How to take advantage of the commodity boom

There’s little doubt that commodities – at least some of them – will continue their price boom this year, despite concerns about slowing Chinese growth and the fragile recoveries occurring in the US and Europe.

But getting on board to take advantage of the trend as an ordinary investor takes some thinking through, and as always you should discuss it with a financial planning professional.

It’s not quite as simple as just buying resources sector shares, since these are a very mixed bunch and include some highly speculative shares as well as some dependent on a single commodity for their prospects. Knowledgeable diversification is the key here.

An investment in Australian coal stocks at the end of 2010 seemed an unbeatable opportunity, but relying on them solely for exposure to the commodity boom would have come unstuck, at least temporarily, early in 2011 as floods ravaged the industry’s productivity.

Mathew Kaleel, director of alternative asset manager H3 Global, has considerable experience investing directly in commodities. He says there are three main ways a retail investor can get exposure over the next six to 12 months.

First, the obvious avenue is through the resources stocks just mentioned, but you don’t have to do it yourself. There are a series of managed funds investing in resource stocks, an example being the Colonial First State Global Resources Fund.

There are also Listed Investment Companies (LICs) that specialise in commodities. An example of a commodity-focussed LIC is Global Mining Investments [GMI], which has a portfolio of global mining stocks managed by Black Rock.

 “While we don’t invest in resource stocks for clients, on a personal basis I wouldn’t be playing a sector or a theme; I would stick with diversified mining stocks or hold resources stocks in multiple sectors, not just oil or coal or gold,” Kaleel advises.

“Commodities have multi-year cycles where demand and supply change significantly. At present, what we see in a number of key commodities we trade are supply issues. Examples of this at present are supply problems in food markets. In terms of cyclicality, while gold has been one of the best investments over the last ten years, it was not such a good investment for the 20 years prior to that.

He warns against investing directly in any single commodity such as gold, whether directly (buying bullion) or through the exchange traded commodities (ETCs) that are rapidly growing in popularity (further details below).

“A good option would be a stock such as Newcrest, which has both gold and copper and a project 20-year mine life. You need to do some research. A lot of consideration should be given to larger resource stocks such as BHP, Woodside or Newcrest, that have low costs, good management and long-term production profiles,” Kaleel says.

Second, you can invest directly in precious metals through what are known as exchange traded commodities, a variety of exchange traded fund (ETF). Most exchange traded funds track an index of stocks, constantly rebalancing to match the index. ETCs, on the other hand, have the underlying commodity or mix of commodities as their only investment and are designed to closely track the price of gold or silver or a basket of precious metals.

Exposure to base metals could be gained through specific shares, but the performance of Alumina Limited shares, to give one example, has been less than inspiring compared with Australian equity benchmarks.

Kaleel says the exception is copper, which is not as abundant and is experiencing growing demand. “If I were personally overweight any base metal it would be copper,” Kaleel says.

But there’s a key to investing in resource stocks that Kaleel is willing to share. In deciding whether to buy a stock, ask what effect a 30 per cent plunge in the underlying commodity price would have on a company’s viability.

“Which companies will still be profitable?” Kaleel says. “A whole host were saved by the recovery after the recent downward price correction, whereas larger stocks, even at the lower prices, would have kept mining because they’re at the low end of the cost curve.”

Third, Kaleel says, you can invest in a managed fund that invests directly in commodity markets. “The advantage is exposure to movements in the prices of the underlying commodities. We offer an active tactical trading fund (the Ascalon H3 Commodities Fund), and because it is active it means there’s a risk that we get it wrong. In 2008 we were basically flat (but significantly ahead of the benchmark) because we went to cash and the fund doesn’t have to be fully invested. We have underperformed our benchmark recently, but have still offered good absolute returns.”

He suggests that an investor with sufficient funds wanting to gain diversified exposure to resource stocks and commodities, should look at making allocations across resources stocks, well-chosen resources funds, direct commodities (via ETCs, for example) and a direct commodity fund.

For smaller investors, “the easiest default option is a blend between two managed funds,” Kaleel says. “If you want an investment you don’t have to monitor pick a good resources fund – there are quite a few available – then a direct commodity fund which gives you exposure to prices.”

An important question to consider is which commodities are likely to show price gains, Kaleel suggests. “In the current environment of QE, we believe there is a risk that commodities are becoming a financial investment, which is potentially quite dangerous because of supply constraints.” In other words, copper hoarding reduces the supply available to industry as well as driving the price up.

Commodities likely to do well in the coming years fall into three groups:

1 Food, including corn, wheat, soybeans and cattle
2 Crude oil, but not natural gas, which is plentiful
3 Metals, notably copper, gold, silver and other precious metals.
 
Kaleel doesn’t mention rare earths, but Australia is poised to benefit by helping to break the stranglehold held by China, which produces over 90 per cent of the world’s supply of these minerals, key to electronics industry products such as computers and mobile phones, and essential in a number of other high-tech applications.

James Staltari, head of Westpac Online Investing, says there are a couple of avenues for obtaining commodity exposure, depending on your investment strategy and the type of investor you are.

“The first is ASX listed exchange traded commodities or ETCs which are traded in a similar way to shares. The ones available are gold, silver, and a basket including platinum and palladium. By far most popular is gold, followed by silver.

“The advantage is that it gives direct exposure, so you see a close correlation between the commodity price and the ETC price,” he says. Investors should note they are investing on an unhedged basis, so that a stronger Australian dollar against its US counterpart reduces their gains.

“The next avenue is shares with commodity exposure,” Staltari says, such as listed investment companies. “One feature of LICs is that changes in commodity prices are not always fully reflected in the company’s share price. There is risk related to their currency exposure, management quality, et cetera.”

Staltari points out that the nature of a managed fund and a listed product are quite different. “Pricing, liquidity, and management fees are all different in a managed fund compared with a listed product.  Listed products also offer transparency. You can see the products in your portfolio 24/7 on line.

 “There are a few popular stocks in the oil sector such as Woodside and Oil Search, and in gold, Newcrest. A benefit of shares is that you can also get diversified exposure across a number of resources, and some of the risks are mitigated by diversification.

“Another advantage of shares is that you can obtain leverage through margin lenders,” Staltari says.

“Then, if you want greater exposure, or a risk reduction strategy, you have derivatives. These include exchange traded options (ETOs), warrants and contracts for difference. With most of these, in particular ETOs you can have greater exposure for a smaller capital outlay, and in most cases it’s bidirectional, so can trade whether you have a positive or negative view of the commodity.”