Seeking Alpha
Dr. Duru, One-Twenty Two (112 clicks)
Long/short equity, event-driven, homebuilders, currencies
Profile| Send Message| ()  

If the world economy gets better, you’re going to make money in commodities because of the shortages. If the world economy does not get better, you’re going to make money in commodities because then they’re [central banks in the developed world] going to print money…
- Jim Rogers on CNBC, July 4, 2011 in “China Bears Have It Wrong

This piece is a follow-up post to “Preparing for Profits in a Resource-Constrained World” (Part 1) in which I discussed the implications of Jeremy Grantham’s fundamental thesis of a new world where resources are constrained and the commodity prices' trend upward rather than downward as they have for the past 100 years. In the short-term, Grantham expects a slowdown in China’s economic growth and a temporary return to normal weather patterns to send commodity prices tumbling, perhaps crashing, thus providing one last opportunity to invest in commodity plays on the cheap. Now, I propose some ground rules for trading and investing on Grantham’s thesis. I also provide some potential picks for many of the commodities in Grantham’s study and additional ideas not included in the study. Note that I have not yet done enough research on potential investments in resource efficiency and conservation. I hope to do so in the coming weeks or months. (Recommendations welcome!)

First, a reminder of Grantham’s investment philosophy:

How does an investor today handle the creative tension between brilliant long-term prospects and very high short-term risks? The frustrating but very accurate answer is: with great difficulty. For me personally it will be a great time to practice my new specialty of regret minimization. My foundation, for example, is taking a small position (say, one-quarter of my eventual target) in ‘stuff in the ground’ and resource efficiency. Given my growing confidence in the idea of resource limitation over the last four years, if commodities were to keep going up, never to fall back, and I owned none of them, then I would have to throw myself under a bus. If prices continue to run away, then my small position will be a solace and I would then try to focus on the more reasonably priced – “left behind” – commodities. If on the other hand, more likely, they come down a lot, perhaps a lot lot, then I will grit my teeth and triple or quadruple my stake and look to own them forever.

Here is my playbook for both the short-term (bearish positions) and the longer-term (bullish positions). I would love to hear other ideas, especially contrary ones.

Meta-rules

  1. Never short any stock or ETF that is of interest for the longer-term. Do not even sell calls against these positions. I think such trading can create too much psychological conflict and could distract from the longer-term focus. Puts are allowed in extreme circumstances while the shorter-term risks are still unfolding.
  2. Accumulate investments directly related to “stuff in the ground”, that is, companies that own physical assets.
  3. Make any short-term, bearish bets on stocks on companies whose well-being depends on the health of asset-owning companies, like mining equipment or rapid growth in China.
  4. Besides fertilizer, DBA (DBA) may serve as a good proxy for all agricultural plays. The other options are ETNs and other futures-related vehicles that may not perform as expected over long stretches of time; invest in them with caution. Farm machinery is another potential proxy, if no other means are available for owning companies with agricultural assets in the ground (or “of the ground”).
  5. Recyclers should also become more important in the commodities ecosystem as mining raw materials becomes more and more expensive and less efficient.
  6. Invest in any dip in oil, no matter what (like now). Oil should be a direct beneficiary of economic growth and most future attempts to revive growth through stimulus and money-printing.
  7. QE2 (the second round of quantitative easing) will be used as a benchmark for measuring any correction in commodities. An erasure of most or all gains from late August, 2010 will be considered a major buying signal. I will be flagging individual plays when (if) this target gets hit.

Short-term

  1. All rallies get sold/faded. That is, these are opportunities to build positions in downside hedges. Watch for overbought signals (such as now)
  2. Keep any (optional) downside hedges simple and limited:
    • Caterpillar (CAT) – sits at the nexus of the business cycle and gets hit if commodities crash.
    • The S&P 500 (SDS) or puts on (SSO) – should decline significantly if commodities crash from global economic weakness, especially given the heavy concentration of multi-national companies with large profit bases outside the U.S. Presumably, lower commodity prices will cushion the blow somewhat.
    • Cameco Corp (CCJ) – nuclear power could be in trouble thanks to Fukushima’s reminders of the real costs of nuclear and uranium stands to lose big in a commodities crash.

Simplifying the short side of the portfolio helps maintain focus on investing opportunities as opposed to confronting the challenge of properly timing and balancing a diversified bear portfolio. The downside hedge should be large enough to provide comfort holding the bullish portion of the portfolio, but not so big that upside profits are constrained (preference for puts over shorts).

Medium-term

  1. Weather is so unpredictable that it provides the least actionable part of the strategy. It seems best to focus on being opportunistic rather than on building skills in meteorology.
  2. Treat bouts of good weather and “reversions to the mean” as random accidents delivering respites to the longer-term, on-going shift ahead. In other words, the mean itself is changing. Expect fertilizer plays to be the most heavily impacted. It is very likely even Grantham is under-appreciating the climate instability that is underway, but it is difficult to tell.

Longer-term

  1. Always have something in a core basket of commodity plays given the long-term bullish context.
  2. Concentrate expertise and invest in what you know best. While commodity prices may increase at different velocities, they should be strongly correlated over time. Thus, it is likely not necessary to develop an extremely broad portfolio of commodities.

With these meta-rules in mind, I constructed a commodities wish list based on Grantham’s table of commodity prices and trends. The list of individual companies is far from exhaustive. I only included the names I personally prefer (with caveats noted below). I provide links to other resources including to posts I have written in the past on specific stocks.

