Why are sugar stocks running? Should you invest in them?

After metal, sugar stocks are now grabbing the spotlight. And for a good reason. Recently, these stocks have gained momentum. But before we delve into the reasons behind the rally, we need to first understand the industry dynamics.

Sugar is extracted from sugarcane. Apart from sugar, sugarcane produces other by-products, including ethanol that is used as an alternative fuel. India is the second-largest producer of sugar after Brazil and houses more than 700 sugar mills with a market size of more than Rs 80,000 crore. Around five crore farmers are associated with the sector, which reflects high dependence on the sector.

Although sugar belongs to a cyclical industry, its demand does not change very quickly unlike many others. Therefore, to understand the sector's cyclicality, we need to focus on the supply side. Owing to the industry size and over-dependence, it receives high attention from the government and therefore, it is highly regulated. The government decides the minimum selling price (MSP), which acts as a cushion and makes the cultivation of sugarcane more lucrative for farmers, as they are assured of their realisation.

During the good-monsoon period, the production of sugarcane is high, which leads to higher production of sugar. Ultimately, it results in low prices and lower profitability for sugar mills. At times, mill owners have to sell sugar at a price that is lower than their production costs, which leads to high arrears for farmers. Then, these farmers switch to other crops, thereby resulting in a decline in the cultivation area for sugarcane and lower production in the coming years. Owing to lower production and stable demand, the prices of sugar rise, which increases the profitability for mill owners. These high prices and MSP, thus, again entice farmers to produce sugarcane, thereby increasing its production again. This entire cycle takes around four-five years and determines the cyclicality in sugar prices.

At present, the production of sugar in Brazil has taken a beating due to lower crop yields, owing to poor sowing and unfavourable monsoon. This has led to a decrease in supply and an increase in international prices for sugar, thereby benefitting its second-largest producer India and its mills. Further, the easy export policy for sugar manufacturers has played a favourable role. Besides, there has been an increase in the demand for ethanol from OMCs (oil-marketing companies) buoyed by the government's plans to ramp up ethanol production and reduce dependence on foreign oil. In the 'National Policy on Biofuels' (2018), the government revealed its plan to achieve a target blend rate of 10 per cent by 2022, i.e., 10 per cent ethanol and 90 per cent petrol. As planned by the government, this blend rate is anticipated to increase to 20 per cent by 2030, which will increase the demand for ethanol and decrease volatility in the sugar industry.

As depicted in the graph titled 'Cyclicality in sugar stocks' constructed by assigning equal weight to the returns of major sugar companies, there is a sharp cyclical trend in this industry. Thus, it is very important for you to time the entry of your investment. Otherwise, it can result in substantial losses, which may take years to recover. Thus, one could refrain from investing in these companies and go for secular-growth companies or gain more insights into the sugar cycle and factors affecting their stock prices before investing in these stocks.