The Hindu Business Line : Fear not commodity investing

For long, the investment universe for Indians consisted of stocks, jewellery, real-estate and bonds. Now, yet another avenue has opened up — commodity futures, thanks to the lifting of the three-decade ban on it.

Though it is four years since the government issued a notification allowing futures trading, commodities attract but lukewarm interest among retail investors.

A large number of brokerage firms are yet to open divisions for the commodities market. Common misgivings among investors are that ``commodities are risky'' and that ``they are difficult to understand''.

Equities versus commodities

Unlike equities, commodities touch every day life. For instance, sugar. Yet, investors keep away from commodities, unable to understand the market. But commodity markets are easier to understand than one imagines.

For one, there are relatively few factors at play, unlike in the case of the equity market where a wide spectrum of factors — earnings, free cash flows, interest rates and risk premiums — drives prices. Also unlike equities, commodities do not carry operational and management risks.

Though to a certain extent, commodity prices are driven by geopolitics and duty structures, they most often reflect the underlying demand-supply situation. A mismatch between them causes price changes.

The risk tag

Investment in any asset class — commodities, stocks, bonds or treasury bills — carries its own risk element. Commodities, in general, are tagged high-risk. This has been validated using statistical tools based on historical data.

Standard deviation is the common tool used to quantify risk, but it reflects volatility more. The risk element is the possibility of the actual varying, on the negative side, from the expected.

Proxies against inflation

Apart from being an asset class, commodities can also be used as instruments to hedge against inflation. In India, a key measure of inflation is the wholesale price index, which comprises both industrial and consumer goods. Though all the goods on the list are not traded in the commodity futures market, investors can use proxies to hedge against inflation. For instance, crude oil can serve as a proxy for diesel and petrol. It may be tempting for investors to invest in commodity stocks rather than in the commodity itself..

For example, the ONGC stock as a hedge against fuel price rise. But investors would need to consider the operational risk that comes with the ONGC stock. A drop in production or drying up of wells would impact the stock adversely limiting its hedging efficacy. But an investment in the commodity itself would not carry this operational risk.

Yet, proponents of the equity market would argue that an investment in a commodity stock is more rewarding than in the commodity itself. The leverage effect that an entity derives would come to the aid of these investors, they say. So how does a firm derive this effect? Take the case of a hypothetical company, Black Tea, which earns an operating profit of Rs 20 crore on a revenue base of Rs 100 crore.

A 10 per cent increase in unit realisation would push its operating profit up to about Rs 30 crore, that is, a 50 per cent growth (assuming the expenditure remains the same). Using the Enterprise Value/earnings befor interest, depreciation, tax and amortisation (EBIDTA) model, a fair value of the Black Tea stock would be 50 per cent higher.

A similar leverage effect is possible in the commodity market as well. For instance, while a barrel of crude oil trades at about Rs 3,900 on the MCX, investors need to pay only the margin, Rs 195 per barrel, to take exposure in a trading lot of 100 barrels.

A 10 per cent rise in crude oil prices would inflate the gains to Rs 390 or about double the investment. Of course, this can work the other way, just as well.

Element of subjectivity

Another argument that stock market proponents might throw is target prices, or the fair value of an asset for an investor. They would argue that arriving at target prices using fundamental analysis is difficult for commodities.

Though the target price — that help establish if an asset is over- or under-valued — approach to investing is thought to be scientific, there is a significant element of subjectivity attached. For, the various valuation models that generate the fair value are based on such subjective elements as growth rates.

Investors need to also understand that target prices do not guarantee returns. Though forecasting the direction of prices does not quantify the possible returns, it is the key to profiting from an investment.

With fewer factors in play in the commodities market, it is easier to forecast the direction of the prices.

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