The Better Way to Buy Commodities

02/15/2013 8:30 am EST

Focus: COMMODITIES

Adrian Day

Chairman and CEO, Adrian Day Asset Management

Should you invest in a commodity ETF, or go with futures, or would miners be a better path? Veteran commodity expert Adrian Day explains how he approaches this critical question.

Adrian, we've had quite a move in the resources sector over the last couple of years. Gold has gone up, platinum, palladium. What are your favorites right now?

You're absolutely right. Before I answer that, we need to look at the factors driving it. Obviously, there's increased demand from China, and there's demand frankly across the whole resource spectrum.

Due to their economy continuing...

Due to their economy growing. Obviously as people advance, they go from a wooden shack in the countryside with no electricity to a condominium in the city with steel and iron and electricity. They go from a bicycle to a motor car. All of these things take a lot of resources, so the demand is there.

The other side of the equation, of course, is the supply, and so I'm really looking at metals in particular that have either a shortage or a potential shortage of supply. Copper is an obvious example. Platinum—well, platinum and palladium are really very obvious examples.

Less so, for example, iron ore. Now, China needs a lot of iron ore, but there's no shortage of iron ore in the ground. You just have to have the right price to dig it up. Whereas with palladium and platinum, there is a shortage in the ground. I mean, at a certain point we just can't find any more.

So if you were an investor, would you just go out and buy the metals, would you buy some of the stocks, or would you maybe go to ETFs if you didn't know a whole lot about the industry?

Well, I apply Occam's razor to investing, which means take the simplest avenue first as long as it's a good one.

Now, with regard to the buying the metal, well, yeah, we can buy gold. You can buy gold bullion, you can buy gold coins, you can buy a gold ETF that's 100% gold. There's a copper ETF. There's a palladium-platinum ETF. But it's very difficult to buy a nickel ETF, or to buy an oil ETF—or to buy oil itself, shall we say. You know, you don't store oil in your backyard or your garage.

So if it's easy to do like gold, silver, copper, platinum-palladium, I would buy the ETF. You get direct exposure to the metal, and you don't have to worry about mining companies. But the mining companies do offer extra exposure, extra leverage, so if you can find a quality company, I'm all for buying the individual companies.

And how does an individual investor judge that? Is it a good...what fundamentals are you looking at?

Well, that's a good question. If you're looking at mining companies themselves—and the companies are actually mining, not the exploration companies but the mining companies—I think you want diversification of world-class assets. All the risk of mining is there if you're mining 10,000 ounces a year or a million ounces a year.

You may as well have the potential from a million. You know, because all the risk is still there. So I like a company that has world-class assets, and a diversification of those world-class assets into different jurisdictions, and a strong balance sheet. A strong balance sheet is essential.

And cash reserves.

Yeah, exactly, because mining is a very, very capital-intensive business. It's not just capital when you buy, there are always ongoing capital expenditures. So having a strong balance sheet is essential.

Makes sense.

Now, in copper we love Freeport McMoRan (FCX) because it's the world's largest publicly traded copper company. It's a great company with a great balance sheet—debt to assets less than 10%, which is very, very strong for a mining business.

And in gold, we like a company called Franco Nevada (FNV), which is a royalty company. They buy royalties on other people's mines. The beauty of that is once they've paid for the royalty, they have no obligation to pay for anything else.

It's gravy.

If things go wrong, they don't have to fix it. They don't have to pay for it. So those are some of the companies I like.

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