The chapter investigates the differences in investor behaviour regarding commodity investing. When the commodity cycle turns around, it has been observed that historically underperforming companies with carried forward losses and a high level of debt provide the highest returns. This is because high-interest rates cause failures, and when the cycle turns, revenues increase while interest costs remain the same or decrease. Furthermore, carried forward losses serve as an asset that can be deducted from period taxes. Both of the factors above raise the EPS and, as a result, the share price.
Commodity stocks follow commodity cycles, and investors invest in commodity stocks based on commodity price trends. Commodity companies are prone to significant swings in profitability, posing difficulties for investors attempting to value such companies. Companies in these cyclical industries, such as steel, paper, chemicals, sugar, and cement, put fundamental valuation principles to the test. The use of the discounted cash flow technique creates obstacles due to cyclical fluctuations and price uncertainty in commodities.
When it comes to investing, shareholders are always looking for the best returns. If an investor had made investment decisions based on traditional valuation parameters, he would have purchased shares of low-cost producers with a lower debt component. His returns, however, would have suffered because these valuation parameters do not apply to commodity companies, where production efficiencies and capital structures differ.
Value investors always avoid commodity stocks because they do not fit their valuation parameters.
Commodity stocks would be ideal for traders and speculators. These stocks provide them with the rush of momentum investing. Unfortunately, most investors, classified as financial addicts, are enthralled by the markets' short-term nature and excessive reliance on quarter-to-quarter bottom-line earnings. This majority forms the crowd, and the standard set by the crowd becomes the popular following. That is precisely why commodity stocks cannot be valued using traditional valuation models.