Tata Steel posted a heady 70 percent increase in its operating profit in the just concluded financial year. This doesn’t happen often. Higher volumes and an increase in prices from near Rs 47,000 per tonne to Rs 63,000 per tonne have led to this big outperformance. Is this normal? No.
The outcome is a result of cyclical and extraneous factors, like China’s regulatory moves on pollution and export sops. Stepping away from steel, global commodities tend to have their cyclical moves—up and down. The last commodity supercycle ended in 2011, with the S&P World Commodity Index (a composite of agri, energy and metals) at well over 400. Following this, we saw a significant drop to about 130 levels in January 2016, and then a climb to a near 300 peak in October 2018. April last year saw the index test the 130 levels again, and we are up near 280 now. How much more is there to run? That’s a trillion-dollar question. But even if we expect to peak near 300 again, there’s maybe another 7 percent upside in the offing.
We’ve already had several company managements, and even the Sage of Omaha, Warren Buffett, speaking of the input price inflation. And this is clearly a worry for several businesses, at a time when demand is in limbo due to the COVID surge and a recovery is likely to be weaker than after the first wave. Will businesses have to absorb some cost and take a profitability hit or will they pass it on and risk inflation crimping demand. We’ll know soon enough. But what can this do to your portfolio? Here there’s hope. Before we get there, though, let’s just focus on the nature of the demand-supply disruption and the price surge.
THE PRICE SURGE
From oil to copper to steel to wheat to soya bean to sugar, commodity prices across the spectrum are climbing higher. Crude, copper, and steel are all up over 30 percent since the start of 2021. Wheat and soya bean are up 19 percent and 21 percent, respectively. There’' also a surge in shipping freight rates, and the digitalization trend has spurred employee cost inflation for the technology majors, as the flight for talent gets fiercer. Costs are heading higher.
Note: YoY is over April-end 2020
Note: YoY is over April-end 2020
Oil for India is the big one, and with fuel retailers starting to raise prices last week after the state elections ended, inflation in transportation costs is expected to work its way into cost escalation for most products.
Interestingly, though, while India's high consuming class will likely need to cope with an increase in prices of several goods that use these commodities—like automobiles, consumer durables, fast-moving consumer goods, and foods—a quick study of Consumer Price Index (CPI) and global commodity prices didn’t reveal a strong positive correlation, as these trends are likely offset by other local factors and other weighted items like housing and education.
So, inflation in many segments is coming, whether it reflects in the overall CPI or not. And that could well hurt profitability or growth for companies operating in these segments, even as it will fuel profits for the commodity suppliers.
PORTFOLIO IMPACT CAN BE LIMITED
For every rupee more a Maruti or Tata Motors spends on steel, a Tata Steel or a JSW Steel likely earns a rupee more. A similar value chain exists in most other segments. So, one man’s loss is another man’s gain. Of course, where India is deficient, pricier imports will not yield higher domestic profits. And oil is the big commodity to track here. If oil prices continue to surge, all of India will hurt.
A study of the Sensex earnings and global commodity prices suggests a moderate negative correlation of 0.52. So, while rising commodity prices can impact earnings, the extent may be limited. This is likely because the diversified set of stocks in the index—some commodity plays and others user segments—will ensure some balancing of the impact.
A quick look at the quarterly performance of 104 companies in the BSE-500 index that have reported results for the fourth quarter reveals that only 50 of them have an input cost to net sales ratio of over 10 percent. Of the 50, 33 saw an increase in input costs to net sales on a quarter-on-quarter basis, with the increase ranging from 0.6-9.5 percent. On a year-on-year basis, though, the escalation was far lower. Against the average quarter-on-quarter increase of 3.2 percent for the 33 companies, their year-on-year increase was only 0.2 percent.
What this suggests, given the sharp spike in commodity prices in the past two months and with older inventories getting cleared, is that a more visible impact is likely ahead of us. And this can lead to moderation in profitability expectations. Couple this with the now anticipated slower growth in revenues due to the COVID disruption, and we might be setting ourselves up for some downward revisions ahead in several sectors, though external economy-linked sectors could fare well given the expected strong US and global recovery.
That's at a broad, industry level. From a portfolio perspective, given the difficulty in forecasting commodity cycles and timing the tops and bottoms, it makes sense to diversify holdings across commodity and user segments, so that when the cycle turns you are hedged. And here, a diversified index like the Sensex or the Nifty is a good bet. In any case, the track record of most active fund managers’ pales when compared to the index returns. So, don’t try to jump into a likely overheated steel or aluminum stock, or out of it. Opt for a disciplined approach, you won’t make outsized profits, but neither outsized losses.
(Edited by : Jomy)
First Published: IST