If you are not comfortable investing in commodities, where one can take bets mostly through futures, investing in a 'related' commodity stock can be a good option. Data show that commodity price movements have a multiplier effect on related stocks. This means if a commodity moves up by, say, 10%, the stock of the company engaged in manufacturing or processing it rises by more than 10%.
This is because while the production cost remains the same, revenues rise (due to high commodity prices), increasing the operating profit (revenue minus cost), which in turn pushes up the stock price.
"Earnings of metal companies have a 1.5-1.8x sensitivity to metal prices," says Kishore Narne, associate director and head, commodity and currency, Motilal Oswal Commodities, says,
The commodity stocks we are talking about could be that of a mining or manufacturing company such as Tata Steel and Steel Authority of India Ltd (steel makers), Sesa Goa (iron ore mining), Hindalco, Nalco and Sterlite (aluminium mining), Cairn India and ONGC (oil & gas exploration).
Let us consider a company that makes 100 units of a commodity whose market price is Rs 5. Its total cost (fixed+variable) is Rs 2 a unit. The total operating profit is Rs 300 while the revenue is Rs 500. The operating profit margin (operating profit/sales) is 60%. Now, if the price of the commodity rises to Rs 7, the revenue of the company will go up to Rs 700 and operating profit (considering the cost remains the same) to Rs 500. The new operating profit margin will be 71%.
However, the reverse is also true. If the price of a commodity falls, prices of related stocks will go down more than that of the commodity.
"The relationship works both ways and this makes investing in commodity stocks a double-edged sword. However, disciplined investing can help investors reap the benefits," says Gopal Agarwal, chief investment officer, Mirae Asset Investment Managers. Gopal Agarwal manages a fund that invests in global commodity stocks.
The price of a commodity and its related stocks show a high positive correlation, which means the two move in the same direction.
Though commodity prices can impact a producing or processing company's stock price, they are not the only influence. Capacity utilisation, debt-equity ratio, valuation, government policies and corporate governance issues also have a big impact on stock prices.
Commodities and related stocks have a positive correlation, but other factors also affect the market, says Vikas Jain, AVP, retail research, Religare Securities.
"A lot of non-commodity factors such as valuation or price-earnings ratio, cost or capital structure (debtequity ratio), hedging policy and government policydriven tariffs or regulations can also affect the performance of stocks," says Kishore Narne of Motilal Oswal Commodities.
WHY STOCKS OVER COMMODITIES?
The reasons are many. The first is that retail investors understand stock markets better than they can make sense of commodities markets. In stock markets, they can buy and sell stocks at current market prices, without the trouble of taking the futures route, which entails predicting future prices. Without full knowledge, futures bets can lead to massive losses.
In commodities, most trading happens in futures. Commodity spot markets for retail investors are not well-developed in India. Also, trading volumes in most commodities exchanges are low.
Another risk is that futures trading is based on margins (taking higher bets by paying a part of the total price). In volatile markets, investors need to have the capacity to pay for margin calls to gain from the uptrend. Investors get margin calls from brokers if the value of one or more securities they have bought by paying a part of the money falls below a level.
Besides, the minimum amount that can be invested in commodities is high, beyond the reach of most retail investors.
Though exposure to commodities mutual funds is a good option, in India, the market regulator, the Securities and Exchange Board of India, does not allow mutual funds to launch commodity funds other than gold exchange-traded funds.