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Our optimism about commodity prices may be too good to be true!

Nov 26, 2014

In this issue:
» The slippery future of oil prices
» Why are aluminium producers in a sweet spot?
» Is it time to limit exposure to equities?
» Roundup on markets
» ...and more!

As traditional value investors, our judgment on stocks are typically influenced by the balance sheet strength and pricing power of companies. Even for companies that do not offer very reliable earnings visibility, we look at the asset based valuation to determine the upside. Thus, while we gauge valuations well, getting a firm grip on macro economic trends, such as commodity prices, is something that comes with decades of experience. And speaking of commodity cycles in particular, India has seen very few commodity booms and busts over the past two decades. Hence timing commodity bull and bear phases more accurately is something we are still working on.

Nevertheless one commodity that perpetually remains on our watch list is oil. After all, this commodity has more impact on not just India's economics but also politics than any other. And hence when the sentiments get too optimistic or pessimistic about oil prices, we try to make sure we don't get too carried away while factoring this into our projections.

Take the current scenario in oil prices for instance. It is not just India but also our Asian counterparts China and Japan that are betting big on cooling off of oil prices. China and Japan are desperately hoping that lower crude prices will enable their economies make a sharp recovery. Indian policy makers, meanwhile, are content with the fact that lower crude prices will keep fiscal deficit in control and improve sovereign ratings.

Now, it is a proven fact that shale gas reserves are more expensive to mine and have shorter lives than other fossil fuels. China itself has not been able to leverage its vast shale gas reserves thanks to some structural bottlenecks. Hence America's shale gas production could temper global oil prices temporarily. However, expecting oil prices to go lower for a prolonged period will result in economies staying unprepared for an eventual crisis, we believe.

All eyes are currently on the next OPEC decision on whether or not to cut output. Stagnancy in oil production could certainly wield further pressure on oil prices in the near term. However, such optimism about constant fall in oil prices certainly does not bode well for an economy like India. The expectation may turn out to be too good to be true! Being heavily dependent on oil imports, India's fiscal position and currency rates could worsen as and when this commodity cycle turns. In fact just like the debt time bomb, this could be the other big risk that can spoil India's recovery.

When it comes to picking stocks once can certainly look for companies that can stand relatively resilient to movement in oil prices. However, worsening of macroeconomic variables needs to be factored in well into the valuations.

Do you think commodity prices can be one of the biggest risk to stock valuations going forward? Let us know your comments or share your views in the Equitymaster Club.

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Speaking of commodities, producers of yet another commodity are currently in a sweet spot! Aluminium is currently attracting a huge premiums in the international market due to shortage of floating stock. In fact, as per the producers, these premiums are here to stay at elevated levels for the next two years. Typically companies fetch a premium over the London Metal Exchange (LME) cash price to cover the cost of freight and insurance. This reflects the regional demand and supply. But in recent months, aluminium premiums have risen two-three times the transportation cost, hinting at serious scarcity in the metal market. In the past few years, aluminium capacities have seen a fall due to a long period of subdued prices. Hence producers who have sufficient capacity currently, including Hindalco and Nalco, are expected to benefit thanks to the pricing power. Nevertheless, unlike branded products, the pricing power in commodities is temporary and investors should not lose sight of that.

The commodity super cycle was driven by emerging markets with China being termed the 'voracious consumer' of the world. However, with the dragon nation and key global economies' growth levels coming down, the general view is that the commodity super cycle has come to an end; and that the current trend should be considered as the 'new normal'. Not to mention that the huge capacity build up that was seen in anticipation of the increasing consumption levels is also another factor that has increased supplies and depressed prices in the process. To add to that is the US shale boom which is expected to keep energy prices low for some time.

The curbing of money printing by the US - which is expected to dry up liquidity situation - a key aspect that has been keeping asset prices in emerging markets firm - over time - is another aspect to take into consideration. Now, while other central banks - Europe and Japan in particular - have upped their printing activity, analysts over at BNP Paribas are of the view that the pace is much slower, not big enough to make a substantial dent. Also, going by the IMF's view, it is expected that emerging markets will not see growth levels clocked during the pre-crisis era. This is on the back of the other exports failing to be productive enough to drive growth at home.

What does all this mean for Indian investors? Well... to safeguard oneself from volatile and sharp movements in input costs, the strategy we feel would be the best suited to avoid taking calls on inflation, is investing in companies that have tremendous pricing power. After all, it is one of the best bets to beat inflation according to us.

 Chart of the day
So, are Indian markets headed for a correction? Well, with the way the markets behaved over the past two to three days, front pages of the business dailies are filled with such stories. So here's our shot at the same...

The fact of the matter is that Indian markets are currently not attractive. The euphoria over how the scenario is expected to improve has been driving the markets; this we say because the data points still do not show any significant signs of improvement.

And with this, it seems the market has reached its 'fairly valued' stage. This we say because historically, the Indian markets - as represented by the BSE-Sensex - have been quite wobbly when they have traded at an earnings multiple of about 20 times. And guess what, we are almost at that such valuation levels now!

And as the chart shows, the markets have corrected at times when the valuations have moved above this mark in the past. In fact, it is during such times that we believe the exposure to equities should be limited. Sure, while one may easily be swayed by the 'This time it's different' line time and again, at the end of the day it all boils down to investors following a certain process. After all, there is evidence that low P/E investing does indeed work.

Are all the upsides factored in at the moment?

So while it may seem that growth in earnings and profitability is bound to pick up by many factors such as increased consumption, capex or higher profitability, it must also be remembered that factors outside of companies' control play a strong role in market movements and sentiments as well. So while the going may seem all hunky dory at the moment, we believe taking a broad view on the overall market at regular intervals is very much required.

The Indian stock markets were trading flat after witnessing bouts of buying and selling for most part of the day. At the time of writing, the BSE-Sensex was trading lower by about 5 points. Asian stock markets ended the day on a firm note today; European stocks were trading in the green as well.

 Today's investing mantra
"No wise pilot, no matter how great his talent and experience, fails to use his checklist." . - Charlie Munger

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee and Devanshu Sampat.

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1 Responses to "Our optimism about commodity prices may be too good to be true!"


Nov 28, 2014

its crazy when commodity prices were shooting up nobody said they will fall and some cos will benefit,now when they r falling u r worried of future rise? stock mkts r made for rise and fall and so r commodities.

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