There are many concepts and thoughts through which one can see commodity businesses. They are termed as cyclical, low PE deserving companies and generally have restricted weightage in one’s portfolio.
Right Definition: We believe that any business or trade where goods are sold without any value addition or without any differentiation can be referred as commodity businesses. Here word “Value addition” has vital meaning and impact. Generally, metals, cement and agro stocks are considered as commodity business. We believe if company has capacity to resist to volatility in base commodity price due to scale, stock or other natural advantage it can be considered as different company from pure commodity play.
Single Commodity Businesses: If going for the commodity companies, we prefer it to have exposure of single commodity as one can calculate impact of the price change immediately. If company is into different product but base commodity is same then it is fine. But company into commodity business with two different commodities is high risk companies, if both commodities can vary independently. Like company is having exposure into Tea and Rubber, Tea and Sugar, Sugar and Fertilizer in these scenario exact calculations cannot be done as both businesses are independent to each other.
Cyclical nature: Commodity businesses are called cyclical in nature and it is rightly so we believe. Generally, there are less entry barriers into this type of businesses. In India, there are large number of unorganized smaller regional players in commodities like cement, sugar, tea and many more. Considering this large competition price is determined by various local and international market factors. Everyone has to follow the trend and doesn’t command any pricing power. Commodity prices move on the back of capacity utilisation levels.
Zero or Negligible Working capital: Due to above reason companies with zero or negligible debt and working capital only can outperform in long term since they don’t have stocks to be sold and debt to be repaid in bear market.
Low Price to earnings ratio: There is a thumb rule in the research world that commodity businesses are fetching lower PE than other companies. We believe considering above factors if company falls into its definition of pure commodity business it will certainly fetch lower PE in long term. Temporary it may fetch better PE in Bull market but since pricing is not in its hand ultimately it will come to lower PE companies.
Exit is Important: It is worth to note that for commodity prices one has to judge valuation based on factors and data available in the market. Certainly, none in the world knows bottom or top of the commodity price and hence conviction plays important role in investment decisions. Further if your initial conviction to purchase has gone right you will have to keep eye when Bull market for the commodity is getting over otherwise exit would be an issue. And hence it has lower weight in portfolio of long-term investors.
“The problem with commodities is you are betting on what somebody else will pay for in 6 months. The commodity itself is not going to do anything for you”
– Warren Buffett