What you need to know about the commodity cycle - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

What you need to know about the commodity cycle 

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In this issue:
» Govt plans to plug loopholes in FDI norms
» Cos to face heat of the new drug policy
» Japan's economic policy is revolutionary: PIMCO
» US may be downgraded: Moody's
» and more....

Commodity prices influence us in more than one way. As consumers, we are interested in commodity prices because of their link to inflation. Higher prices lead to higher inflation and therefore a larger hole in our wallets. But commodity prices are of utmost concern for investors too. Allow us to explain how.

Commodity prices have a strong link with inflation and economic growth. When prices are high, there is inflation which in turn forces the Reserve Bank of India (RBI) to adopt a hawkish stance. When prices ease, the reverse happens and we can expect the RBI to cut down on interest rates. This in turn boosts investments in the economy which then leads to higher economic growth.

This is the macro picture. But even for individual companies, commodity prices have a direct impact on their profitability. Higher prices lead to higher material costs. Like we saw till last year, higher commodity prices had led the margins of most companies to come under pressure. Things become worse in the event of economic slowdown. Because then the companies are unable to pass on the increase in costs to the customers. As a result margins come under pressure. But the companies in the basic material industry have a ball during commodity booms. Obviously they are the only ones who pray for higher commodity prices.

So far we have established that commodity prices have an impact on us. Both as consumers as well as investors. This leads to the question as to what is happening with the commodity prices. Till recently the prices of nearly every commodity were raging high. A big reason for this boom was the stellar growth seen in resource consuming nations especially in China. The dragon nation was a glutton for commodities and this led international prices to soar up. But in recent times the country has seen its growth slowdown. This in turn has had an adverse impact on the demand for commodities. And as such commodity prices have eased. The question now is whether this is the end of the commodity boom cycle. Will prices now remain at lower levels? Unfortunately, there is no definite answer to this. If global macro conditions continue to remain subdued then we can expect prices to remain under pressure.

Therefore what is it that one needs to do as an investor? The answer to this is to focus more on the bottom up stock picking and stick to one's core competence. If one is unable to predict the direction of commodity prices with a great degree of assurance, efforts should be diverted towards looking for companies that have a sustainable competitive advantage, strong fundamentals and robust management. Because these are the companies that will be best positioned to deal with whichever commodities prices come their way. And if they are available at cheap discounts then it presents good opportunities to buy them rather than wait for higher commodities prices to cool down.

Do you think that it makes sense to predict commodity cycles when it comes to stock picking? Please share your comments or post them on our Facebook page / Google+ page

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01:15  Chart of the day
Through the dawn of the global crisis, India had been able to dazzle the world with its stellar economic growth. But things have changed. High inflation rates, RBI's hawkish policy and lack of policy reforms led growth to dip. The fiscal year 2013 saw growth come in at less than 6%. Though the outlook for 2014 is better; however, it is not much better. As shown in the chart the various forecasts for India's growth range from 5.8% to 6.7%. Not one thinks that India can grow at over 8% like it had done in the past. Things have definitely improved when compared to where we were last year. Inflation has eased off. This has made RBI adopt a more liberal stand and roll back interest rates. The government seems to be working on reforms albeit in a small manner. But a lot more needs to be done. Most importantly the government needs to work towards restoring investor confidence in the country. Only that will help boost investments which are needed to spur growth.

Source: Financial Express
PMEAC - Prime Minister Economic Advisory Council
NCAER - National Council of Applied Economic Research
ADB - Asian Development Bank
IMF - International Monetary Fund

There are two ways to get control over a company. One is to buy a majority stake in the company. And the second one is to get access to management control via getting board seats. This can be done by getting majority of the board seats. Since now you have the majority in board seats you can influence the decision making of the company in an indirect way though you are not a majority shareholder.

Until now, this second way was used by minority foreign investors to gain backdoor entry into Indian markets. Say for example that foreign direct investment in a particular company was limited to 50%. The foreign partner in this case can stay within the defined limits and at the same time have the right to appoint majority of the director's board. In this way, he can influence the decision making of the company. This gives him greater control over the company. However, the government has decided to plug this loophole. As per the new guidelines, the definition of control has changed. It is not only limited to stake acquisition. Gaining indirect control over board comes within the purview of control. This change in definition will prevent the misuse of guidelines that happened earlier.

