Limited supplies and high demand may continue to boost metal stocks

Driven by higher metal prices, the past 12 months have been one of the best for investors in metals & mining stocks. The BSE metal & mining index is up 144 per cent since the end of March 2020. The index closed on Monday at 13,960, against 5,713 at the end of March last year. This is the highest level for the index in nearly three years. The rally has been driven by better-than-expected earnings growth,

The combined net profit of the country’s leading ferrous and non-ferrous metal firms jumped over seven times in Q3FY21 as they benefitted from a surge in the prices of their produce and greater volumes, thanks to pent-up demand.

Gains from higher metal prices are reflected in the industry margin. At 24.7 per cent of revenues, the industry operating or Ebitda margin in the third quarter was the best in at least five years and up nearly 850 basis points on a YoY basis.

Being part of a capital and energy-intensive industry, metal producers also gained from the decline in energy prices and interest rates after the Covid outbreak.

This has led to rerating of the sector by brokerages and rating agencies. India Ratings and Research (Ind-Ra) has revised its outlook on the base metals sector to stable for FY22, from negative. "Metal demand and respective prices rebounded strongly over H2FY21, led by pent-up demand and strong government stimulus, especially China, amid supply shortages. Supplies have mostly restored to pre-pandemic levels. However, limited new supplies amid likely healthy demand should continue to support firm metal prices," wrote the rating agency.

Crisil expects primary steel producers to reduce debt by nearly 15 per cent or Rs 35,000 crore between FY21 and FY22, using the higher operating profits generated for prepayment.

This has kept metals stocks in bullish zone and the sector continues to outperform the broader market. The BSE metal index is up nearly 9 per cent since February 21, against a 2.2 per cent decline in the benchmark BSE Sensex. On Monday the BSE metal ended with gains of nearly 0.6 per cent, while the Sensex ended in the red.

However, with the rally in metal and mining stocks, stock valuations in the industry are now close to previous highs, limiting incremental gains for new investors. The top 10 metal stocks, including Tata Steel, Hindalco, JSW Steel, Steel Authority of India, Hindustan Zinc, and NMDC, are trading at 1.7x their price-to-book value, up from 0.6x at the end of March last year. This is the best valuation for the industry since FY11 when its P/B ratio peaked at 2.5x. Industry P/B had peaked to an all-time high of 3.7x in FY10 in the post-Lehman crisis recovery.

So theoretically, metal stocks can rally further from current levels but valuations are no longer in the value zone. This increases downside risks for investors if earnings growth disappoints.