If you buy commodities, know when to sell them

The performance of corporate India, in aggregate, for the listed universe, is not very encouraging. But different companies have different stories to tell. This is a market where tall tales find ready acceptance and helps someone to make a ‘buy’ decision. The latest reports are quite encouraging. It tells us that the NIFTY companies managed to increase their earnings by nearly twelve percent. This is surely an excellent number.

If you look at various NIFTY indices, each of them shows different valuation. This clearly tells us what is happening and that too in the mid cap space. And the numbers probably hide the growth expectations behind the valuations.

Let us take the example of a sector like “Metals”. After a few dismal years, thanks to China, the sector is seeing a twin barreled growth. A domestic thrust on infrastructure which pushes the demand and a lull in the China output which gives pricing power to the domestic producers. These result in some spectacular growth in profits on the back of some dismal past. Naturally, this exuberance pushes the prices of stocks and the valuation numbers do not tell the story. For example, if a company was having an EPS of 2 rupees, and the quarter ending September shows an EPS of 4 rupees, the index measures etc do not tell the facts. The historical PE will still be based on the EPS of 2 rupees for last year. On the other hand, the investors have already put in their estimates (say 10 rupees for this year). This probably explains the dichotomy.

However, what is genuinely a matter of concern is the exuberance of expectations. This growth from a supine position to a standing position, cannot be extrapolated in to the future.

Commodities go through price cycles. No one can predict the highs or the lows. In general, there is global overcapacities across commodities, with China being the fulcrum. China’s output and demand make a huge difference. In addition, many commodities, being natural resources, face environmental issues as well as regulatory issues in different countries.

We have seen commodity companies making losses, defaulting on their loans and then coming back in to prosperity. What happens is that somewhere, someone gives up something and the notional number of ‘capital employed’ shrinks. The earnings probably suffice to service this lower number. The other thing that happens is that a favourable price movement and a higher capacity utilization both add to the profits number. A potent combination, where the first change from a poor financial health suddenly transforms to something shining.

Once the prices go up (at best case a two year window) and new capacities do not come up, the returns continue to be high. Regulatory actions, tariff barriers all come in to play and knock the earnings back. The only permanent gain that remains is the lower notional number of “Capital Employed”.

Thus, the earnings growth, after the first blush will taper off. At that time, debate on valuations will start. Till then, enjoy the ride. Knowing when to get off a moving train, sometimes becomes important, when we play the commodity stocks. (The writer is a veteran investment adviser. He can be reached at balakrishnanr@gmail.com)