Buy stocks which will benefit from steep margin expansions

Last week the global oil prices fell 4.4%, taking the overall fall to 51% in the last one year. This is a boon to the domestic industrial economy, which is yet to come out of near-stagnation, and also to few sectors, which are still struggling to show any credible business growth. There are very few sectors like IT and FMCG which are growing though the revenue growth rates have tapered off to single digits in dollar and volume terms, respectively.

Fortunately, there are certain businesses, which though posted stagnating or even steep decline in their sales, managed to post robust growth in profits in the latest quarter. Especially, the users of crude oil or its derivatives and other commodities like natural rubber, steel, etc, benefited from cheap raw material costs. Tyre industry is a clear winner in this commodity meltdown as it uses natural rubber and also derivatives of crude oil like nylon tyre cord, carbon black, etc., as core inputs.

The domestic price of natural rubber, which accounts for as much as over 40% of total production costs of tyre industry, has fallen about 25% from the last year's peak price of Rs 165,000 per tonne. By last week, it fell Rs 8,500 per tonne (6%) from the two-month high of Rs 133,000 per tonne. The tyre industry, which used to enjoy a thin profit margin of around 4% till a few years ago, has started posting robust operating margin of over 15% in the latest quarter. A tyre major, which announced its quarterly result last week saw its margins going up by whopping 690 bps on year-on-year basis.

Going ahead too the outlook for both oil and natural rubber looks quite pessimistic – in fact, the International Energy Agency expects oil price to remain bearish in 2016 as well. Further, the slowdown in the economies of Euro zone and China is expected to keep the natural rubber price remain subdued at least for the whole of 2015, if not till the end of 2016. Hence, the tyre companies are likely to sustain such high operating margins at least for another 2 to4 quarters.

Interestingly the tyre manufacturers, who focus majorly on the domestic markets, have another unique advantage – the sales of tyre to the replacement market accounts for almost three-fourth of their total sales. Therefore, the poor automobile sales didn't deter their profit growth – some of the tyre companies have posted as high as 100% year-on-year profit growth in the latest quarter. The retail investors would do well if they accumulate good quality stocks of tyre companies, which predominantly sell in the domestic market at least to the extent 5% of their portfolios.