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Over the past few years, I have had multiple people ask me about investing in commodities. Often times they ask about investing in stocks of companies that produce or use commodities in production so they can gain exposure to a desired commodity in their portfolio. This is referred to as indirect commodity investing. These questions have arisen again over the past two weeks mainly because of the drop in gold prices. This article serves the purpose of explaining indirect vs. direct commodity investments and why investors should use the direct method for gaining exposure to commodities. I will demonstrate various points in this article by using Smithfield Foods (NYSE:SFD), Tyson (NYSE:TSN) and Hormel (NYSE:HRL) as examples, as well as the commodities corn and lean hogs.

To start you must know the difference between indirect and direct commodity investing and their histories. Direct commodity investing is cash market purchases of physical commodities or exposure to spot market changes via derivatives. Since most investors do not want to take physical possession of commodities, exposure via derivatives is the most popular (that being the futures market). Historically, this was expensive and not an option to most retail investors. Indirect commodity investing, as mentioned above, is having an indirect claim on commodities through investments such as equities. Historically, this method was chosen by most investors. Two key things changed this. The first being the invent of computers (availability and expense decreases) and the second being ETFs (wide scale use of computers also allowed the mutual fund industry to develop commodity mutual funds).

I state earlier that investors should gain exposure to commodities via the direct method. This is the case because companies will not have full exposure to changes in commodity prices for various reasons. Reason number one, hedges the company has in effect will vary from company to company and also shift within companies over time, for example, Smithfield Foods. Historically, Smithfield Foods only hedged feed cost (primarily corn) when they thought feed prices would rise. This would allow them to cap cost but participate fully on the upside if feed prices were to drop. The result, extremely volatile earnings (other factors also played a role in earnings volatility such as hog prices). Recently, Smithfield announced they are implementing a new hedging strategy where they will be implementing hedges on a full time basis. This means that they will neither fully participate in the rise nor fall of corn prices.

Reason number two, companies are often exposed to various commodities as well as involved in various market segments. Smithfield Foods is exposed not just to corn prices but also hog prices. In addition they not only raise hogs but distribute them as well. To take this one step further, we can look at Tyson Foods and Hormel. Each has operations not just in pork but beef and chicken as well.

Reason number three, market multiples changing over time. I will use the P/E multiple to demonstrate this because this is what most investors are familiar with. If a company has earnings of $1.00 per share and the market prices the shares at 11 times earnings, then the share price is $11.00. If the market as a whole becomes more optimistic, this multiple will shift higher. This is also true on the downside. For example, during the downturn at the end of 2008 and early 2009, the market was punishing companies that were highly levered. Both Tyson Foods and Smithfield Foods had relatively high leverage and were thus punished by the market. Their share price decline had relatively little to do with commodity prices. In actuality, corn prices decreased drastically from summer of 2008 to the beginning of 2009. If Smithfield and Tyson's share prices were inversely related to the price of corn, you would have expected their share prices to increase. During this time, Tyson lost close to 50% of its value.

Reason number four; social, economical, and political factors. Social factors often play a big role on commodity prices over time. For example, the shift to healthier foods in the United States. This has led pork and beef consumption to stabilize while turkey, chicken and fish consumption has trended upward. Also, food perceptions such as pork containing a lot of fat. However, few realize that pork tenderloin actually has less fat than boneless, skinless chicken breasts. Another example is the increasing trend to "fuel efficient" vehicles. Economically, if one product is too expensive, consumers can easily switch to a substitute (this does not apply to all commodities). If pork gets too expensive, then consumers can switch to turkey and vice versa. Historically, when the economy picks up so does beef sales. Each company will have differing effects on their share price based on their exposures. The last factor is political. One of the most notarized political policies currently relating to food is the policy regarding ethanol. Currently, 40% of corn production in the United States goes to producing ethanol which in turn is contributing to the spike in corn (much of the spike is due to drought but corn began trending upward before the drought and will continue to do so after the drought). You also have a tremendous amount of regulation from the EPA that increases costs and influences stock prices.

I will provide two examples of how indirect commodity investing would have given you undesired exposure over the past year. On August 21, 2012 corn closed at a high of $813. If I believed corn would decrease, I could directly take advantage of this by shorting corn futures or indirectly by going long Smithfield Foods, Tyson Foods, or Hormel because their highest cost is feed which consists mainly of corn. On this same day, Smithfield, Tyson and Hormel closed at $19.27, $15.32, and $28.51, respectively. Corn closed today at $623 which would have provided me with a gain of 23.42%. Smithfield, Tyson and Hormel closed at $26.29, $24.88 and $41.40 for a gain of 36.43%, 62.4%, and 45.21%, respectively. These gains demonstrate why the indirect method would not have gained proper exposure. More specifically, if we focus on Tyson, we see that in addition to lower feed prices the company improved its financial position and were upgraded from non-investment grade to investment grade, therefore providing an additional boost to the stock. Smithfield was lower than its peers not because of varying exposure to corn but because it is the only one that is vertically integrated in its hog production which weighed down profitability. As another example, again on August 21, 2012, if I thought hog prices were going to go up, I could directly invest in futures or indirectly invest by going long in Smithfield Foods. Hog prices actually dropped 7.53% since then yet Smithfield is up 36.43%.

All-in-all there are many contributing factors that determine stock returns. This is why it is recommended that if you seek exposure to commodities to do so via the direct method. If comfortable, you may do so in the derivative markets or invest into mutual funds/ETFs that invest into these markets.

Disclosure: I am long SFD, TSN, HRL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Indirect Commodity Investing