Investors fear big decline in metal companies' margins and profits

Investor fears of an earnings growth in the metals and mining space is at its worst in a decade, leading to a sharp fall in the valuation of stocks in the sector.

The S&P BSE Metal Index is currently trading at a trailing price-to-earnings (P/E) multiple of 4.5x — the lowest in over a decade. The combined market capitalisation (m-cap) of the 10 stocks that are part of the BSE Metal index is down 30 per cent in the past three months as investors fear a big decline in metal companies’ margins and profits in 2022-23 (FY23) due to a combination of price decline and lower volumes. This makes the BSE Metal Index the biggest underperformer in the recent sell-off in the broader market.

Historically, metal stocks have always traded at a discount to the broader market due to the sector’s higher earnings volatility. But the valuation discount is now at a record high. The benchmark BSE Sensex, for example, is trading at a trailing P/E of 21.8x.

The companies in the metal index had a combined m-cap of Rs 6.37 trillion on Tuesday — down from Rs 9.15 trillion at the end of March this year and Rs 7.1 trillion at the end of March last year.

By comparison, the companies in the BSE Metal Index reported a combined net profit (adjusted for exceptional gains and losses) of Rs 1.43 trillion in 2021-22 (FY22) — up 136 per cent year-on-year, from Rs 60,454 crore a year ago.

Most analysts, however, see the big jump in metal companies’ earnings in FY22 to be an aberration which they will find it tough to repeat due to global macroeconomic headwinds.

“Mining and metals would decline further because of the risk of recession in the global economy. A global recession will result in lower demand for industrial metals and thus, a sharp fall in their prices and earnings of mining and metals companies,” says Dhananjay Sinha, managing director and chief strategist, JM Institutional Equity.

The metal sector also faces headwinds from an investment slowdown in China that accounts for more than half the global metal demand.

“Cyclical sectors, such as consumer discretionary and industrials, score poorly in the Asia Pacific region. With China moving away from investments and transitioning towards more consumption, it is where past performance could be an unreliable indicator of future performance,” write analysts at UBS in their report on fears of a stagflation in the global economy.

Another reason for a possible further decline in metal stocks could be because the sector has been cheaper in the past on a price-to-book (P/B) value basis.

The BSE Metal Index is currently trading at a P/B ratio of 1.25x — nearly 20 per cent higher than 1.04x at the end of March 2020 and nearly 10 per cent higher than 1.13x at the end of March 2019.

In India, the future outlook for the sector has also been clouded by the recent government move to curb metal prices and reduce exports. Last month, the government imposed export duty on steel and made its import duty-free. This led to a decline in steel prices in the domestic market that could adversely affect the earnings of steelmakers in the first quarter of FY23 and beyond.

Steelmakers like Tata Steel and JSW Steel were the biggest drivers of an earnings surge in the BSE Metal index last financial year.