Why One Man Thinks Commodities Are Gold
11/24/2010 10:52 am EST
John Heinzl, reporter and columnist for GlobeInvestor.com, discusses the commodities boom and tells how investors can increase their commodities exposure.
Commodities are all the rage, or at least that’s what we’ve been told. Here at Investor Clinic we prefer to get our commodity exposure the conservative way, through oil and gas pipelines that pay us a rising dividend. That way, we don’t have to lose any sleep worrying about what direction commodity prices are heading.
We also get commodity exposure through the iShares S&P/TSX 60 index exchange traded fund (Toronto: XIU.TO), which has about a 47% weighting toward energy and materials producers.
But we recognize that some investors may want more direct exposure to the wonderful world of commodities. So we invited John Stephenson, author of The Little Book of Commodity Investing and a portfolio manager with First Asset Investment Management in Toronto, to tell us why commodities are booming and what investors should do about it.
Many commodities have had huge gains already. Isn’t it too late to jump in?
The average length of a commodity cycle is 20 years and, even accounting for the rise in commodities at the start of 2000, we are at most four innings into the rally. The average mine takes the better part of a decade and more than $1 billion to bring into service, which is why the cycle is so long. What’s more, when commodity prices are high, manufacturers have difficulty passing on these raw material increases in their finished products, so their margins and stock prices tend to suffer. Since rising raw material prices are inflationary and higher interest rates tend to follow higher inflation, bonds suffer when commodities zoom. Commodities zig when bonds and stocks zag, so if you're not considering commodities, why not?
What’s the biggest factor driving prices higher?
In the long term, all that matters for commodity prices is supply and demand. To understand demand is to understand China, which is the engine of demand growth. After more than two decades of underinvestment in commodity production and [then] the global financial crisis, supply is nowhere to be found. Copper inventories on the London Metal Exchange represent just eight days of global consumption—a very tight market.
During the 1960s and 1970s, around 75 million people entered the global middle class in Europe, Japan, and North America. This time around, hundreds of millions of people in Asia are entering the global middle class while the supply situation is way worse. Prices will go higher and stay higher for longer than anyone suspects. Eventually, supply will adjust and demand will be satisfied and the bull market in commodities will be over—it just won't be any time soon.
What’s your favorite commodity?
Oil. It's a miracle fuel that powers your car, buses, airplanes, and is used to make perfumes, plastics, and other everyday items, and it's cheaper than orange juice on a volumetric basis.
Natural gas. We have way too much of it in North America and US producers are drilling not because it makes economic sense, but to retain their land base. With no producer discipline, prices are likely to remain in the basement for the foreseeable future.
What’s an appropriate portfolio weighting in commodities?
During the 1980s and 1990s, the average investor would have held a zero weight toward commodities. Today, an appropriate weight would be much higher, closer to 40% or more. Of course, your age, risk tolerance and level of investment sophistication will figure prominently in this decision and may cause this weighting to fall.
What’s the cheapest way to get exposure to commodities?
The cheapest way is through exchange traded funds that are backed by physical commodities. That way, investors get low fees, and the price tracks the price in the here and now as investors would expect.
What sort of allocation do you recommend between the various commodity classes?
Of your total portfolio, including the non-commodities portion, gold should represent 10 to 15%. Of the commodities portion, energy should be 30 to 35%, base metals 25%, agricultural should be 25% and bulk commodities, such as coal and iron ore, around 20%.
So you think gold still has room to run. What about all those poor folks who bought gold back in 1980 at $850 (US) an ounce, only to watch the price collapse?
The US has in the past used the printing press to flood the money supply with more dollars and, in essence, debase the dollar. They did it after the Second World War and they did it after the Vietnam War, and those were both times that gold started to soar. That’s why with QE2 [a second round of quantitative easing] being floated there’s a lot of concern that’s what the US intends to do—inflate away their problems. You want to hold gold if that scenario unfolds. If there’s any time to buy gold, it would be now.
What’s in your personal portfolio?
All of the things I say. I have about a 15% weighting in gold, mainly gold producers but I also have the SPDR Gold ETF (NYSEArca: GLD), which is probably the most common. And I have well over half my portfolio in commodity-oriented stocks. I also have some dividend stocks, too, a few bond funds and some cash for buying opportunities down the road.