad? How will you find a buyer? The other—and much simpler—option is to buy a futures contract of chilli for November or December and sell it when the price goes up.

Of course, it is not as simple as it sounds. These are leveraged trades and while your gains are multiplied by a factor of 10, so are your losses. For example, you can buy a chilli contract worth Rs 50,000 by paying just 10% of its value as the margin. If chilli prices rise by 2%, then the value of the contract becomes Rs 51,000. This means your investment of Rs 5,000 has earned Rs 1,000 or 20%. But remember, if the price falls by 2%, the contract value drops to Rs 49,000 and you lose Rs 1,000.

This is a 20% loss on an investment of Rs 5,000 and your broker will ask you to make good that loss or square the trade. So it is very important to understand the risks before you plunge in. It is equally important to do your homework before you buy. Read the relevant research material on a particular commodity and the factors that might cause the prices to change. Investing blindly on the basis of ‘hot tips’ is a recipe for a financial disaster.

A fundamental requirement is monitoring the demand-supply scenario of a commodity. If research shows a mismatch between consumption and supply in the future, prices are likely to move sharply. For instance, current indications are that the pepper prices may go up. The global pepper production has fallen from 3.62 lakh tonnes in 2003 to 2.71 lakh tons in 2007 and no improvement is likely in 2008 and 2009. “Pepper exports from India rose by 22% in 2007-8 compared with the previous year. This has lowered the pepper stocks and the prices could move up by 15-20% in the coming quarter,” says Kuljeet Kataria, vice-president at Motilal Oswal Commodities.

You can also diversify into commodities by buying commodity stocks or through mutual funds, which primarily invest in such companies. “Mutual funds allow the retail investor to profit from the commodity market and benefit from the expertise of professional investment analysts,” says Kumar.

Moving unlinked

Commodities are not linked to other assets.
A low correlation with debt, real estate and
stocks means commodities can go up even
if prices of other assets are down
— 0.22 Debt0.54 Real estate0.21 Stocks
 Figures are correlation of ING OptiMix Commodity index with other assets between Oct 2001 and Jun 2008

 

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