Tenets of Commodity Investing – Framework, Experience & Learnings

In this post regarding investing in commodity businesses, I cover the following:

  1. Natural vs Processed Commodities,
  2. 10-pointer framework/takeaways based on our experience,
  3. How our stock-picking has evolved and current commodity positions in the portfolio. 

We broadly divide the commodity universe into two categories – first is Natural Commodities (/Resources); these are nature’s gift to mankind. All one needs to do is just extract these and sell to the customers. Some examples of natural commodities include minerals like iron ore, coal, oil & gas, limestone, agricultural produce like tea leaves, green coffee, cotton, wood etc.

Iron ore mining companies like NMDC or Sandur Manganese typically own their mines or have them on long-term lease. To dig out the iron ore, they hire mining operators and pay them on output basis (per ton) in addition to some royalty to the government for every ton of ore mined. These two are the primary cost components, and important to note that both remain the same for every ton of output irrespective of its selling price. It is similar for Coal India while mining coal or for ONGC while drilling natural gas. In case of a tea plantation, the same plants yield tea leaves every year for over 50 years – all you need to do is get them plucked manually, which makes labor as the key cost element.

In all the above cases, the unit operating cost is largely fixed in nature, while the selling price is totally market determined and keeps changing. All industry players are price-takers – they accept the market price given the product sold by them is homogeneous with no major differentiation. A fluctuating selling price with a fixed unit cost leads to wild fluctuations in revenue and profits.

Let’s assume the total cost of mining iron ore is Rs 1,500 per ton. Some time back the iron ore selling price (spot) rose to Rs 10,000 per ton implying the gross profit was Rs 8,500. But more recently, the spot price has corrected to Rs 5,000 implying the gross profit has dropped to Rs 3,500 (since the mining cost still remains the same at Rs 1,500). In percentage terms, the gross margin fell from 85% to 70%, but absolute profitability drop is much more significant at 60%, which implies while analysing commodity businesses, looking at absolute profitability i.e. Gross Profit per ton or EBITDA per ton makes much more sense than looking at distorted percentages.

Since commodity prices can be tracked daily, while the volume run-rate can be gauged by historical operations, the quarterly P&L of these companies leave little scope of surprises. An exception is when companies do a step-up jump in volumes; a relevant example could be that of Sandur Manganese which has applied for an Environment Clearance for enhancing its annual permissible volumes to almost 3x.

Otherwise, the key variable to track in such businesses remains the selling price of underlying commodity, which moves in cycles led by global demand and supply. Assuming the market, at the starting point, to be equilibrium, the marginal (incremental) demand or marginal supply can distort the entire pricing. A 5% extra tea production in Sri Lanka or Kenya can depress global tea prices by 20% as they dump the excess stock. Similarly, a sudden demand spurt or supply shock can increase commodity prices by 200% as seen recently in iron ore.

The second category is that of Processed Commodities – iron ore processed into steel, green coffee beans to instant coffee, maize to starch, cotton to yarn, wood to paper, limestone to cement etc.

Just like natural commodities, here too everyone is a price-taker given the product sold by them is homogeneous with no differentiation.

But unlike natural commodities, tracking the selling price alone serves little to no purpose for an investor, because their cost too is fluctuating. Accordingly, the profitability of these companies depend on spreads – the difference between sales realisation & input cost.

The spreads could be shrinking even when selling price is rising, if input cost is rising faster. On the other hand, spreads could be rising even if selling price is falling, if input cost is falling faster. The only relevant metric to track here is the SPREAD.

An exception would be a vertically integrated player who is insulated from input cost variations – like a steel mill with captive iron ore mines or a paper manufacturer with captive wood plantations and pulp unit.

