Value Investors Tribe

Author: Gautam Baid

The Joys of Compounding by Gautam Baid is a comprehensive stock market education guide for anyone who’s starting to learn about investments as well as for anyone who has been investing for a while. Gautam Baid skillfully articulates the lifelong learning required for investing as well as documents the essentials of investing in common stocks. In this part 5 of decoding the book we’ll summarize how Gautam guides us in investing in commodity stocks. Commodity stocks are stocks where the underlying business is involved in selling commodities such as graphite electrodes, metals, paper, sugar and similar other products which are cyclical in nature and rarely have product as a moat since customer inherently chooses cheaper product. Below are the guidelines by Gautam Baid on how to invest in commodity stocks:

• Prices of commodity stocks depend heavily on capital cycle. A capital cycle is based on the premise that the prospect of high returns will attract capital just as low returns repel it. The resulting ebb and flow of capital effects long-term returns of shareholders in what often are predictable ways, this is defined as capital cycle.
• Commodity businesses are not a long-term investment opportunity but a short-term opportunity when the businesses are in down cycle because of multiple reasons and general cyclicality in the industry.
• More than consistency and traditional metrics, a percentage change in business’ earning results in higher return. As a result, a well-managed, low-cost commodity producer usually do not generate high returns but a high-cost producer generates higher return since percentage gain is shown higher in the later one.
• When comparing commodity stocks to buy, valuation in terms of Enterprise Value (EV)/Earnings before interest, taxes, depreciation and amortization (EBITDA) i.e. EV/EBITDA ratio is favorable. A business with low EV/EBITDA ratio is considered cheaper irrespective of P/E ratio and other traditional metrics.
• A loss-making company with sizeable revenues and a low market cap to sales ratio proves to be more profitable investment since even a small change in profits shows higher percentage gains which drives market attention.
• Operating Leverage plays big role in these businesses. Instead of looking for total installed capacity, look for existing capacity utilization and room for excess capacity. This excess capacity available will be utilized in up cycle without much capex showing higher percentage gain compared to peers.
• In an up-cycle, integrated players with captive power and/or raw material linkages are biggest beneficiaries and hence investing in these businesses can provide high returns.
• A signal of up-cycle in the industry is the insider buying. Usually when the insiders are buying the shares in open market, it is a clear signal of up-cycle.
• Government regulations such as imposing import and export duties can significantly impact these stocks. As a result, keeping an eye on policies can help understand the future impacts on the business.
• In an up-cycle, the profits soar and the management announces capacity expansion which in most cases is irrational projection of future in a cyclical industry. When multiples businesses in an industry do this, it is a good time to exit or at least reconsider the initial investment thesis.
• When only one or two companies in an industry are profitable, it is a good indication that the commodity in question is in down cycle or nearing the bottom of the cycle.
• Investing in commodity stocks is highly counterintuitive since the traditional metrics such as P/E ratio, ROCE. ROE etc. does not play important role and unconventional metrics such as EV/EBITDA ratio, Price/Sales, capacity utilization etc. play critical role. As a result, investing in commodity stocks should be pursued with thorough checklists and preparation.

This part 5 of summarizing important concepts from Joys of Compounding is to highlight some of the insights shared by Gautam Baid to be a successful investor. I highly recommend reading the book for some more interesting insights and to sharpen your skills.

Disclaimer: The content in this blog is purely for educational purposes. We do not claim any copyright of the book Joys of Compounding, all rights reserved by the publisher and the author of the book