Commodity stocks have just over 10% weight in the Nifty. The outlook for commodity stocks going forward is dependent on how leveraged a company is towards commodity prices. The higher the leverage, the more a company is dependent on the prices of a commodity and vice versa. Should you buy cheap, leveraged commodity stocks or expensive deleveraged commodity stocks? Given the macro headwinds facing developed nations and the debt issues plaguing sovereigns worldwide (see economic analysis), a prolonged slump in commodity prices will pull down companies leveraged towards commodity prices. Investors should avoid stocks leveraged to a rise in commodity prices at present and can invest in debt free companies in the commodity sector.
Markets are giving higher earnings multiples to de leveraged stocks
The market is giving higher price earning multiples to debt free companies as seen in Table 2. The fact that price earnings multiples are high for strong balance sheet companies does not really make the stock expensive. Strong balance sheet companies are in a position to acquire debt ridded weak companies in a period of low commodity prices. Such companies can also build leverage if conditions are right for increasing capacities.
Stocks with low price earning multiples can also see a prolonged period of below par performance if commodity prices do not go up. Hence such stocks are not really cheap. An improvement in macro economic conditions can change the fortunes of some of the leveraged companies and once such changes are spotted, investors can switch from low debt stocks to high debt stocks.
This is not the time to switch from low debt to high debt stocks.
Tata Steel is receiving lower price earnings than SAIL due its high level of debt of Rs 60,000 crores. Tata Steel acquired Corus in 2007 for USD 12 billion and that acquisition has made the company vulnerable to steel price movements. Jindal Steel’s fortunes will fluctuate with steel price movements even though the company is acquiring coal and iron ore mines across the globe and is building up power generation capacity. If the outlook for steel prices is positive, Tata Steel will be the best pick given its leverage.
Hindalco is also receiving lower price earnings multiples by the market due to its debt. Hindalco acquired Novelis for USD 6 billion in 2007. The markets have not taken the high debt levels of Hindalco due to the Novellis acquisition too favourably. Hindalco is now dependent on a favourable macro economic environment for its future performance.
Stocks in the cement sector have been given higher price earnings multiples by the market despite an environment which is unfavourable to the sector. Cement companies face the similar macro economic headwinds as other commodity companies but the fact that companies like ACC, Ambuja Cement and Grasim have almost zero (ACC, Ambuja Cement) debt or manageable debt (Grasim) makes these stocks less vulnerable to prolonged softness in cement prices.
Seas Goa is one low debt company that is given low multiple by the market. The reason is the issues facing iron ore mining in India with mining scams and environmental issues hitting mining operations. Sesa Goa is also being used by its parent Vedanta to acquire a 20% stake in Cairn India for around Rs 12,000 crores. Further acquisitions by Sesa Goa on the behest of its parent can take the debt levels of the company higher.
Chart 2. Base metals price movements
Coal India is given high multiples by the market due to its coal reserves and the fact that it’s cash generating, debt free company. The company’s fortunes will fluctuate with coal prices. The government ownership of Coal India (90%) will have an overhang on the company as the government controls coal prices in the country.
Sterlite’s fortunes largely depend on Zinc and lead, which contributes to 75% % of profits though contribution to sales is less than 40%. Copper, which contributes to 50% of sales, is not very profitable, contributing to only 13% of profits. Hence positive outlook on Zinc and Lead will be positive for Sterlite.
Investors should have a view on commodity prices before investing in commodity stocks. If view is not positive, stocks leveraged towards positive commodity prices should be avoided and if view is positive, it will be a good time to buy into the leverage stocks such as Tata Steel and Hindalco.