Generally speaking, we do appreciate the macroeconomic views coming in from Pimco, the global investment firm. Co-founder Bill Gross and CEO Mohamed El-Erian often share interesting insights on the global economy. In fact, they have been quite vocal about their criticism of reckless monetary policies. But we came across an article in Moneynews that really shocked us.

Apparently, EI-Erian is quite impressed with Japan's quantitative easing (QE) program. To give you a gist, the central bank of Japan has pledged to double its monetary base. In other words, a lot more money printing than what even the US did. El-Erian has hailed it as a revolutionary economic experimentation. And he believes Japan's easing is a high-risk, high-reward effort. Just to recall, a year ago the gentleman had criticised US's QE3 program. What makes him optimistic about Japan's plan? We have no clue.

We believe such excessive doses of cheap money are akin to booster drugs. They may temporarily lift up the economy. But they don't change the long term economic fundamentals. The eventual side-effects of such drugs can cause irreparable damage to an already ailing economy. As such, we do not at all share El-Erian's enthusiasm about the Japanese monetary easing program.

Pricing of drugs in India has always been a bone of contention between the government and pharma companies in the country. The government's rationale has been to make medicines more affordable to the public. Many of the pharma companies believe that too much of price control tends to hamper profitability. But in the latest such move, the government has gotten the upper hand. The new drug pricing policy is all set to come in force. Accordingly, 348 drugs will be brought under price control. This is unlike the earlier scenario when only 74 drugs were regulated. It is expected that this policy will result in the price of certain essential medicines reducing by as much as 80%. The extent of impact that this policy will have on pharma companies will depend on the product portfolio and business model of each player. Having said that, MNC pharma companies will certainly get impacted more than their domestic counterparts. For starters, most MNC pharma medicines tend to be priced at a premium and this will now have to come down. Secondly, MNC pharma companies are entirely focused on the domestic market. Whereas for Indian pharma companies, the Indian market forms only one chunk of the total revenue pie. They have considerable revenues coming from the exports markets as well. What seems sure is that the Indian consumer will certainly benefit from lower drug prices.

If you think ratings agencies have the ability to move markets, here's a piece of news for you. Moody's has warned that US faces risk of downgrade if it does not outline plan to check its burgeoning debt burden. Moody's is happy that the US Government is projecting for lower deficits going forward. However, it believes that more needs to be done on the policy front.

It should be noted that another ratings agencies S&P had cut the US ranking from AAA to AA+ in August 2011. But here's the interesting part. Rather than sending the yields on US debt soaring, the cut took them to new lows. The episode proved that markets have their own way of analysing things rather than going by what ratings agencies say. In any case, these agencies proved hopelessly inadequate in reigning in the previous financial crisis. In fact, it is their connivance that played an important role in the crisis bubbling up to unprecedented levels. Little wonder, their credibility has suffered a serious setback.

What do you think of a business deal that offers upfront payments for services to be rendered? That puts the service provider in a position of very comfortable liquidity. More so, if the payments are several times the value of services actually offered. Well, the deal is compelling indeed. And brokerages that have devised such a 'package' to lure unsuspecting clients are rubbing their hands in glee.

Now, brokerage revenues do depend on the number of times clients trade. Hence irrespective of whether the client makes money on the trades or not, brokers insist on trading more often. Hence the prepaid package is devised in a way that it prompts the client to trade maximum number of times. The package requires investors to make a one-time upfront payment to the broking firm for subsequent trades. In an instance cited by Business Standard, the prepaid fees were so high that the client would have to multiply his trading volumes several times to use up his deposit. Moreover, there is mis-selling here as well. Clients are made to believe that the upfront fees will cover cost of purchase of stocks, which is anyway not the case.

So please beware of such unscrupulous schemes! Also, the next time your broker asks you to trade more often, ask him how it will help your portfolio.

In the meanwhile after opening the day on a positive note, Indian equity markets slipped below the dotted line. At the time of writing, the Sensex was down by about 67 points (0.3%). Barring Korea, the other major Asian equity markets have closed the day on a high note with Japan and Hong Kong leading the gains in the region.

04:55  Today's investing mantra
"You are neither right nor wrong because the crowd disagrees with you. You are right (or wrong) because your data and reasoning are right (or wrong)" - Benjamin Graham
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