Why you should avoid commodity stocks

This year, there were crores of rupees (millions) to be made on sugar stocks. And there were crores to be lost too! With the infrastructure and consumption stories becoming key stock-market triggers, commodity stocks like cement, steel and sugar have been the biggest buzzers in the recent past.

But, should you really be investing in them? Outlook Money finds that while these have been running up significantly and many are said to have a lot of steam, investors must be careful about parking their money here.

Let's look at what happened to sugar. By the end of March this year, wholesale sugar prices were on a high of Rs 2,100 per quintal. In response, sugar scrips burned up the stock tickers. In November 2005, the Bajaj Hindustan share quoted at about Rs 200. By April 2006, it was quoting at Rs 550, and no party seemed sweeter.

When the  markets crashed in May, so did sugar stocks, and on June 14, the Bajaj Hindustan stock was down to 250. By July, it recovered, along with the markets, to Rs 400. But, while the markets continued to surge though the second half of the year, sugar stocks went into a slide, and as we write this, the stock is at Rs 260, for a net loss of over 50 per cent from the year's high.

While steel stocks have softened a bit, the sector that continues to soar is cement. For instance, ACC has doubled over the last year to Rs 1,070. But, experts' view on  cement continues to be bullish because of the boom in infrastructure and construction. What is our take on cement stocks?

Given the current market conditions, it is impossible to predict where a stock is going to be in a week or a month. However, a look at the past does yield some clues as to how rewarding it is to buy commodity stocks, especially sugar and cement.

By way of comparison, we looked at investment in shares of pharmaceutical and FMCG companies, the classical defensive sectors. In each of these four sectors, we looked at five leading companies over the last 15 years (from 1991 to 2006), tracking both share prices and profitability.

Absolute Returns: Of the 20 companies that were examined, maximum gains came from ITC, a whopping compound growth rate of 37.3 per cent. This means Rs 10,000  invested in ITC shares in January 1991 is worth Rs 11.6 lakh (Rs 1.16 million) now. This does not include dividends paid to the investor.

The second-highest return came from the  pharmaceutical sector, with Cipla returning 35.57 per cent compounded. A total of five companies returned more than 30 per cent year on year, and all of them are in the  pharma and FMCG sectors.

At the other end of the scale, seven of the companies returned less than 15 per cent compounded. With the exception of Colgate Palmolive, all of them are from the  commodity sector. If one were to go by this sample, pharmaceutical and FMCG stocks are not just defensive stocks, they also yield high returns to the long-term investor.

This despite the high earnings multiples they enjoy, which is also the reason that they are able to command these premiums.

Earnings fluctuations: The other piece of analysis was to look at how company earnings have fluctuated during this period. For this purpose, profit after tax for each of the 20 companies for every year since 1991 was mapped. Cipla saw earnings improve year after year, for every one of the 15 years, while Nestle and ITC saw earnings slip in only one year. Hindustan Lever saw lower earnings in two years out of 15.

By way of contrast, Sakthi Sugars saw earnings fall in more years than those in which earnings improved -- it saw better earnings in only six years out of 15. Even Bajaj Hindustan, which returned almost 30 per cent to the investor over 15 years, saw earnings drops in seven years. In some years, the swings have been extremely violent.

For instance, Bajaj Hindustan lost Rs 23 crore (Rs 2.3 million) after tax in 1993. It showed a profit of Rs 95 crore (Rs 9.5 million) next year, and the year after, in 1995, it made only Rs 13 crore (Rs 1.3 million).

Surprisingly, an investor in Bajaj Hindustan would have made almost exactly as much money as an investor in HLL over 15 years. Rs 10,000 invested in HLL stock in January 1991 would be worth Rs 5.28 lakh (Rs 528,000) today, compared to Rs 5.03 lakh (Rs 503,000) that Bajaj Hindustan would have yielded.

This truly encapsulates the essence of the commodity stocks story. The best of commodity stocks may match the long-term returns of the top pharma or FMCG counters. But, as commodity prices tend to fluctuate quite sharply, their share prices see violent swings.

Those who are on the inside of these cycles are able to anticipate them, and can profitably trade both commodities and shares of commodity companies.

Those on the outside, which includes most of us, notice commodity price booms only when they are well under way. By the time you enter, you have missed much of the party, and if your timing is really off, you are faced with a long slide to the bottom. The Bajaj Hindustan shares went from Rs 73 in March 1993 to Rs 400 in August 1994.

As the company slid into sustained losses, the share dropped, month after month, to a low of Rs 26 in 1996. If you had bought at the top, the wait to merely recover your money would have been a long one -- 10 years almost to the day, before the share reached Rs 400 again!

So to go back to the question, "Buy cement stocks now?" our answer is a categorical "NO"! If you are invested, book your profits and look at a non-cyclical sector.

Compounded Returns

Earnings Over 15 Years