Grantham starts his list with the commodities least likely to return to their previous downtrend in price (see exhibit 4). That is, the list is sorted from top to bottom by increasing likelihood that the commodity may return to the previous downtrend. For some perspective, iron ore tops the list with a 1 in 2.2 million chance of returning to its previous downtrend. Cotton is #23 down the list with odds of a return to the previous downtrend set at 1 in 44. Natural gas picks up the rear with 1 in 2 odds of returning to its downtrend (I believe it REMAINS in a downtrend from 2008′s peak).

Iron ore: BHP Billiton Limited (BHP), VALE S.A. (VALE)
Coal: Peabody Energy Corporation (BTU), CONSOL Energy Inc. (CNX)
Metallurgical Coal: BHP, Cliffs Natural Resources Inc Co (CLF), Alpha Natural Resources, Inc (ANR), Walter Energy, Inc. (WLT), CNX
Copper: Freeport-McMoRan Copper & Gold (FCX), BHP, Southern Copper Corp. (SCCO)
Corn: Teucrium Corn Fund (CORN), iPath Dow Jones – UBS Grains Total Return Sub-IndexSM ETN (JJG)
Silver: Pan American Silver Corp. (PAAS), iShares Silver Trust (SLV). I only excluded Silver Wheaton (SLW) because it does not own a mine. SLW could still be an adequate silver play as long as it continues to manage its purchase agreements well.
Sorghum: ?
Palladium: Stillwater Mining Co. (SWC), North American Palladium (PAL) {already given up most of QE2 gains}, ETFS Physical Palladium Shares (PALL)
Rubber: Cabot Corp (CBT) (the top 3 natural rubber producers are Malaysia, Thailand and Indonesia – I could not find any related US-based trading vehicles)
Flaxseed: ?
Palm Oil: ?
Soybeans: JJG
Coconut Oil: ?
Nickel: BHP
Gold: Goldcorp (GG), SPDR Gold Trust (GLD)
Oil: Exxon Mobil Corporation (XOM), Petroleo Brasileiro S.A. Petrobras (PBR), Schlumberger (SLB), Helix Energy Solutions Group Inc (HLX) {“value” play}, Guggenheim Candian Energy Income (ENY), BHP, PowerShares DB Oil Fund (DBO), Penn West Petroleum (PWE)
Sugar: iPath Dow Jones-UBS Sugar Total Return Sub-Index ETN (SGG)
Platinum: SWC, Platinum Group Metal (PLG) {Canada and South Africa}, ETFS Physical Platinum Shares (PPLT), First Trust ISE Global Platinum Index Fund (PLTM) {illiquid}
Lead: BHP, Nyrstar {Belgium company listed on European exchanges},
Wheat: JJG
Coffee: iPath Dow Jones-UBS Coffee Total Return Sub-Index ETN (JO)
Diammonium Phosphate: CF Industries Holdings Inc (CF) {production}. Saudi Arabia has a large deposit also see here
Jute: ?
Cotton: iPath Dow Jones-UBS Cotton Total Return Sub-Index ETN (BAL)
Uranium: CCJ {see notes above on using this as a short}
Tin: No U.S. listings? China Yunnan Tin Minerals Group Co., Ltd. (0263.HK); Metals X (MLX) in Australia (also see the Australian atlas on tin)
Zinc: No U.S. listings? Nyrstar is the world’s biggest producer of zinc. China’s largest zinc producer is Zhuzhou Smelter Group (see “Survival of the fittest for lead and zinc miners” for a description of how the 2008 crash devastated the industry.)
Potash: Potash Cp Saskatchewan (POT), Mosaic Company (MOS), VALE
Wool: ?
Aluminum (Bauxite): BHP, Alcoa (AA), Century Aluminum Company (CENX), Kaiser Aluminum Corp (KALU)
Lard: ?
Pepper: ?
Natural Gas: San Juan Basin Royalty Trust (SJT), ENY

Agriculture (non-fertilizer): Deere & Co (DE), Manitowoc Co Inc (MTW), Lindsay Corporation (LNN) {also a play on clean water}

Other commodity-based and energy plays that did not get mentioned by Grantham:

Gypsum: Eagle Materials Inc (EXP)
Manganese: BHP, VALE
Molybdenum: Thompson Creek Metals Company Inc. (TC), BHP, FCX, SCCO
Rare earth elements (REEs): Molycorp (MCP), Great Western Minerals (OTCQX:GWMGF), UCore Rare Metals (OTCQX:UURAF), Stans Energy Corp (OTCQX:HREEF)
Recycling materials: Schnitzer Stel Industries (SCHN), 5N Plus (VNP.TO), and several others…
Solar Energy: First Solar (FSLR), GT Solar (SOLR), Trina Solar Ltd. (TSL), Jinko Solar (JKS), Amtech Systems (ASYS), Ja Solar Holdings Co (JASO), LDK Solar Co (LDK), ReneSola Ltd. (SOL), Memc Electronic Material (WFR) (scan my many previous posts on investing in solar companies or click on the links above for specific companies if you are trying to sort through this group)
Specialty materials: 5N Plus and any others…
Tantalum: CBT
Titanium: BHP

Special notes

  • BHP is a well-diversified commodity play. While Rio Tinto Plc (RIO) has performed closely to BHP since the recovery, RIO has had more financial issues and under-performed BHP greatly in the immediate aftermath of 2008 crash.
  • VALE is a diversified commodity company based in Brazil. It includes logistics and transportation networks.
  • Economies heavily reliant on commodities are worth investing in through currencies and/or ETFs: Australia: iShares MSCI Australia Index Fund ETF (EWA), Rydex CurrencyShares Australian Dollar Trust ETF (FXA); Brazil: iShares MSCI Brazil Index Fund ETF (EWZ); South Africa: iShares MSCI South Africa Index Fund ETF (EZA)

Be careful out there!

Source: Profiting from Physical Assets in a Resource-Constrained World - Rules and Picks