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Suresh Krishnamurthy

The continued fall in the dollar and a weaker US economy do not augur well for most industries. There is thus a strong need to hedge the dollar decline, and commodities fit the bill.

STOCKS of commodity companies conjure up an image of volatility and unreliability. For investors who have been in the business since the early 1990s commodity stocks would also invite memories of embarrassingly shocking investment decisions and huge losses.

There is, however, a strong case for commodity stocks now. They have had a great run over the past 24 months. This may be extended further if the dollar keeps depreciating against major currencies. There is thus a strong case for holding on to commodity stocks, though they have notched up handsome gains and commodity prices are at their peak now.

Dollar and commodities: Commodity prices have strengthened considerably over the past three years. There are a couple of reasons behind the firm trend in commodity prices. One, the sustained increase in demand from China. And, two, the fall in value of dollar.

A fall in the dollar value, for several reasons, has led to a sharp increase in prices of commodities, and the prices of all commodity stocks have risen in recent years.

A continued fall in dollar could spell a continuation of the firm trend in commodity prices. On the other hand, a continued fall in dollar accompanied by a weaker US economy does not augur well for other industries. There is thus a strong need to hedge a possible fall in the value of dollar, and commodities fit the bill aptly. Analyst Jim Rogers has said that the bull run in commodity prices would extend into the next decade. He has also singled out coffee and sugar futures as commodities that could flare up.

Incidentally, in the past, commodities have proved an even better hedge than commodity stocks. Studies have shown that returns from commodities may have been as much as three times the return generated by commodity stocks. Indian investors, however, have no option but to go in for commodity stocks as there is neither a market in receipts certifying ownership of commodities nor commodity mutual funds.

Getting down to stocks: Commodity stocks are the next better bet. There are several stocks of worthy commodity sector firms available in the market. There are 40 companies that have turned in a return on shareholder funds of at least 10 per cent in each of the past ten years.

The average price to earnings multiple of these companies is about 10.6 and their dividend yield is 2.6. The average market capitalisation to sales ratio is about 1.25. These numbers are based on trailing 12-month profits. These profits may have been inflated by the run-up in commodity prices.

However, as we are looking at the prospect of sustained higher commodity prices, these profits are representative of likely trends over the next year or two. The average valuation thus looked reasonable especially as they were below that of the market index such as Sensex or Nifty. Among this list of 40 stocks, the following ten appear compelling:

HPCL, West Coast Paper, BPCL, Aarti Industries, Tata Sponge Iron, Reliance Industries, Balrampur Chini, Maharashtra Seamless, CCL Products and Hindalco.

Aarti Industries, HPCL, West Coast Paper and BPCL make it to the list because they are strong dividend yield candidates apart from their fundamental strengths. Balrampur Chini and CCL Products have been included because the price dynamics for sugar and coffee appear favourable.

The strengths of sponge iron as an indispensable link in the steel industry is behind the inclusion of Tata Sponge Iron. And Maharashtra Seamless and Hindalco Industries are not cheaply valued. Both these companies boast of a strong track record of generating profits. Reliance Industries appears attractively valued and its large-cap status is also a positive factor.

The average PE ratio of these ten stocks is 10.3, and the average dividend yield about 3.1 per cent. In contrast, the PE of Sensex stocks is about 15.5, and its dividend yield is 1.75 per cent. This portfolio could capitalise on commodity prices showing stability at higher levels with an upward bias.

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