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Betting on commodities

Gopal Agarwal of Mirrae Assets says commodities as an asset class is very cyclical in nature

This fund house has a very diverse equity portfolio. While two funds are focused on the domestic market, one is a China-dedicated fund and the other a commodities fund with an exposure to the domestic and international market. Gopal Agarwal, deputy chief investment officer and equity head, not only shares his views on the market but delves in detail as to why investors must look at commodities too.

Mirae Asset offers a commodity fund. Don't you think commodities are too volatile an asset class for a retail investor?

We agree with the view that commodities, as an asset class, are volatile in nature. The news flow concerning commodities is immense and all this influences the prices significantly. Let's say you are purchasing the stock of a construction company. You may be unaware of the operating margin of the company until the quarterly results are declared or till the time the management comes out with its guidance. Not so in the case of commodities. Their annual report will tell you the cost of production and the realisation is available on a daily basis from the exchanges. Consequently, commodity stocks are relatively more volatile since the news flow is continuous.

Having said that, there certainly is money to be made in this asset class, so why should investors not participate? In this current rally itself, which started in March 2009, the BSE Metal index was the first to cross its earlier high. The Sensex moved up from 9,000 to 18,000 while BSE Metal crossed its previous high much faster. So those who allocated part of their portfolios to this asset class would have definitely benefitted.

There is money to be made, but this asset class is very cyclical in nature.

Everything is cyclical. Even the stock market is cyclical. World growth is cyclical. Between 1996 and 2002 world growth was in bad shape. From 2003 onwards there was a recovery till the collapse of 2008. The commodities market follows the same pattern. Commodities are cyclical and so is world growth.

In my opinion, demand for commodities and world growth go hand-in-hand. We cannot have a situation where there is world growth but no commodity growth. If there is no growth, commodities will be beaten down significantly.

Commodity producers are not huge in number, when looked at from the macro perspective. The demand is plenty; there are many more users than producers. So pricing power lies with the commodity producer. As demand rises, so will prices.

That is why I believe an investor must have some exposure to commodities at any given point of time. Commodities, as an asset class, will boom as world growth picks up.

How much of an investor's portfolio should be allocated to commodities?

We would recommend at least 10-15 per cent of one's portfolio in commodities. Yet, we emphasise that this investment must take place via the systematic investment plan (SIP) route due to the level of volatility of this asset class.

The volatility can be gauged from the case that a fund can at times lose over 50 per cent of its value and similarly gain an equal amount in a short period of time. Hence retail investors should preferably invest using the systematic investment plan route unless one is sure about the commodity market and its valuation.

What is the main differentiating factor you employ when picking stocks for the commodity fund?

The prime differentiating factor where the commodity fund is concerned, as against a regular equity fund, is that we employ the top-down approach with regards to our investment style. The bottom-up strategy comes only later where one looks at management, growth, valuations and other such issues.

The most important factor is the outlook on commodity prices and how sustainable they are. For example, we believe that coal is in a structural bull run. There are huge power plants coming up in the country for which a lot of coal will have to be imported since domestic production will be insufficient. China is currently a net importer of coal due to infrastructure bottlenecks and will continue to be so till 2014. With such a strong demand from these two emerging economies, prices will remain strong. We are not saying that it will scale phenomenal highs, but will remain strong. And when there is strong demand-supply mismatch, there will be a sizeable jump in prices.

Every single commodity has a different demand and supply mechanism and a very different cycle. Right now platinum is in very good shape and is the best performing metal. Being a precious metal it is bought for safety. It is used as a catalytic convertor in automobiles to reduce emissions. Demand for automobiles is on the rise, cleaner emission norms are the need of the hour and emphasis is on Euro III and Euro IV*. At the same time supply is limited. All this has contributed to the metal doing exceedingly well. So a top-down view is of paramount importance.

Copper is on a rally right now. What's driving it?

Where copper is concerned, there are no new copper suppliers coming into the market. Yet, demand is not very high. What is high is speculation due to exchange traded funds (ETFs) coming up all around the world. For speculators, copper is a good commodity. They are aware that the supply is not going to come in hence they are in a position to push up copper prices. Demand is stable but not so high that it should be trading at $7,000/tonne. Copper and aluminum are both conductors of electricity, the former being better. Hence, they should trade at a 3:1 ratio. So if aluminum today is $2,000, copper should trade at $6,000, based on a fundamental view. That is not the case and it's trading higher at $6,800- $7,000/tonne.

Do you think investors should book profits in gold?

One should stay invested in gold till the Fed rate (U.S. Federal Reserve) is below 2 per cent. Because this will mean that the world economy is not in the pink of health. The moment interest rates start rising, get out of gold. We are not saying that we are bullish or bearish on gold. All that we are saying is that it is like buying insurance. Whether it will work or not, time will tell. But to be safe, stay invested.

What global factors do you consider when looking at commodities?

We look at currencies very closely. We look at the Euro and the U.S. dollar.

Most importantly we look at the Australian dollar simply because it is a direct measurement of the commodity market. Australia has a strong economy but a small population of a little more than 20 million with an unemployment rate of less than 5 per cent. It is a highly rich commodity-driven economy. It has a supply of numerous commodities like coking coal, iron ore, copper, thermal coal and even LNG. So if the commodities market is buoyant, the Australian dollar gets stronger and vice versa.

To some extent, the same is applicable to the Brazilian currency though the linkage is not as strong as the Australian dollar. If oil is above $60/barrel, the Brazil currency is strong.

