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A Small Secret to Finding the Right Commodity Stock for 2016

Dec 24, 2015

In this issue:
» Bank credit growth on a turnaround path?
» What could ruin the India story as per Raghuram Rajan?
» ....and more!
0.00
Rahul Shah, Co-Head of Research

Our way of evaluating commodities stocks is simple. We claim to have no special expertise in predicting commodity prices. Consequently, we don't try to value commodity firms using the earnings method. For earnings are highly sensitive to commodity prices and if you can't predict the latter with reliable accuracy, you can't rely on the former.

How, then, do we value commodity stocks? Well, we do the next best thing: We rely on a valuation parameter that's more objective and less susceptible to change than earnings - that is, the company's assets.

If the P&L statement is too volatile, it makes sense to rely on balance sheets and value companies based on their book values. This method is not without its share of risk however.

The balance sheet method prescribes that commodity stocks should be bought at a discount to their book values. But who is to say the stock can't fall further? When the sector is in disarray, it is not uncommon to see even the best commodity stocks trading at a huge discount to book values. Therefore, an investor who thinks he is getting a good deal buying a stock at a 20% discount to book can easily see his stock go down another 50%.

Then there's also the possibility of a stock remaining depressed for years before things turn around. In this case, even if the stock does well eventually, people either lose patience and exit the position or the eventual returns don't come out that attractive.

So, is there a way to time our purchase better? Can we buy at a point in the cycle where we have a much greater chance of earning fabulous returns and still be a value investor? Well, until recently, we would have answered this question in the negative. After all, there aren't any bells that ring to signal the bottom of an industry or a stock.

However, a recent interview with Edward Chancellor piqued our curiosity. He claims to have found a way to get a lot more of our commodity calls right and earn big returns in the process. And he believes his approach could prove useful in other sectors as well.

What exactly is his approach? He says companies shouldn't be assessed on their valuations alone. One should also take into account whether capital is flowing into or out of the industry. If it is the former, then the collapse is yet to play out and one is better off not investing in the space.

Chancellor makes a fair point. A lot of value investors get carried away with statistical cheapness and don't bother to look into other aspects, especially the capital flows. However, once you take the capital flows into account, one gets a better sense of where one is in the cycle. This then helps zero in on only those stocks that have a better chance of a turnaround by virtue of new capacities not coming on stream.

Let us try and understand this with the most talked about commodity these days, crude oil. We are sure about a year ago there would have been a lot of oil and gas stocks that would have been value buys based purely on valuation. But was it the right time to invest in those stocks? Maybe not if we go by the capital flows theory. This is because the energy sector was going through a huge investment boom, with fracking companies as the primary recipients. The chickens of these over investments have come home to roost as crude prices have tumbled. So, is now a good time scour the universe of energy stocks? Perhaps yes, because capital flows into this sector have slowed considerably.

Similar themes have played out in steel, aluminium, and other commodities. Therefore, investors wanting to invest in these sectors in 2016 could do well to consider the capital flows. Is the capital still flowing in or have new project launches come to a standstill? The answers to these questions will help you make more informed decisions.

Do you think taking capital flows into consideration boosts our chances of finding the right commodity stock? Let us know your comments or share your views in the Equitymaster Club.


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2.45 Chart of the day

Talking of a turn in cycles, the fortnight to 11 December has seen a sudden but definite spurt in bank credit. Bank credit grew 11% YoY during this period. As the chart shows, this is well beyond the growth that was being logged in during the preceding part of this fiscal.

This might be too small a period to draw any major conclusions from. Nonetheless, bank credit growth is an important data point. It is usually the first to pick up during a turn in the economic cycle. And reports indicate that there has been a definite uptick here since the Reserve Bank of India cut repo rates.

Another point to consider before taking this data too seriously is that this increase must come from higher lending to companies rather than to individuals for it to be meaningful from an economic cycle point of view.

Sign of recovery or meaningless spurt?

3.50

However, all is not well with the banking sector. So much so that RBI governor Raghuram Rajan and his team at RBI have flagged off grave concerns about the overleveraged state of many corporates in India.

Here's some statistics it has highlighted. Nearly 20% of all listed companies have imprudent levels of debt currently. In the 2,711 publicly traded non-government, non-financial companies that the RBI analysed, 19.4% of them either have a negative net worth or a D/E (debt to equity) ratio of more than two. This is way more debt than one would be comfortable with.

But it gets worse. Over 15% of the 2,711 are even more highly leveraged - they have a D/E ratio of more than three and an interest coverage ratio of less than one! And the number of such firms has only increased over the past year.

Along with that, another danger is the sharp increase in the share of NPAs of large borrowers from 78.2% in March to 87.4% in September. The RBI fears that such weakness in the balance sheet of corporate India may pose a risk to financial stability.

While corporate India quickly needs to get its act together, it is also high time that Indian banks - especially the public sector lot, start becoming much more stringent in their lending norms.

4.40

The Indian stock markets today were largely trading close to yesterday's closing level. At the time of writing, the BSE-Sensex was trading down by around 60 points. Losses were largely seen in consumer durable and banking stocks.

4.55 Today's investing mantra

It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.- Warren Buffett

Editor's note: Please note that there will be no WrapUp on the 25th and 26th December, 2015 on account of Christmas Holidays.

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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Equitymaster requests your view! Post a comment on "A Small Secret to Finding the Right Commodity Stock for 2016". Click here!

3 Responses to "A Small Secret to Finding the Right Commodity Stock for 2016"

suman biswas

Jan 1, 2016

silver is trading 28000 to 56000 in 2016

Like 

Giten Shah

Dec 26, 2015

Yes considering capital flows along with other parameters such as book value etc will help in making investment decision in commodity stocks more rightly. As ultimately prices will move on demand supply situation and decrease in capex will lead to reduction in supply of commodity over a medium to long term and eventually demand outstripping supply. Currently power and commodity stocks offer best investment opportunities for the long term investors.

Like 

Balakrishnan R

Dec 24, 2015

Dear Mr. Shah, The approach evaluating Commodity companies based on capital inflow / outflow need not always be correct. I have seen some companies expand (i.e. spend capital) during lean periods so that they can reap better benefits during the immediate up trend periods.

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Equitymaster requests your view! Post a comment on "A Small Secret to Finding the Right Commodity Stock for 2016". Click here!
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