The relationship between stock prices and stock market with commodity prices and commodity news explained.
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UDAYAN RAY Falling commodity prices, rising commodity prices, this seems to be the kind of buzzwords sort of going around for quite a few years now. Now how does it really impact a completely different market which is the stock market? It’s a different market where you buy and sell shares. To figure this out we have got with us stock market expert Mohit Satyanand.
MOHIT SATYANAND Hi Udayan!
UDAYAN RAY Mohit, there’s a commodities market from “dal” to crude petroleum to gold and what not you have. Everything figures in the commodities market. More and more of us Indians are getting used to caring about it. How do the fortunes, upswing or downswing actually impact stock markets (international) stock markets in India, share prices, shares, and what is the link and what should an investor be looking at? Is it just noise or is there something important out there?
MOHIT SATYANAND See, most of the time for a lay investor commodity prices is just noise. I think the exceptions are when you have dramatic spikes or dramatic falls. Now, dramatic falls matter a lot when you own shares in a commodity company. So, if for example,you own shares in a company that exports iron ore, the fortunes of that company are directly related to the price of its product. Its iron ore prices fall, the profitability of that company falls hugely because the cost of its labor is not falling, the cost of its electricity to run the machinery that extracts the ore is not falling, the cost of shipping the iron ore to overseas market is not falling etc. So for companies like that, dramatic drop in commodity prices, obviously play a critical role. And these companies can turn from huge super normal profits to massive losses within one financial year.
UDAYAN RAY Sure.
MOHIT SATYANAND So that’s clearly a caveat that you need to be looking at. Huge and sudden spikes in commodity prices impact the fortunes of those companies that consume those commodities as inputs. To take one example, supposing I run a company which manufactures snack foods, and a significant component of my cost is the plastic packaging in which the snack food is sold. Now plastic is a petrochemical and the price of petrochemicals is related to the price of oil i.e. crude oil. If the price of crude oil goes from $40 to a $140 in the course of a year or year and half, it suddenly changes the economics of my production. And I can’t alter price to the consumer so drastically, so rapidly. And so for a while I go through a huge margin compression. That means that my profitability suffers. And this would be true of the spike in commodity prices of any significant input into what I am manufacturing. So yes, we do need to look at commodity prices. But with the caveat or the exception of commodity prices I have a slightly different theory. I have a slightly different way of looking at it, which is that to go back to the example of snack foods. What really matters to me as an investor is whether this company whose shares I own has pricing power or not. Meaning, do the customers like its product enough so that in the medium term, meaning over a year or two, that the company can adjust its prices so as to preserve its margins? Most companies are able to do that.
UDAYAN RAY Okay.
MOHIT SATYANAND They are able to do that. So you have these temporary aberrations. So for example, if the price of–again to look at petroleum products because that’s our biggest import and that’s where we as a country are most vulnerable, it could take up their cost of plastic packaging and it could take up the cost of the input into paints for example. And it does mean that there is a margin compression for a paint company.
But over a few quarters, it all rights itself. And what typically happens when you have these kinds of disruptions is that the weakest fall. So you may have a company which has in any case not been growing well in the paints sector and it drops out. In the medium term, the number of houses in India is only going up. The frequency with which we paint our houses is only going up. The average room size is probably going up. And therefore when this kind of disruption happens, the more successful company is going to grow.
And these become opportunities. If you keep your cool and if you remember that in the medium term companies can bring their margins back to a healthy level, most commodity price spikes create an opportunity for entry. And I would much rather look at which are the companies that will be able to survive this disruption and get in and buy stocks of those companies at that point in time?