How to Make Big Money in the Materials Sector

A framework for investing in cement, chemicals, metals and paints

It was in the beginning of 2019 that I was asked if I want to start covering the Materials sector. Asset management has a very simple objective; in its crudest form, the only goal is to make money. I had no reason to feel or exhibit any objection to this proposition.

By then I had spent five years in the markets, in institutional equities. However, I was tracking structural stories like technology, internet, exchanges and business services. These were almost simply predictable, easy to determine the trajectory of and touched peaks and troughs only occasionally, that too slowly over an elongated period of time. In short, they were easy to make money of.

With Materials, the only attribute I knew of was cyclicality. And it can be rather intimidating (because of the lack of familiarity), the large and rapid swings that cause stocks to double or halve in weeks. However, when one’s managing assets, this is the most exciting life can get. Volatility equals opportunity.

Over the next year and a half, I picked up one sub-sector after another, deep-dived into it, formed an opinion on it and its constituents, played around with their positioning in the portfolios and managed to crack consistent outperformance. In fact, most of my outperformance at the portfolio level can be attributed to Materials. The other sectors either contributed insignificantly or just cancelled each other out.

The only lesson I took away was that if you understand the Materials index well, you can make a tonne of money by playing it right. Despite the cyclicality, one can materially outperform the markets just by following a few simple tricks. Not few, just five. Here they are.

1. To beat the index, first understand it

The MSCI India Materials index is a very diverse one. It is made up of 12 stocks with weights ranging from 4% to 19%. At first glance the constituents appear very diverse — Ultratech Cement, UPL, Tata Steel and Asian Paints amongst a set of more spread-out names.

In this case, how do you even make sense of the direction the index will take? Ultimately, that broad directional call with determine your relative sectoral positioning in the portfolio, and even stock selection.

The easy way to tackle it is through structure. Club companies together as closely as you can, and what you end up with is an almost equal division between Cement, Chemicals, Metals and Paints.

Now each sector within Materials has its own drivers, direction, trend and fundamentals. But the beauty of a well, and in this case, almost equally divided index, despite its inherent cyclicality is that it all cancels each other out. Its a classic case of diversification and risk distribution. When you plot the monthly returns of these high-cyclicality wild animals together against the broader MSCI India index, they can be called nothing other than domesticated.

Lesson: you don’t have to think much about where the index will be headed. It has a high correlation with the broader market and will almost always follow it. An extrapolation of your call on the market to the Materials index can be worked with. So where’s the opportunity, you may ask.

If you plot the four sub-sectors of the Materials index and the Materials index itself in terms of monthly returns, you will see a high amount of deviation amongst the sectors. The high dispersion of monthly returns around their weighted average mean can be seen from how far the sub-sectors sway each month.

See the variance, but don’t understand what the big deal is? Let me plot it differently — a bar graph of relative monthly returns of the sub-sectors will show the relative under / out performance of the sub-sectors against the Materials index.

Notice how at ALL times, there’s at least one sub-sector with an opportunity to outperform the Materials index (and hence the broader market) by at least 5% each month. This is a goldmine.

Also, see how cyclicality beautifully moves across the time period. Each sub-sector alternates between underperforming and outperforming, with cycles lasting anywhere between two months and six months.

2. Identifying cycles

This is the tricky part. The cycles look choreographed in the hindsight, but that’s the benefit of looking backward. One doesn’t make money by thinking about the past, but does by predicting correctly what will happen in the future.

You can’t escape research. The only way to benefit out of the opportunities is to understand each of the sub-sectors, and what moves them. Each of the cycles has a fundamental reason explaining the movement. The key to cracking this is by

a. understanding the determining variables,

b. knowing where they stand at this point in time,

c. how they will move going ahead,

d. what impact they will have on the sector and companies within, and

e. how and when investors collectively will perceive this, and consequently react to it.

A few examples:

(1) Cement demand is highly correlated with how the previous year’s monsoon has been. 2019 was a good monsoon year, and logically 2020 should have been a good year for cement demand bar the pandemic.

(2) Cement demand shoots up in the year before elections as governments try to speed up spending and show progress to people. Immediately after the elections though, the excess demand dries up resulting in a slump in volumes.

(3) Trade restrictions on China result in a volume uptick for chemical exporters as users look to source chemicals from other regions. Since China forms a sizeable chunk of the total pool, sudden shortages in the global market also result in higher pricing.

(4) A pick-up in global production of automobiles results in higher demand for Aluminium.

(5) Excess steel capacity in China and low prices have a downward impact on global steel prices.

Over the past year and a half, here’s a brief attribution for the sectoral performance.

One doesn’t need to be right each time to benefit out of such a sector. In fact, having expectations of getting it right each time is only detrimental to the process. Behavioral biases can emerge from success and failure, which need to be kept at bay in order to maintain a healthy win ratio over time.

Lowkey flex (not) — out of the 12 cycles you see here, I was able to get eight of them right. By right I mean, being able to generate an overweight or underweight position in the sector to match with the prevalent underlying cycle. That implies a 67% win ratio. Of course, only being positioned correctly isn’t the only determinant of success. The more important one is the degree by which you’re overweight or underweight when you’re right or wrong.