Based on our experience of investing in commodity businesses, we share the following 10 pointers that may help others with forming or improving their own framework to operate in this segment:

  1. Short-Term Opportunity: Commodities and hence commodity businesses move in cycles, making them less attractive for long-term investing. Although, they can provide excellent opportunities to trade whenever cycle turns favourable. Keeping this in mind at all times is important so that one stays agile and track industry developments closely. This is not for the lazy or fainthearted.
  2. Opportune Buying: Most money is made when one is acting contrarian as opposed to buying when the consensus is already positive on sectoral prospects. This implies opportune time to enter commodity businesses is when the underlying commodity price is at or below marginal cost of production, causing losses to majority of the producers and thereby reported return ratios are below the cost of capital. This leads to exit of weaker players restoring demand-supply balance and increasing prices, similar to what we witnessed in Graphite Electrode industry globally in 2017.
  3. Ignore Price-Earning: Standard valuation metrics like price-earnings – buy low & sell high, doesn’t apply to commodity investing. In fact, what works here is its opposite. In bad cycles, when profits are depressed or company is incurring losses, the P/e would optically look  insanely high or negative but that could be an attractive entry point if our view on cyclical turnaround is positive. In the midst of a good cycle, the profitability is inflated and the P/e is low, but those optically looking cheap P/e of 2-3x could later prove to be very expensive when cycle turns negative and earnings contract or altogether disappear.
  4. Initiate with Quality: When entering during a bad cycle, it is safest to be with lowest-cost producer with strongest balance sheet (lowest debt-equity). They are always the last man standing and first ones to bounce.
  5. Alpha in Going Down the Quality Curve: Once it is established that the cycle has indeed turned favourable and here to stay for a while, the weakest players with sub-optimal cost structures and leveraged balance sheets bounce back the sharpest. In a bad cycle, they are most vulnerable to bankruptcy which is also reflected in their starting valuations being way below replacement cost, hence when they get back to profitability, their stocks provide the maximum upside riding both earnings explosion as well as valuation re-rating.
  6. An Illustration – Steel: If one has to place a bet in the middle of a weak steel cycle with an assumption that the cycle has bottomed out, JSW Steel could be a safe choice given it is amongst the lowest cost producers, as well as boasts of a strong balance sheet. The safety comes from the fact that even if the cycle were to take longer to turnaround, JSW wouldn’t face a bankruptcy risk. But once it is established that cycle has indeed turned around, companies like SAIL or Godawari Power can provide maximum upside as witnessed in the recent cycle as well.
  7. Tracking the Relevant Variables: Depending on the category of commodity business one is invested in, tracking the right variable is crucial. For natural commodities, tracking only the commodity price would suffice. But for processed commodities, tracking the selling price alone can be misleading. Rather one needs to keep a hawk eye on the spreads – difference between the input cost and the selling price, this is the key to determine the direction of profitability. Within an industry, one has to determine how soon the price changes are reflected in a specific company’s P&L – for example Coal India only sells 10-15% of its coal production on spot basis in the e-auction market while the rest is all under long-term fuel supply agreement, so delta would be a lot lesser and slower here versus a company which entirely sells in the spot market. Further, most rewarding would be the company which is going to experience the potent combination of a step up jump in volumes while being in a favourable cycle of rising realisation. Prefer working with absolute profitability numbers i.e. Gross Profit per ton or EBITDA per ton as opposed to distorted percentages.
  8. Selling Timely: Selling at the right time and locking those notional gains is most crucial given the cyclical nature of business. History shows that most cycles last at max a couple of years while very few go on longer to be termed as ‘super cycle’. Near the peak of the cycle, all companies typically run at high utilisation making loads of money and almost always end up undertaking synchronised capacity additions (to protect their market share). When such a large capacity hits the market at the same time, it is natural for the demand-supply equation to flip in favour of consumers. A useful thumb rule is to get cautious and prepare for exit when the enterprise value (market cap + debt) of commodity businesses move above the replacement cost of their operations. Such valuations generally point to exuberance and also become a precursor for new capacity announcements. Over staying in good cycles based solely on ‘narratives’ like the company is transforming itself into a value-added products company or backward integration will lead to permanently high margins, mostly lead to disappointment via subsequent drawdowns. Adhering to exit rules and being okay leaving some money on the table generally serves as a good process, on the whole, even if it implies  missing 1/2 companies that indeed transformed away from commodity and created cross cycle wealth for its shareholders.
  9. Risk Management: Given the volatility and inherent risks, keeping a check on individual stock allocation as well as to overall commodity basket in the portfolio is crucial. This could be different to different people based on their risk appetite and understanding of the underlying commodity markets. However, for an average investor capping individual allocation at 5% and overall commodity basket exposure at 20-25% of the portfolio could help manage the risks well. Further, the typical investment horizon in these commodity plays could range from as low as few months to a couple of years, which implies the released capital will have to get rotated again and again. This exposes us to reinvestment risk i.e. not able to find reasonable investment opportunity, having to sit on cash for extended periods of time or go down the quality curve / pay higher valuation to enter alternate long-term opportunities.
  10. Stress of Maintenance Research & Volatility: Commodity Investing can surely be rewarding when done right, but chances of getting it wrong on either the entry or the exit remains high. The maintenance research, information bombardment, volatility and associated stress is never ending and one needs to stay ever alert given its a ‘timing’ game. Few years ago, I had talked about this at length in a post I wrote for Safal Niveshak titled ‘The Low Stress Way to Research Stocks’, link is shared at the end of this post. Our prior investments in commodity companies have been a mixed bag – while Goodricke (Tea) was a bad experience, we continue to have some exposure like in Gujarat Ambuja Exports where we have made reasonable returns (32% CAGR) & continue to be positive. Although incrementally we are gravitating more towards the opposite of commodity investing, and that’s where the bulk of our portfolio resides today.

