Investing in commodity stock is a dreaded topic among investors. Why should not it be? Given the unpredictability of earnings, it requires very attentive investing.
Before we get into investing in commodity business, I would like to explain you what are commodity stocks or commodity business.
Commodity business are those where the company’s main source of revenue are the products for which they can not set prices on their own but are dependent on external factors to decide their product prices.
How to invest in shares of Commodity businesses?
What is a Commodity business?
A commodity business is one where the prices are set by international trend & to a very limited extent by domestic trend.
In simple words, the company does not have the ability to price its products but rather to sell products depending on prevailing prices in the market.
Let me give you a few examples of such commodity business: Steel, Aluminium, other metals, Sugar, Petrochemicals, chemicals, paper, Cement etc Investing in commodity business
How does commodity business work?
If {Raw material cost + employee cost + power cost + other expenses} of a unit <Selling price of the product, the business would be sustainable. Higher the selling price, higher will be the profits.
If, {Raw material cost + employee + power + other expenses} of a unit > Selling price of the product, the company will go into losses and make the business unviable. If the prices of product persist to be below cost of production, the company’s or plants gets shut.
Because of the low demand of graphite electrodes,(since China was expanding steel production through Blast furnace route (till 2010) & not via EAF route where graphite electrode find usage), the prices fell below the manufacturing cost and persisted over a long period, during which lot of facilities got shut.
When the commodity price increases, the expansion in the profit margins are quite remarkable. When the price increases, revenue increases( Volume * New product price) Since, in terms of cost only the raw material cost will change to certain extent but all others remain the same.
How to invest in shares of Commodity businesses?
How can commodity business differentiate?
Since for commodity business, the end product selling price is more or less similar for all the companies, the differentiation comes from being a lower cost producer.
How can a company become lower cost manufacturer?
1. Bringing efficiency in manufacturing process
2. Replacing outdated machinery
3. Low to almost no debt
4. Captive power generation
5. Higher asset turnover
6. Lower logistical expenses
In terms of lowest cost manufacturer, we have Maithan Alloys in Ferro alloy segment, Bhansali Engg polymers ltd(BEPL) in ABS segment.
If you are aware of any such companies please type in the comment section.
How to invest in shares of Commodity businesses?
Why are commodity businesses are cyclical?
When the prices of product increases, so does the profitability of such companies. Extrapolating the present, management starts expanding capacities(human psychology). With additional capacity, supply increases.
When Supply > Demand, prices start dropping and at certain point it becomes unviable to operate.
During the golden economic boom all across the globe between 2003-08(China growing at more than 10%+ gdp), the steel prices reached a high of $1000/T compared to a average between$400-$600/T, thus multiplying the profits.
It was thought that these prices will keep growing or atleast stay at the same level, that lead to mindless expansion by many steel companies in India such as Essar Steel, Bhusan steel etc. which failed to accept the cyclical nature of commodities and now are into bankruptcy.
Commodity prices 1996-2012 Source:http://aacemahakam.blogspot.com/2012/10/w10tri-hot-rolled-coil-steel-in-gold.html
Investing in Commodity Business
Inventory problem
Commodity business contracts are usually a mix of short term and long term ones. Short terms are the ones derived using formula with the spot prices(current price) whereas the long term contract are from a few months. Mostly it is of spot in nature.
Almost all commodity companies keep inventory on the basis of expected demand in the short term. If there is a festive season in the near future, plastic manufacturers will keep a lot of inventory in anticipation of the demand.
If there is sudden drop in product prices, the company would have have to sell the products at the new prices(short term contracts) whereas the inventory that the company has will be of higher cost(higher cost of raw material when the product price was high). This gets normalized when the higher cost inventories are exhausted and it typically takes 2-3 quarters.
If there is sudden upmove in the product prices, then the profitability gets positively impacted.
Here is a article talking about high cost inventory problem for JSW Steel.
Chaitanya Dalmia, a well-known investor in the book “Masterclass with Super Investors” , points out that FMCG companies can at max raise their product prices by 5-6% per annum, thus taking 10 years to double the price whereas in commodity business, prices can double in a very short period of time. It can crash pretty quick as well. So, if you get the timing right, a lot of money can be made in a short period of time.
They have the following checklist:
1. The company should not be going bust
2. Their balance sheet are not damaged beyond repair
3. The company should be making some money even in bad times
4. The company’s valuation should be pricing in the current earnings and not the good news of the future, in particular if it is available at 0.5 times P/B value.
In a commodity business, the Price to earning ratio expansion(that stock price increase) comes close to peak on the cycle.
Investing in Commodity Business
Most of the commodity business does well when the global economy is also doing good. That would mean more demand for the products. Steel does well in similar situation as growth is synonymous with infrastructure spending where steel finds its usage.
The problem is that one needs to a very good knowledge of the commodity and the factors impacting its demand-supply.
Sometimes, the elevated pricing for certain commodities might be just for a quarter or half year. And many may consider it to be of longer period, in particular that of chemicals. This usually is caused by temporary closure of a plant which affects demand-supply equation.
But in terms of metals such as Steel and aluminum, the cycles are much longer and and predictable to some extent. AND THE BEST TIME WOULD BE TO BUY WHEN THE COMMODITY PRICES ARE DEPRESSED, AS IT ONLY LEAVES ROOM FOR UPWARD MOVEMENT.
Also, shares of such companies can give a handsome return within a short period or can bring down the investment amount even more. Given, the unpredicatibility of earnings of commodity stocks, it is very difficult for them to be a multibagger stock. Only Shree Cements Ltd and Avanti Feeds which are in a commodity business has been a multibagger. Investing in commodity business
Commodity stocks perform the best towards the last leg of the bull market rally when all the global growth seems and demand for these commodity products reaches its peak outstripping supply, thus pushing the prices upward, hence the company’s profitability and the share prices.
Resources to track commodity prices
Updates on chemicals & petrochemical prices:
Steel Prices:
Commodity specific to India:
Here, goto the bottom of the page. Click on search data. Then do (Ctrl+F), and type in what you are searching for.
Metal prices: