Commodities: Avoid Early Selling in a Super Cycle - Adrian Day

Includes: FCX, GLD, PPLT, USO
by: Hard Assets Investor

<< Return to Part 1: 'Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks' - Author Q&A

Mike Norman: Hello everybody, and welcome to I’m Mike Norman, your host. And I’m here with the second part of my interview with Adrian Day, president of Adrian Day Asset Management.

In our last interview, we discussed the macro picture. You talked about how we’re in the midst of another commodity super cycle. This one is going to be longer, perhaps, and bigger than the last one. In your book [“Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks”] you discuss some ways to take advantage of this. What would be some of the simpler ways to get involved? And also, let’s take into account the fact that we’ve already seen 10 years of this bull market play out. So if you were talking to a new investor who has interest in getting involved, what would you tell him?

Adrian Day, president, Adrian Day Asset Management (Day): OK, that’s a good question. First of all, as a value investor, I’m always reluctant to chase prices when they've moved up. But also, of course, you have to look where you are today. You know, we didn’t invest five years ago, 10 years ago; where are we today? So I think it’s important for investors, if they buy into the argument, to realize we’re only near the beginning, or at least no more than halfway through this commodity super cycle that’s going to take prices much higher. So you want to avoid the temptation to sell too soon.

I like the fact that you said, “simple ways to invest,” because I think a lot of investors make investing too complicated, and particularly in this area, where stocks can be very volatile. And let’s face it, a lot of expiration companies have a lot of risk. People take on too much risk, and make it too complicated.

So some of the simplest ways … if an ETF is a good ETF − meaning they hold the commodity itself, and the costs are relatively low − they don’t have that contango problem with contango’s rolling …

Norman: I want to get into that.

Day: OK. Then I think some of the ETFs can be good. We own GLD for gold. We own the palladium ETF, PPLT. There’s also, it's not an ETF, but it’s a closed-end fund in Canada, that holds uranium. Obviously, the costs are a little bit more, because it costs more to store uranium than other things. That’s the uranium participation certificate.

So those are excellent ways to invest, and they are direct ways. The price of platinum goes up, PPLT goes up. You don’t have to worry about the mine flooding or costs of production, or the government changing or anything like that. So I like that first of all.

Now you come to some other commodities. If we have a really good company, with good reserves, diversified reserves, I’ll buy that. So in copper I love Freeport (NYSE:FCX). Freeport is the largest publicly traded copper mine in the world. But it’s also a great company, a great balance sheet, great management, strong dividend. They just doubled their dividend. So I love Freeport.

So you know, I like the most direct way possible.

Norman: You wouldn’t use, let’s say, derivatives or futures, or that sort of thing, options?

Day: Well, we use options a lot, but we don’t use futures, only because I’m not licensed to do that. That’s just not what I do. I’m not recommending someone doesn’t do it. It’s just not what I do.

Norman: In options then, what would you buy? Far-out-of-the-money calls … ?

Day: We normally sell puts, to be honest. And we normally sell puts when the stock’s moved up a little bit above where we actually want to buy it. So we’ll sell the puts. Now in that case, if it’s a stock where we actually … we only have a seller put on a stock we want to own anyway. And the premiums can be very attractive, because commodity stocks, resource stocks, tend to be so volatile that you can pick up some pretty darn attractive premiums. So we will often do that.

We have bought long-term calls. In this area, I prefer to pay up for the longer-term calls, even if I sell it shorter term. But you don’t want to pay too much of a premium for call.

Norman: Now, let’s talk a little bit about the roll cost; you mentioned it earlier. And I always find it fascinating that when you talk to investors, for example, and it’s happened over the last several years, in oil, the ETF USO, when oil prices went up to $150, that ETF didn’t do very much because there was a built-in cost that most investors didn’t understand, which is the roll cost. Why don’t you explain that.

Day: No, that’s absolutely true. And I think it really illustrates one of the problems of investors: buying things without doing their homework properly. And we’re all short on time; I understand that. The problem with some of the ETFs, where they buy futures − and in particular the oil ETF was a classic example − you have to constantly roll over.

You buy futures. When the future expires, you have to sell it and buy another one at a future date. You have to keep doing that. So if the investor holds the ETF for two or three years, he can easily be rolled over six, seven, eight times. Well, every time you roll over, there’s a cost.

But with the oil, in particular, the contangos were so high − contango being the difference between the long-term contracts and the short-term, or the spot price.

Norman: Futures prices were higher than spot.

Day: Right. And so every time you buy the futures, you’re paying that difference, you’re paying that premium. But of course, when you sell it to roll over to another one, you don’t get …

Norman: I think it was like 20 percent at one time, which subtracted off of your return.

Let me ask you something, because I think there’s a strong argument, and indeed it’s an argument that we hear frequently now, that we’re in really a deflationary environment. If you look at asset prices like the main assets that people own − their homes, for example, or wages, which are going down − how do you square the boom in commodities with what looks to be a deflationary cycle?

Day: That’s an excellent question. Unfortunately, a huge answer. And I’ll try to do it quickly.

No. 1, we have a deflationary scenario in Europe and the U.S., but we do not have a deflationary scenario in China. And China is now the second-largest economy in the world. It’s overtaken Japan. But it is also the fastest-growing economy in the world. So not all the world is in deflation. We have to remember that, No. 1.

No. 2, let’s look at gold for a second. Gold typically does better in deflations than it does in inflations, throughout history. Going all the way back to the Roman Emperor and the fall of the Roman Empire. Gold outperforms in deflations. But we think of it as inflation. We think of it as inflationary because of two reasons.

One is our most recent experience with a strong moving gold in an inflation. So we say, “Oh, 1970s − gold went up. 1970s − inflation; therefore gold is an inflation hedge.” But that’s only because it’s our most recent experience. If you go back throughout history, you see gold does better in deflations. But it doesn’t necessarily go up in nominal terms.

So again, we think of gold going from $35 to $850, but $35 was not officially a depressed price; $850 was a blip on the screen for a few minutes. And if you look at it in real terms, it wasn’t quite so stunning. So in real terms, gold does better in deflations.

There’s an excellent book on the subject by Roy Jastram. Unfortunately he’s deceased now. But he wrote a study of gold prices all the way back to the middle of the 14th century, 1350, with annual prices from 1650 onwards, showing that in deflationary periods, gold outperforms. It’s a fascinating study.

Norman: And something that most people don’t know.

Day: Right.

Norman: Adrian Day. The book once again, “Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks.” That’s it for now. Adrian, thank you very much. This is Mike Norman, folks. See you next time. Bye-bye.

Disclosure: No positions