But what is the opposite of Commodity Investing?

The opposite of commodity investing is looking for businesses that aren’t price takers. In other terms, they enjoy pricing power i.e. have the ability to pass on the burden of increased input costs to customers without losing the customer to a competitor, and thereby maintaining the profitability. The simplest way to ascertain whether a business enjoys pricing power or not, is to see whether the annual gross margins over the last 5-10 years are reasonably stable or showing a wide variation.

It takes a lot more effort to find such investment opportunities, it takes a lot more patience to wait for the right valuation to enter such companies, but once done right, the incremental journey of compounding can be very peaceful. I can’t emphasise enough how wonderful it is to be invested in companies where one can stay invested for long-term (3+ years), as there are very few such businesses. It compounds capital. It reduces churn. Lessor number of decisions lowers the chance of wrong decisions. It plugs trading-induced leakage via brokerage, STT and short-term capital gains taxes. It reduces stress and improves staying power during market crashes. One can keep deploying more capital in same businesses as they keep growing while justifying higher buying prices. One can allocate big to such businesses leading to a fairly concentrated portfolio (20-25 positions) which can be tracked better and, when needed, course correct timely.

Just to be clear, it doesn’t mean we aren’t hungry for generating alpha anymore or okay missing obvious opportunities. For example, we do find it exciting how steel production in India is poised to grow throughout this decade and we want to participate in this growth opportunity. However, instead of investing in steel producers and exposing ourselves to global commodity price fluctuations, we have been invested in an ancillary play, a fast moving industrial goods (FMIG) company that supplies critical raw material to steel makers while exhibiting pricing power across cycles. Since investing in this company in 2017, we have compounded at over 30% CAGR, without any major drawdowns. The incremental returns for next 3-5 years continue to look attractive at 20% CAGR giving us staying power without worrying about what would China do next year regarding its steel policy or praying that Indian Government imposes anti-dumping duty on imported steel.

Disclosure: We may have ownership of stocks discussed in this post under ‘Treasure Trove’ (a model portfolio consisting of our top 20-25 fundamentally strong stock ideas for long-term) and Anti-‘ES’G Smallcase. 

Relevant Links:

  1. Video covering thesis on Gujarat Ambuja Exports: www.youtube.com/watch?v=ry2mMFFnkbc
  2. Guest Dashboard (Free) with some current research reports (GAEL, Wonderla, Suven Pharma etc) & all past equity research reports:
  3. The Low Stress Way to Research Stocks
  4. Anti-‘ES’G Smallcase

Disclaimer: This is not a recommendation to buy/hold/sell. Please consult your financial advisor before acting on it. Read the complete disclaimer here.

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