Commodity price recovery provided strong visibility on the earnings of commodity companies for most of 2009.
S. Hamsini Amritha
Riding the global revival theme, commodities were early movers in the concerted rally in global asset prices in 2009. Stimulus spending being the key trigger for the global economic recovery, commodities (mainly, industrial commodities) scripted a strong comeback story from their lows of last year.
Alongside this, the prospect of supply shortages helped agro-commodities such as sugar, rice, tea and coffee record impressive price appreciation in the last twelve months. This leads to the questions: Should an investor looking to play the revival bet on commodities or on stocks of companies processing the commodities? Would holding a stock like Sterlite Industries be a better bet than buying copper? Commodity stocks have won hands down during the recent rally; but investors need to know there are exceptions too.
Stocks outpace commodities
In most cases, commodity stocks beat the underlying commodity in terms of returns in the 2009 rally. Sesa Goa delivered a return of 350 per cent, against a 67 per cent rise in iron ore prices; Sterlite Industries rose two-fold, while copper prices on the LME increased a lower 133 per cent. Most Indian sugar stocks outpaced the 121 per cent rise in global sugar prices over the past year.
There are two reasons for this. One, even as most sectors faced difficult times last year, the commodity price recovery provided strong visibility on the earnings of commodity companies for most of 2009. This allowed stock prices to catch up with and outperform the underlying commodity pretty quickly.
Two, it is low PE stocks that led the recent market rally. After the battering in 2008, commodity companies led the list of low-PE stocks during the market lows of late 2008 and 2009. The combination of improving earnings outlook with the stock market rally made the rebound in commodity stocks stronger than that in other sectors.
When commodity prices recover from their lows, earnings of commodity companies can expand manifold; the combination of improving earnings and lower valuations can obviously deliver a strong boost to stock price returns. Some good examples for this are tea and sugar stocks.
For instance, while tea and sugar prices were up 21 per cent and 121 per cent in the global market since January 2009, stocks such as Jay Shree Tea and Shree Renuka Sugars appreciated by 350 per cent and 220 per cent respectively over the same period.
Thanks to capacity additions and a sharp rise in domestic sugar prices, Shree Renuka Sugars has managed an over 70 per cent growth in net profits on a 150 per cent expansion in sales for the year ended September 2009.
With sugar prices continuing to head up, the stock's PE too has improved from around 13 times (trailing 12 month earnings) to 33 times between last January and now.
Such trends are, in fact, mirrored by most Indian sugar stocks, though the re-rating has been slower for companies with higher debt on their balance-sheet.
While stocks of most commodity processors outpaced the underlying commodity in the rally, the trends during the earlier meltdown were more divergent.
Divergent trends in a fall
As commodity prices peaked and then went into a free fall between July and December 2008, the Hindalco stock fell more than aluminium prices on the LME (60 per cent decline against 48 per cent), and most sugar stocks underperformed sugar prices.
If you perceive a weakness in commodity prices, sell the stocks with weaker financials first — that seems to be the key lesson for investors from this trend.
The prospect of lower volume sales with a cut in realisations seems to be the key trigger for the sharper falls in these commodity stocks. However, the exceptions to this trend were such stocks as Sesa Goa and Sterlite, which fared better than the underlying commodity. Reasonable volume growth for Sesa Goa, low leverage and good cash coffers for both companies appears to have aided performance during the commodity price meltdown.
Take the case of Sterlite Industries. Its consolidated profits grew at an annual rate of 40 per cent till FY07. Though this saw moderation in FY08, the company still managed to expand its profits by 19 per cent in FY09.
As a result, though its stock price fell by 59 per cent between July and December 2008, it was quick to bounce back from January 2009 and the stock has since posted 217 per cent returns.
On the other hand, Hindalco, with its prospects heavily hinging on its Novelis' operations, took a while to catch up in the stock market.
Hindalco's consolidated net profit for FY 09 declined by 22 per cent, while until that fiscal the company had notched up a 30 per cent profit growth.
In general, companies which have posted strong sequential profit growth have seen better returns in the stock market as well. For example, Sesa Goa, Jay Shree Tea, Hindustan Zinc and Shree Renuka Sugars lead the list of top performers, while Balrampur Chini, Bajaj Hindustan and Hindalco are at the bottom end.
VALUATIONS run ahead
Both in the meltdown and the rally of 2009, stock prices for commodity companies tended to anticipate the earnings picture well in advance. PE expansion in this rally has preceded an actual improvement in earnings for most commodity companies.
The PE multiples of Hindustan Zinc, Sterlite Industries Sesa Goa and Jay Shree Tea are currently at 20 times, 14 times, 16 times and 32 times respectively.
The extent of re-rating enjoyed by them is clear from the fact that the valuations for these stocks were at 3, 4, 2 and 7 times respectively in January 2009.
Commodity stocks have always traded at a discount to the BSE Sensex and that continues today as well, though the discount to the Sensex widened during the fall and has narrowed during the recent rally.
With a strong turnaround coming through in their earnings, valuations for commodity stocks may head lower in the forthcoming quarters.
Indian angle
One important facet of the recent rally in commodities is that, despite stronger domestic demand, prices of commodities in India have tracked global price trends.
According to latest figures published by International Aluminium Institute, the world aluminium market saw a 9 per cent decline in production of the metal, while the Indian market grew 16 per cent in January-December 2009.
Despite this, spot prices of aluminium at India's MCX and the LME went up by the same extent — 45 per cent.
However, Indian commodity stocks tended to outpace their global peers in the 2009 rally, probably a rub-off effect of the Indian stock market doing much better than the world markets.
Even global mining majors, such as Alcoa and BHP Billiton delivered much lower returns than the home-grown Hindalco or Sesa Goa in 2009. The more uncertain global demand outlook and excess capacities owing to their aggressive expansion just before the commodity bubble dampened earnings prospects for some of the commodity giants.
With the Indian economy on a strong growth path, volume growth at least is not a challenge that many commodity processors are likely to face in the coming quarters.
Happy Trading,
United we grow!!!
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