the stocks of most metal companies are trading at their two-year high PEs

Not Enough Legroom

Currently, the stocks of most metal companies are trading at their two-year high PEs. The economy, overall, has to do well to sustain such a rise

SANTAN U MI SH R A ET I NTELLIGENCE GROU P 

THE past few months have seen a strong rally in metal stocks—both ferrous and non-ferrous. There is also a rise in the prices of raw materials, mainly in case of steel. To be more specific, the prices of coking coal and iron ore—the two main raw materials for steel making—are also surging up. 
    For instance, the LME (London Metal Exchange) aluminium and copper prices have risen in the range of 16-20% in the last two months alone. Similarly, Chinese steel (benchmark hot rolled coil) has increased by around 13% duringthe same time period. Even in India, major steel producers like Tata Steel and Steel Authority of India have raised the prices of different steel products by Rs 1000-Rs 2000 per tonne. Please refer to the table for details on global metal prices. 
    While there is some recovery in global economy, such a rise in metal prices has left investors wondering. One has to remember that the prices of most of these metals are determined by global forces. The impact of such a rise can also be seen in stock prices of these metal companies. ET Metal Index, a benchmark index comprising stocks of major metal companies, has been outperforming Sensex since the middle of last year. What is important is that its quantum has widened significantly in the last few months. Looking back at the past, there is little room left for such uptick. 
    It means the broader indices have to move up for the metal indices to go northward. Please see the chart for details. In such a scenario it is important for investors to look at different aspects of this price rise. What could be the impact of this price rise on India Inc? Has the time come to realign the metal portfolio? And finally, how much steam is left in these leading metal stocks? 
    More than proportionate rise in raw material costs is going to impact the profitability of non-integrated steel producers. With the annual contracts for raw materials to be entered in next 2-3 months, it appears that integrated players will once again become the favourites of the market this year. It means investors may consider assigning higher weights to the stocks of integrated players depending on the amount of backward integration. For instance, the stocks like Tata Steel and Steel Authority of India may trade at a premium to others like JSW Steel. This also holds true for base metal companies. 
    Further, within the smalland mid-cap steel segments, many non-integrated companies halted steel production in the recent slowdown and shifted their focus to areas like power. Keeping current trend in mind, it appears that these companies will come back to core business once again. Hence the stocks of such companies that have not run-up much in the last few months have higher potential. 
    All the expectations about the rise in stock prices of metal companies this year is based on the assumption about faster economy recovery across the globe. Any negative news from that front could impact the prices of these stocks heavily, which are already trading at a rich valuation. For instance, Sail is currently trading at a trailing twelve-month price-earnings multiple (P/E) of 17 approximately, which is similar to what it was in 2007. Others like Hindalco and Sterlite Industries are trading at P/E multiples, which are even higher than their 2007 level. It means that these companies have to post significant earnings growth in the next several quarters to justify the rise in their PEs. In some cases such growth rates could be as high as 50%. 
    In the absence of such growth rates and inflow of any bad news could result in sharp fall of these stock prices. Hence risk-averse investors may consider reducing their exposure to some of the overvalued stocks like Hindalco and Sterlite Industries among others. 
    santanu.mishra@timesgroup.com