Commodity Stocks: The Potential, Perks And Profit

Even as commodity prices gain, investors are beginning to get clueless as to how to benefit from such a jump. Buying commodity futures is often not the optimal way to profit from the price movement as it may involve taking exposure via futures (derivatives). Buying futures of the underlying commodity is betting on the future price of the underlying commodity, which is a risky proposition for most investors. Instead, taking exposure to commodity stocks may be a good idea. Karan Bhojwani explores the benefits of investing in commodity stocks and explains the correlation between commodity prices and the key benchmark equity index

The stellar rally in equity markets has managed to surprise even the best of seasoned investors with Sensex gaining almost 30 per cent from its lows made in March. What this amazing rally has done is captured investors’ imagination, so much so that the impressive performance of other asset classes is almost forgotten. Commodities, for instance, have also managed to stage a strong recovery in the past few months with copper gaining 25 per cent since March 23 and zinc up by almost 20 per cent since March 23. Crude oil staged a solid recovery to gain 63 per cent from its March lows. When it comes to precious metals, silver is up by almost 26 per cent even as gold is up by 13 per cent since March 23.

One of the most logical ways to benefit from the rise in commodity prices is to buy the underlying commodity. To take exposure in the underlying commodity, the only way for investors is to take exposure via the futures market. But a majority of investors are averse to risks and may not prefer to take exposure via this route. In such cases, commodity stocks emerge as a lucrative option for investors. Commodity stocks are stocks of those companies which are directly or indirectly related in the manufacturing process of the commodity and hence have a positive correlation with the commodity. 

Commodity Investing and Diversification

Participating in the equity market successfully is all about managing your portfolio in a diversified manner. In fact, it is one of the most important tasks of a portfolio manager to identify stocks that can add diversification benefits and have potential for good returns. Commodity stocks in this context fit the bill perfectly. Investing in commodity stocks is lucrative as it can provide an excellent diversification benefit in the overall portfolio.

Commodity stocks tend to have slightly higher positive correlation with the Nifty index than the real commodity but are not always perfectly correlated with the key benchmark indices. However, commodity stocks do provide the much-required diversification benefit in the portfolio. Commodity stocks are not only popular because they can provide diversification benefits but also because they provide good return potential and act as an inflation hedge. Individual commodity prices may fluctuate due to factors such as supply and demand, exchange rate, inflation and the overall health of the economy. While overall inflation may be detrimental to financial assets, commodities are the major beneficiaries of inflation. Hence, including commodity stocks in the diversified portfolio can provide protection against any such inflation. 

While commodities have shown strong performance in periods of high inflation, investors should note that commodities can be much more volatile than other types of investments. 

Almost all commodity prices saw sharp declines during the past three months as the COVID-19 pandemic worsened. Mitigation measures have significantly reduced transport, causing an unprecedented decline in demand for oil, while weaker economic growth will further reduce overall commodity demand. Crude oil prices are expected to average $35/bbl this year and $42/bbl in 2021—a sharp downward revision from October in both years. Non-energy prices are also expected to fall this year. Metals are projected to decline more than 13 percent in 2020, before recovering in 2021 while food prices are expected to be broadly stable. The risks to the price forecasts are large in both directions and depend on the speed at which the pandemic is contained and mitigation measures are lifted. A Special Focus investigates the impact of COVID-19 on commodity markets and compares it with previous disruption episodes. It finds that the impact of COVID-19 has already been larger than most previous events and may lead to long-term shifts in global commodity demand and supply.

Source : World Bank Report !

Commodities Correlation with Nifty

With rising commodity prices several investors are speculating whether it is an early sign of an economic recovery and revival in the equity markets. If we go by historical data, it fails to conclude that there is a steady positive correlation between commodity prices and the equity markets or for that matter GDP growth. The correlation is patchy to say the least. That said, the year 2020 has been a year where most of the commodities have risen along with the equity markets so far, thus reflecting a high positive correlation.

Correlation: January 1, 2013 to June 10, 2020

The table below highlights the correlation between the commodities and the Nifty index. We can see that the correlation is high for the period mentioned for aluminium and zinc while the correlation is low for copper. There is a negative correlation observed for crude oil in the period mentioned.

Also, it is found that different commodities move differently and rarely do they move in the same direction to be able to arrive at any objective conclusion on how recovery in commodity prices reflect overall economic recovery. For example, copper showed high correlation with Nifty index in 2020 and in 2017 while aluminium showed high positive correlation with Nifty index in 2020, 2017 and 2014. Zinc showed positive correlation in 2020, 2016, 2014 and 2013 with Nifty index. 

Commodity Prices and USD

It is a foregone conclusion amongst market participants that there is an inverse relationship between commodity prices and USD. However, evidence suggests that the inverse relation does not exist anymore. For instance, commodities generated strong returns in the fourth quarter of 2016 as indicated by 9 per cent jump in Goldman Sachs Commodity index. During the same period USD gained almost 7 per cent against major currencies. 

Conclusion

Typically, investors invest in commodities for three key reasons: protection against inflation, diversification benefits and return potential. As commodities are real assets unlike stocks and bonds which are financial assets, the risk return profile of commodities varies with that of financial assets. Commodity investing is useful to manage market volatility as commodity stocks don’t move in lockstep with the key benchmark indices. Commodities as an asset class are known to benefit from rising inflation. The current secular rally in commodities could be hinting at prospects of higher inflation expected after massive liquidity influx into the global financial system.

Whether the recovery in commodity prices is suggestive of global economic recovery cannot be confirmed as it is indeed a cocktail of complex factors including commodity prices that will decide the quality of economic recovery. Commodity prices are mostly driven by the underlying fundamentals of demand and supply of that particular commodity. As far as the commodity prices and their dependence on equity goes, historical data suggests there is low dependence of commodity prices on equity prices in the short run. However, the dependence improves as we consider longer time horizons.

In other words, it is not unusual to see both commodity prices and equity prices running in the same direction in the long run though in the short run one may not expect similar correlation or dependence. In case investors would like the benefit of being invested in commodities (real assets) and at the same time enjoy the benefits offered by equity (financial assets), taking exposure to commodity stocks is the most profitable way to so. By investing in commodity stocks one can expect to get advantages of both the asset classes and align the expected returns meeting the overall portfolio investment objectives.

Nifty Commodity index is one example which highlights the performance of commodity stocks. Investors can analyse the constituents of Nifty Commodity index in case there is a need to include commodity stocks in the portfolio. In general, a rise in commodity prices has had a positive impact on the stocks of companies in related industries. However, while investing in commodity stocks it is not enough to bet on the direction of the underlying commodity. One has to gauge the quality of management and apply various quality parameters before choosing to invest in commodity stock. Valuation (PE) matters and so does the capital structure adopted by a company. Various government policies affecting the commodity sector need to be carefully analysed as well before taking a decision to invest in commodity stocks. There is no doubt that commodity stocks may increase more than the increase in commodity prices as operating leverage is at play.

Further, investors must remember that investing in commodity stocks is a double-edged sword as the prices of commodity stocks can fall sharper then the commodity prices itself. It is seen in metal stocks that the earnings have a 1.5-1.8x sensitivity to metal prices. Include commodity stocks in your portfolio only after analysing the fundamentals and studying the leverage adopted by a company. Only because the zinc prices are expected to go up does not qualify Hindustan Zinc as a good buy!