Have Chemical Stocks Peaked Out in 2021?

Nov 25, 2021

Seeing the collective wisdom in the stock market, I am reminded of a quote by J Templeton about 'consensus' in the stock market.

  • 'If 10 engineers tell you to build a bridge a particular way, then that is how you should build the bridge. If 10 doctors provide the same diagnosis then you should follow the treatment. However, if 10 analysts tell you that a stock is cheap, then you must avoid it'.

Mr Templeton's point is we should always be wary of consensus. Seldom has the stock market done what public opinion expects it to do. That's why the old timers say, market has a mind of its own.

The recent IPO mania has increased my conviction in this quote. The problem is everyone believes making money is easy and the consensus is upwards.

Last weekend, I talked to an experienced investor about new age IPOs.

A statement from our conversation with him struck me. He said...

  • 'The older generation might not understand new age tech companies and Cryptos, but the new generation doesn't understand risk'.

I think legendary investor, R K Damani, described stock market crashes very aptly,

  • 'After the crash, people with money get the experience and people with experience make money'.

That is precisely what is playing out in the stock market.

Many companies and entire sectors have been 're-rated' beyond any logic. While some of the re-rating is warranted, a lot is excess.

--- Advertisement ---
Govt's 257 Bn Rupees Boost for EVs- Your Chance for Potentially Wild Profits

Recently, the government announced that it will be pumping a whopping 257 billion rupees into electric vehicle initiatives by 2025.

We urge you to become a part of the EV gold rush that's happening now and gain the early mover advantage.

We have closed in on 3 EV stocks which could potentially hand you over insane profits in the long run.

We will be revealing all the details in one of our upcoming special online event.

Sign Me Up For the FREE Event
------------------------------

Time and again, to justify valuations and support the momentum in the market, sectors have been given FMCG-like PE ratios.

I distinctly remember, during the peak of the auto boom in 2017, stocks like Maruti and Eicher were trading at life time highs PE ratios which weren't justified.

Maruti at its peak was trading at a 28-30 times forward PE.

To justify this, analysts threw in the commonly used 'under penetration theory'.

Metrics like penetration as a percentage of households was used to show how the sector was 'underpenetrated'. Also, comparative analysis with developed countries was used to help strengthen the case.

However, the western world is different. It has limited public infrastructure. As a result, owning a vehicle is indispensable. India does have public infrastructure for last mile connectivity.

So to justify the unsustainable valuation multiple for Maruti, I recollect an analyst who assigned the valuation multiples of Voltas and Crompton Consumer for Maruti!

His logic was that both had the same level of penetration and huge headroom for growth.

Now, in what way can you compare, a company which sells fans or A/Cs to a company which sells passenger vehicles?

It's an Apples and Oranges comparison in the truest sense.

When such narratives start floating around in the market, it's time to be cautious.

After 2017 the auto cycle peaked and turned down.

While the markets have been hitting new highs, the auto sector is in doldrums.

Maruti Suzuki and Eicher Motors are 25% and 20% below their peaks in 2017.

Revealed: Richa Agarwal's Top 3 Stocks for 2022

Where is the froth today?

I believe there is a froth in the valuation of some smallcaps in the chemical sector.

Just like the auto sector in 2017, the same narratives of comparing the chemical space to quasi-consumption are evident.

This is what happened in the chemical space over the past 18 months.

The chemical sector has been re-rated, in terms of both PE ratio and earnings upgrades.

The earnings growth of these companies have been fantastic over the past 6-8 quarters.

Last 9 Months Earnings of Chemical Firms > full year FY21 Earnings

  EPS  
  2018 2019 2020 2021 9 months FY22
Balaji Amines 35 36 32 73 102
Deepak Nitrate 5.8 13 45 57 78
Alkly Amines 13 16 42 58 61
Galaxy surfactants 44 54 65 85 80
Manali Petrochemical 3.3 4.4 2.7 11.7 22
Supreme Petrochemicals 12 5 11 51 72
Data Source: Company reports

However, the primary reason for sharp increase in operational performance was led by unsustainable price increases of the underlying chemicals.

This was due to the China factor.