3. Broad calls versus deep-dives

In dealing with cyclicals, what’s worked brilliantly for me is to focus on identifying cycles and playing them, rather than deep-diving into stocks and taking a bottom-up approach. Intuitively, and logically, if you’re playing cyclicality, you want to go top-down.

For stock selection, I figured three approaches to have worked in the case of Materials — (a) sensitivity analysis to see which factor impacts which company the most, (b) a non-circumstantial avoid list in each of the sub-sectors, and © structural favorites to beat the cyclicality. But I’ll come to stock selection a little later.

For cycle identification and to gauge its impact on the sector, broad investment frameworks add a lot of structure, aid clarity of thought, contextualize the cycle and help identify how best to play it. For the sake of keeping this short (which I’m already failing miserably at), I’m going to take just one sub-sector as an example.

The idea is to do the following:

(1) Take a call on demand growth depending on how the monsoon has been, whether there are any upcoming state or national elections, if there any government schemes like the PMAY supporting demand, what the size and status is of major infrastructure projects like metros and dams, how the urban housing demand-supply situation is turning up.

(2) Understand supply dynamics by keeping a track of which company is adding capacity, where, whether it is greenfield or brownfield, in how long it is coming up, if it is clinker addition or just grinding capacity, if limestone is available to the company from existing mines or new ones.

(3) Gauge the impact of the demand-supply situation on volume and pricing. In most times, demand trends are easy to gauge. However, pricing is a complex one. Pricing trends are more regional and not national, and are determined by demand, market share dynamics (is one player dominating decisions or is the market fragmented), new capacity addition (more capacity will lead to price pressure, new/small players don’t have much ability to determine pricing despite their need to get more of the new output sold and lower ability to deal with increased periods of low utilization), profitability (are raw material cost increases being passed on or absorbed), etc.

(4) Determine profitability trends from demand, supply, raw material costs, etc.

(5) Based on all of the above, determine which region is more preferable, or if pan-India players will benefit the most. Form regional calls and map the pecking order with the output split for companies to collate a list of favorable companies.

(6) Assess various companies and their sensitivity to these factors not only in terms of geographical mix, but also based on factors like efficiency of plants, operational factors, lead distance, branding, etc. to determine beneficiaries.

(7) Look at relative valuations and hunt for mispricing or potential re-rating candidates.

(8) See what the market is giving more importance at what time. There can be periods where demand is weak, but intact pricing and low raw material costs can lead to heightened profitability and valuation re-rating.

4. Avoid lists

For one, it seems intuitive that when a sub-sub-sector is in vogue (East India in Cement, Fluorine in Chemicals, Steel in Metals), that all companies within that classification will move in one direction. However, they will move in varying degrees depending on their sensitivity to the cycle, how fond the market is of those companies, potential for valuation changes from pre-cycle levels, and multiple other factors.

I love the idea of avoid lists when dealing with cyclicals because of the simplification it can result in. The focus then can be on identifying cycles and just picking a name from the preferred list, and entirely avoiding the avoid list. My avoid lists were either for simplicity of decision making or for stress-reduction at the cost of lower returns. Here’s a couple of examples:

(1) Simplicity: I generally avoided investing in South Indian cement names for the excess limestone in that region and a highly fragmented market resulting in constant price wars. Avoided fertilizer companies for the high regulation and government intervention, and the likelihood that any government policy change would be in the favor of farmers and not corporates.

(2) Stress-reduction: I avoided any names with a higher-than-peers leverage and companies that would potentially find it difficult to repay debt, or those with corporate governance issues. Even if the company has a higher potential benefit from an underlying factor, and can lead to more upside; I’d be okay losing that excess return and rather be in a safer name that won’t shock me on a governance lapse. But that’s a personal choice to make.

5. Structural stories to hedge cyclicality

If you observe any of the sub-sector cyclicality charts, you won’t see Chemicals making any significant difference. That’s to do with the companies getting represented — Grasim, Pidilite and UPL. They are distinct from each other and have their own stories to ride on and hence don’t really collectively exhibit trends.

However, Chemicals as a sector has been killing it for India’s increasing footprint in the global chemical supply chain. What eventually happens in most chemical companies is that increase in volume (led by structural factors) and profitability (because of a migration from basic chemistry to value-add products) override the effect of any negative impact from cyclical downturns in volumes and pricing. Being invested in such names gives a structural turn to the portfolio, and a natural benefit when compared to the underlying comparable cyclic index.

Or consider Paints. Asian Paints has been a winner for years now. Playing on the themes of unorganized to organized, market dominance, quality of network and distribution, branding, a superior product portfolio, etc. the stock has been a structural game. Just being overweight in this one would result in better than markets performance.

Getting structural stories on board adds to predictability, reduces the impact of cyclicality, diminishes the need to identify cycles and rotate the portfolio, allows a more comfortable earnings-valuation play over time, and even leaves room for error in playing cyclicality.

In conclusion, a combination of all the above five points leads to a decent enough framework to mint some serious money in a sector that throws opportunity consistently. It’s something one better not ignore because just nailing this one sector is enough for you to be able to consistently outperform the markets.

At the end of the day, volatility = opportunity!