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Sunday, Sep 12, 2004

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Agri-commodity stocks: In buoyant phase

Aarati Krishnan

COMPANIES processing and marketing agricultural commodities may be the next dominant investment theme in the stock market. After years of rising production, surplus stocks and depressed prices, fundamentals for commodities such as sugar, tea, coffee and rice are looking up; throwing up opportunities for investors.

Price spikes, an opportunity

In the domestic market, tea prices, after languishing for years until 2003, have shot up about 20 per cent this year on expectations that a decline in output and higher exports will shrink domestic tea inventories. Poor climatic conditions have led to a 9 per cent drop in tea output in 2004.

With exports surging 22 per cent so far this year, industry watchers expect the tight supply situation to continue and predict that prices will continue their climb well into 2005.

Sugar prices have spiralled by over 25 per cent over the past year. Sugar production is expected to be down by a sharp 30 per cent in 2003-04, after rising relentlessly the last five years.

This is expected to shrink accumulated stocks of sugar to 71 lakh tonnes by end of this sugar season (September 2004); this would be the equivalent of just four months consumption.

With a recovery expected only by 2005-06, the supply position is likely to remain tight. This means sugar prices may not soften anytime soon.

Or take the rising global prices of coffee and rice, which means that Indian exporters of these commodities can expect a boost to their profits.

Frontline companies in the sugar sector, such as Balrampur Chini, Bajaj Hindusthan and EID Parry, have been star performers on the bourses in the past six months. A host of second-rung tea stocks are warming to the news of rising tea prices.

Investing in agri-stocks

Is investing in agri-commodity stocks as easy as spotting the price trend in a commodity and simply investing in a company that markets it? No.

With cyclical earnings and a slew of external risks to their earnings numbers, these stocks are certainly not the kind that you can invest in and then forget about, secure in the belief that they will deliver attractive returns over the long term.

Earnings of agri-commodity companies are transparently linked to commodity prices, which are easy to track.

As mentioned in the accompanying story, there are several money-making opportunities in commodity stocks, even if you enter the cycle late in the day.

If these arguments prompt you to make a beeline for such stocks, remember that these stocks are certainly not everyone's cup of tea. Here are a few common features that agri-commodity stocks share:

Bumpy earnings: Production and prices of commodities usually follow a cyclical pattern. When commodity prices are on a cyclical upswing, companies that market them often reap bumper earnings because every additional rupee realised goes straight to the bottomline.

Sugar companies, for instance, easily doubled their profits over the past year. Earnings growth may slow from this frenetic pace, as the base effect kicks in.

But with prices of the sweetener continuing to rise, robust double-digit growth is still likely.

When commodity prices unwind from their highs, expect earnings of such companies to decline swiftly.

If earnings can rise disproportionately during an upswing, they can fall as precipitously in a cyclical downswing. Balrampur Chini Mills, which doubled its profits in 2003-04 on the back of rising sugar prices, reported a 36 per cent drop in profits the preceding year, when sugar prices were moribund.

Swings in valuation: Valuations of these stocks also swing up and down in line with the commodity cycle.

When commodity prices are rising, the stock market is often willing to pay more for every rupee of a sugar or tea company's earnings. When prices are down, valuations also tend to slump.

Sugar companies, for instance, were trading at valuations of 7-8 times their earnings in 2001 and 2002; they now enjoy earnings multiples of 12-13 times their trailing earnings.

This pattern tends to magnify the ups and downs in the prices of stocks of agri-commodity companies in a cyclical reversal.

Such stocks can, therefore, deliver substantial index-beating returns, or trail far behind the index, depending on the phase of the cycle.

Handling the downswing: More often than not, it takes a sharp drop in output to spark a recovery in the commodity cycle.

Lower output certainly helps companies liquidate accumulated stocks at lucrative prices. But a fall in output can also create a serious problem of raw material availability for commodity processors.

For instance, a very sharp drop in sugarcane output could reduce cane available for crushing by sugar mills.

A drop in tea production may prevent a Tata Tea or a Williamson Tea from taking advantage of buoyant domestic or export prices. Or non-availability of rice for exports may prevent domestic exporters such as Satnam Overseas or KRBL from cashing in on a sharp uptrend in global prices.

Even in a recovery phase, a company's experience in dealing with shortage situations and the nature of relationships with its raw material suppliers will determine the extent to which it can take advantage of buoyant commodity prices.

Good for diversification: Despite their high volatility, agri-commodity stocks — even those of such frontline companies as Tata Tea or Balrampur Chini — have low betas. This is not because they are less risky, but because they often do not move in the same direction as the market indices.

Most agri-commodity stocks are small or mid-cap and are under-researched. Besides, commodity price cycles and policy factors influence these stocks to greater extent than do broad market movements.

This feature may make them good options for diversifying your equity portfolio.

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