Supply disruptions from China was a key reason for price increases along with high logistic costs due to container issues.

--- Advertisement ---
Markets in Downturn? Here's What You Must Do...

The markets corrected sharply in recent days...

And it's impossible not to be reminded of the bloodbath we saw in March 2020.

The truth is...

Stock market corrections and recessions are inevitable and painful...

But this #1 video with Rahul Shah has the power to change how you perceive corrections and crashes. In fact, you'll master the art of turning every market crash to your advantage...

Watch the COMPLETE Lazy Millionaire Summit Right Now
------------------------------

Prices of both specialty and bulk chemicals have increased 5-10 times in the past 18 months.

With this kind of operating leverage playing out, there was a massive expansion in margins.

Meteoric Rise of Chemical Stocks

Particulars 15-Apr-20 Peak Current Price
Balaji Amines 355 5,200 3,150
Change (%)   1,365% -39%
Deepak Nitrate 470 3,020 2,160
Change (%)   543% -28%
Alkly Amines 611 4,740 3,250
Change (%)   676% -31%
Galaxy surfactants 1320 3,600 2920
Change (%)   173% -19%
Manali Petro 17 138 120
Change (%)   712% -13%
Supreme Petrochemicals 141 818 675
    480% -17%
Data Source: BSE

I believe the best is behind these Stocks

In the chemical sector we see the following.

  1. Too much price volatility and the dependence on global and Chinese prices. This gives it the characteristics of a commodity. Hence, it's cyclical in nature.
  2. Margins are at a peak. Tailwinds in the form of chemical prices and operating leverage have played out.
  3. Raw material cost has started to increase. This is evident over the past 2 quarters.
  4. These are B2B business with very little or no pricing power.

In a nutshell, most of re-rating in the stocks of chemical companies has already happened.

We are in a scenario where bulk commodities are available at 3-4 times above their mean valuations.

Niche chemical companies do deserve some premium, but the way their stock prices have risen, the margin of safety is very limited.

Here is an example of the amines sector in India.

The amines industry in India is a sort of duopoly with Balaji Amines and Alkyl Amines being the only 2 major players. The industry is a niche when it comes to products.

Balaji Amines reported fabulous performance and continues to do so, however the stock has gone up 1,365% in 18 months.

This resulted in its PE expanding from 10-12 to 40 at its peak. A 40x PE ratio for a B2B chemical company.

Food for thought

I cannot fathom paying Balaji Amines and Godrej Consumer similar multiples.

It doesn't make sense to give the same multiple to the firm making a consumer product and a chemical maker whose products are used as intermediaries.

Even if earnings double from here in next 2 years (which is highly unlikely), Balaji Amines is available at a PE of 20x on FY23 earnings.

It's fairly valued for a chemical company.

What are the risks?

I do understand factors like China plus 1 strategy playing out, but these are very long term in nature.

The China plus 1 is not as easy as it is made out to be. There are other countries like Taiwan, Vietnam, and Thailand also in competition to grab market share from China.

Stock prices of chemical companies have fallen 20-30% over the past 2 months. It's a sign the market is taking note of the froth in valuations.

Most chemical companies have strong financials and balance sheets. My view is from a valuation and future growth/re-rating perspective.

Bigger companies like PI Industries, Atul, Aarti, and others continue to be good long-term investments.

But the risk-reward is not favourable in these small and mid-sized chemical companies.

As I end this piece, let me caution you against chasing less known chemical names. They are more like commodity stocks in nature.

Warm regards,


Aditya Vora
Research Analyst, Hidden Treasure

Recent Articles

The Right Way to Profit from Disruption January 28, 2022
You might be betting on the right megatrend, but are you betting on the right stock?
Why You Should Not Buy Stocks Like Zomato in this Market Crash January 27, 2022
The margin of safety is still not favourable for tech stocks.
Why the Correction in Indian Tech Stocks Should Excite You January 26, 2022
A few tech incumbents are all set to become very attractive to investors.
Stocks to Buy in this Market Sell-Off January 25, 2022
How you approach this correction will determine your wealth for the years to come.

Equitymaster requests your view! Post a comment on "Have Chemical Stocks Peaked Out in 2021?". Click here!