State of cyclicals: Metals & Mining

The cyclicality of the metals-and-mining segment is driven by the law of supply and demand. When companies foresee a rise in demand, they go for capacity expansion. However, this capacity expansion doesn't happen overnight. For example, it takes seven to 10 years to develop a mine and only after that, the supply comes to the market. This mismatch between supply and demand causes metal and mineral prices to rise. Another determining factor is where metals and minerals are produced and consumed. If we consider steel, Australia (around 30 per cent of global production) and Brazil (about 16 per cent) are the major suppliers of iron ore, which is a key raw material for steel.

China accounts for 53.3 per cent of the global steel production and around 50 per cent of its consumption. Hence, to understand the steel cycle, it's important to understand the business conditions in these countries. Similar is the case with other commodities as well.

HISTORICAL PERSPECTIVE
The last metals-and-minerals super cycle, which started around 2002, was led by China and other emerging economies, like India. Construction of modern infrastructure and cities at an unprecedented scale left suppliers struggling to fulfil demand. The rally lasted till 2014, post which a slowing global economy led to a drop in prices.

OUTLOOK
A rebound in Chinese economy from the pandemic-driven slump, boosted by large spending on construction, is positive for the metal-and-mining sector. Low interest rates, rising global demand post COVID and huge investments in clean energy are some other reasons cited for the recovery. Iron-ore prices have reached a decadal high in recent months largely on account of a mine disaster in Brazil, which blocked a significant chunk of output. Copper, which is trading around its 10-year highs, will see renewed investments due to its essential role in major appliances, batteries, electric cars and others. Vedanta is looking to set up a copper-smelting plant with an investment of Rs 10,000 crore. Hindalco has announced an expenditure of Rs 7,000 crore to double its aluminium downstream capacity over the next few years. After the COVID-led lockdown, the economy recovered swiftly in Q2 and Q3 of FY21. Tata Steel achieved the highest-ever quarterly operating profit of Rs 8,811 crore in Q3 FY21. Similar was the case with JSW Steel, which recorded 13 times growth in net profit. A sharp recovery in silver and zinc prices, along with volume growth, also pushed Hindustan Zinc's operating profit up by 42.8 per cent in Q3 YoY.

Methodology
Equal-weight index: Sectoral cycles are a long-term phenomenon and to observe them we require a long-term index. Since the available stock indices generally don't have such a history and homogeneity, we had to create our own index. To do so, we considered companies that had a 20-year history.

Within a sector, there could be multiple industries, so we tried to make the index as inclusive as possible. We then assigned all the components equal weights. This gave us our 'equal-weight' index.

Financial performance: In order to see whether the various sectors are on the road to recovery, we assessed the combined five-year revenues, profits and median margins of the companies constituting the equal-weight index. An upcycle often results in an uptick in these three. Do note that the idea here is not to assess the quantum of revenues or profits but to assess the trend.