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For those interested in commodity stocks, it may be worthwhile to look at Mesabi Trust (MSB), a publicly traded royalty trust that distributes cash to the unit holders quarterly. MSB is created for conserving and protecting the trust estate, which includes certain rights to royalty payments derived from mining activities carried out by Northshore Mining Company, a third party operator, on the land of the estate, some cash, securities, and other assets. Under the trust agreement, MSB cannot actively engage in any business activities, mining or otherwise, nor does it own the title to the land.

Pros

MSB provides investors with exposure to commodities, and therefore can be utilized as a hedge against anticipated inflation. Not only does MSB derive its royalty revenues from iron ore shipments, but the royalty rate is also inflation adjusted according to the agreement between MSB and Northshore, the company that actually mines the land. In the current environment where there is much fear for inflation in the near term due to the government’s stimulus spending, easy liquidity on the market, and emerging economies’ increasing demand for raw materials, MSB has the right story to attract investors’ attentions. In fact, as of April 26, 2010, MSB is traded at $22.91 per unit, with a year-to-date capital appreciation of approximately 80%. As long as the inflation story is still intact, it may have the potential to go even higher.

In addition to its appeal as an inflation hedge, MSB is also an income investment that distributes most of its royalty revenues to the unit holders. Its cash distributions for the first and second quarters in 2010 are 55 cents and 12.5 cents, respectively. This represents a range of annualized yield from 2.2% to 9.6%.

Cons

Although MSB has its appeals, they do come with risks. Since MSB has no ownership rights to the underlying land, in the event where the trust terminates, the unit holders will be left to split the trust estate, essentially consisting of a bundle of beneficial interests, amounting to only a small faction of its current market value. MSB has a current market capitalization of $300 million compared to its reported book value of $1.13 million as of January 31, 2010. This would expose investors to greater risks than bonds, which can be redeemed on face value at maturity, and other common stocks, which are typically traded at only a few times their book values.

MSB’s distributions can be quite volatile and unpredictable. MSB has no control of the decisions made by Northshore as to whether or not to mine the land, and how much. As a result, in the past year, MSB could go from making no distribution at all in one quarter to 55 cents in another. Moreover, the revenues received by MSB in one quarter can be positively or negatively adjusted by Northshore in the following quarters. For example, in the midst of the generally recovering economy in the first half of 2010, MSB’s cash distribution was cut from 55 cents per unit in the first quarter to 12.5 cents per unit in the second quarter, due to MSB’s paying back part of the excessive royalties it received in the past. Unless the adjustment scheme is transparent and clearly understood, an accurate prediction of its future distributions will be difficult to make.

The Bottom Line

Although MSB can be a hedge against inflation, its downside risk cannot be ignored. For those who like to invest based on the fundamentals, MSB at the current price may not present an attractive investment opportunity. For those who believe that market perception and speculation are as real as the fundamentals, MSB does have the potential to keep riding on the commodity and inflation story. In such a case, I’d think that it is a good idea nonetheless to buy some put options to limit the downside risks.

Disclosure: No position

Source: Mesabi Trust: A Pricey Inflation Hedge