We also keep a close watch on China. It is the real driver of commodity prices because of its high demand.

In your view, how valid are the estimates of China slowing down?

Is growth in China really slowing down? In 2008, the U.S consumed 98 million tonnes of steel, which fell to 57 million tonnes in 2009 and is likely to be 73 million tonnes this calendar year. And we are saying that the U.S is recovering.

In 2008, China consumed 485 million tonnes of steel, it went up to 538 million tonnes the very next year and this year steel consumption is pegged at 575 million tonnes. And people are saying that China is cooling down!

Roubini said that China, Brazil and India may be overheating and there is a possibility of developing asset bubbles.

In China, one would find asset bubbles in certain parts of the country but we do not see it as a threat. Real estate prices in the coastal regions have shot up, but not in Central China. And Shanghai real estate prices are lower than Mumbai's real estate prices.

The Chinese are very speculative in nature. Since the debt market is not very developed, investors dabble in the stock market and real estate. Since the equity market is faltering, the action is in the property market. Once the equity market begins to perform, the speculation will shift to the equity market.

As for India, we do not see any bubble. Real estate prices have gone up but are not in the 'overheated zone', so to speak. One can compare Mumbai to Hongkong because both are landlocked and the supply of land cannot increase, though demand always exists. Hence, prices in these cities will always be on the higher side.

How dependent is earnings growth on commodity prices?

Significant. Commodity stocks have a high operating leverage. For example, let's say the cost of production of zinc for a company is $800/tonne. If the price of zinc moves from $1,500 to $2,000, then profitability goes up significantly because the cost of production is fixed. Commodity prices are volatile and they impact the earnings and stock prices significantly.

Will companies be able to sustain a high earnings growth with material costs rising and interest cost heading upwards?

In India, 40 per cent of Sensex earnings come from commodity companies. The higher RoE in 2007 and 2008 was mainly driven by commodity companies. Today the RoE is 17-18 per cent.

Infotech companies are insulated from commodity prices. Demand for automobiles is strong so earnings growth will be sustained. If commodity prices stay firm, capital goods companies will get higher orders and growth will be maintained. So we do believe that high commodity prices will be good for India.

We believe that if oil prices are below $60/barrel, it will not be good for the global economy. Similarly, if it is above $85/barrel. But should it remain within this price band, it will be excellent for the world economy. Below $60/barrel indicates insufficient world growth. The OPEC countries generate $600 billion of cash flow and this money goes across the globe fuelling growth. But if it goes too high then the issue of inflation and interest rates comes into play resulting in falling demand.

The valuation gap between mid and large caps has shrunk. Is it safer to go for large caps now?

On a general basis, there is some validity to that statement. But when you look at specific stocks the situation changes. There are many mid caps with strong balance sheets, low gearing and higher return ratios. They are still being quoted at lower valuations in comparison to some large caps in the same sector. Large caps are not overvalued but they are out of comfort zone, at least in the short term.

If you are looking at a 2-year horizon, then large caps still make good buys. But if you are taking a 6-month to 1-year horizon, then large caps are not cheap.

Are the market gains driven by expanding PE multiples? Is the market too expensive?

No. this year we have 22 per cent earnings growth so we do not agree that it is purely PE expansion. But the market is not in the value zone.

Are capacity constraints hurting growth in the manufacturing sector?

No. We do not see capacity constraints as a big issue at this point in time except in case of few sub sectors.

Last year investors bought in anticipation of a recovery. On what basis should they be investing today?

Commodity investors should look at a stable recovery in emerging markets and sustainable recovery in the U.S.

In the equity market in India, one can look at the long-term structural growth story. The GDP rate should be around 8.5 per cent, corporate balance sheets are in the pink of health and consumers have purchasing power. With these three factors in conjunction, investors have a lot going for them.

What are the global risks? Spain is tipped to be heading the Greek way.

If the global economy slows down considerably, it will impact India. We are running a huge current account deficit. We are sustained borrowers so we have to look at the global economy in a bigger way. We are very much dependent on foreign portfolio investment. So if money goes out from the Indian equity market, we have a problem. While these global factors will not impact consumption or the economy in a big way, they will impact the equity market. In May this year, the correction in the equity market was mainly due to FII outflows.

If global growth slows, there will be a sharp fall in the commodities market. A sharp drop in world GDP will result in agricultural prices dropping sharply too. We can put up artificial barriers like import duty. If the steel market is down, it will impact the commercial vehicle industry in India significantly. Same is the case if China does not buy iron ore.

What macro factors are you keeping an eye on?

In India inflation is a problem mainly because of supply side constraints. This problem cannot be resolved by hiking interest rates. With a high base effect, the inflation numbers will be moderate.

What one should really look out for is how the government will reduce the fiscal deficit on a sustained basis. This year we have the 3G auction, which is a one-time issue. But issues like reduction in subsidies and an increase in tax collection will go a long way in dealing with the fiscal deficit and give a positive signal to the market. There are three major factors contributing to the fiscal deficit: Fuel, Fertiliser and Farm. All these are heavily subsidised.

What are you betting on?

Consumption is a big theme. We are bullish on capital goods and construction companies. Corporate capex too is going to pick up. We are positive on Pharma but very stock specific and selective in terms of valuations and growth.

Euro III and Euro IV: Reference to European emission standards / RoE: Return on Equity / GDP: Gross Domestic Product /FII: Foreign Institutional Investor / PE: Price Earnings