How commodity stocks fared versus underlying metals

What if you had to make this hypothetical investment decision: Six years ago, you had Rs 1 lakh to invest in either commodities such as zinc, aluminium, iron ore or in companies that process those commodities, such as Hindustan Zinc, Sesa Goa and NMDC.

Which would have made for a better bet? Turns out the companies were far better investments than the products they manufactured since 2005. But will that continue to be so? The six years between July 2005 and October 2011 have seen no less than four phases in the commodity markets.

The Run-up

Between July 2005 and July 2008, the prices of steel billets roughly quadrupled. Global production of crude steel soared by 26 per cent in absolute terms. Tata Steel and SAIL, highly integrated domestic steel producers, saw their profit margins expand on higher steel prices. In SAIL's case, profits after tax shot up by 87 per cent. Similarly, Tata Steel's net profit grew 35 per cent.

As profits at these companies rose, the market paid higher PE multiples for each rupee of earnings. Result, their stock prices soared three-fold and four-fold by the stock market over the four-year period to peak in January 2008.

Stocks of iron-ore producers did even better, with NMDC and Sesa Goa up 16-fold and seven-fold respectively. This outpaces the gains in iron-ore prices, that were up less than three-fold. Both volume improvements and better realisations helped the companies. The stock of India's sole listed aluminium player, Nalco, an integrated producer, shot up 260 per cent between 2005 and January 2008, exceeding the 87 per cent three-year gain registered by aluminium contracts on the LME over roughly the same period.

Certain metals peaked far ahead of steel and others. Hindustan Zinc was up five-fold in the two years from July 2005 to July 2007. This was more than double the gains registered by LME Zinc contracts over the same period. This three-year period was a dream-run for investors who chose to bet on stocks of commodity companies rather than the underlying commodity itself.

Sharp squeeze

The depths to which metal stocks sank in 2008 tested market faith in the theory that there was an ongoing commodity ‘super-cycle'. When commodity prices corrected, they fell quite sharply and the stocks of producers dropped even more. In down-markets, it appears that commodities may have the slight upper hand over the equity option.

During this phase, Nalco had shed 59 per cent from its January peak, which was on par with the 57 per cent loss in LME aluminium prices from July 2008. LME steel billet prices lost 75 per cent of their value. Tata Steel, with its more vulnerable European operations, shed 82 per cent.

SAIL, which is more dependent on robust domestic markets, shed 72 per cent. Sesa Goa and NMDC shed 58 and 68 per cent from their peak values under-performing the 55 per cent shed by iron ore from its July 2008 peak.

Hindustan Zinc, among the lowest-cost producers of zinc, did limit losses from its 2007 peak, shedding 55 per cent compared to the 67 per cent loss registered by LME Zinc contracts.

Comeback kings

Following the various stimulus packages and tax breaks rolled out to boost the economy, the prices of key metals shot up just as quickly as they had fallen. By April 2010, iron ore prices doubled from their early-2009 lows. Sesa Goa, a major exporter to Chinese markets, was up just under six times in the same period.

NMDC, a domestic producer with lower pricing, just about doubled in the same span. During the same period, both Tata Steel and SAIL were up four-fold and three-fold. This beat the two-fold increase in steel prices. Hindustan Zinc proved hardier than the metal, returning 280 per cent returns versus the 120 per cent registered by LME Zinc prices.

These results reinforced the trends noted in the earlier three-year bull-run. Here, again, metal and mining stocks (barring NMDC, whose FPO did result in a correction) comfortably outshone the commodities they produced. But old challenges cropped up again.

The hurdles

Starting in April 2010, the commodity and metals space faced a series of setbacks that made the business more risk-prone. The stack of global troubles included the advent of quarterly pricing contracts, a volatile Chinese economy, a hurdle-ridden US and the European debt crisis.

Indian miners also faced their share of challenges: A crackdown on illegal mining saw several mines shutdown, a new Mining Bill which takes a chunk out of miners profits and the recent cooling-off in the economy. Since the summer of 2010, iron-ore prices are down by around 26 per cent. As a result of these troubles, Sesa Goa and NMDC are down by 55 and 18 per cent over the same period. Nalco tumbled by a third during a period when aluminium prices fell by ten per cent. Steel prices are down by around 10 per cent. However a sharp rise in coal prices has squeezed the margins of steel producers. SAIL and Tata Steel are down by 51 and 31 per cent respectively. Hindustan Zinc again proved to be an exception to the rule and remained flat, compared to the 20 per cent loss registered by LME Zinc prices.

Recent entrants to the mining space Coal India and MOIL failed to track their underlying commodities. Coal India is down four per cent over the last year as it has struggled to raise output, apart from adverse sentiment over the proposed Mining Bill taking a 26 per cent bite out of its pre-tax margins. A 22 per cent correction in manganese prices has stymied MOIL India's returns. The stock has corrected by a third from its offer price.

Phase-dependent

Commodities do appear to fare better than stocks of their processors in bear markets. The converse is true in bull markets.

During harsh market conditions, commodity prices find floors at price points that represent the production cost for producers at various points. For example, iron ore prices slid by 20 per cent over the last seven weeks, and reports indicate that several Chinese mines are unviable at this price.

Similarly, zinc prices have dipped 20 per cent since mid-July. This price renders several high-cost global producers unviable, forcing them to shut their mines. This provides a very effective floor or support for commodities.

On the flip side, commodity stocks enjoy a double-whammy during bull markets. First their earnings expand as commodity prices rise.

Second, investors don't mind paying a higher premium for these earnings during bull markets.

This works against commodity stocks during bear markets. Not only do earnings shrink, their price earnings are also susceptible as investor appetite for risk wanes.

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