Investing in Commodities: Is the Fear Factor Justified?

 |  Includes: CELTF, DBA, LYSCF, MON, MOO, POT, RYN, sda-old
by: Travis Johnson

Does anyone still remember when the one thing investors tried to avoid like the plague was a commodity investment?

So I'm being a little bit facetious here, but it strikes me that with commodities taking a bit of a hit recently on fears of a recession (or something much worse, depending on who you talk to, and on whether or not you work at Bear Stearns), maybe we're going to have to look at what "commodity" really means.

What it used to mean for Wall Street was, "stay away." Does that ring a bell? We used to fear the commoditization of anything, particularly a company's products, because it meant that profit margin would inevitably fall.

The great fear about Sandisk (SNDK) was that it's flash memory products would become a "commodity" instead of a branded product. That has kind of come true, though Sandisk is still developing proprietary stuff as well.

The fear was that the iPod might become a commodity if everyone developed great MP3 players. It didn't exactly work out that way, and apparently Apple (NASDAQ:AAPL) can charge whatever it wants, and not lose any market share.

The DVD player certainly did become a commodity. It is selling for $20 at Wal-Mart (NYSE:WMT), and very few people care what about the player's brand. How long will it take before Blu-Ray players become commodities? Probably a while, but the commoditization cycle seems to move faster and faster every year.

What are we to make of the recent meteoric rise of commodities? What does the fear of commoditization mean for these companies?

Well, some of them are not really "commodities" anymore - PotashCorp (NYSE:POT) has such a stranglehold on its fertilizer products, and there are so few other producers, that really what it's selling is no longer a commodity - it's a proprietary fertilizer product that it can price accordingly, though certainly scarcity is a large part of the reason for the company's pricing power.

And Monsanto (NYSE:MON) doesn't really sell a commodity product - the company has patented seeds and pesticides that help produce stronger, more efficient crops.

Is it important to be in companies in the commodity space that can provide a differentiated, special or unique product? Or do you just want to be in a company that processes a particular volume of whatever commodity it is, and takes the price offered by the market?

What's most important, perhaps, is that we consider that most commodities have no "backstop" - there is nothing that matters except overall demand. The companies don't own proprietary processes, or patents, or in some cases any physical assets apart from the actual commodity product.

If you're talking about corn or wheat or copper, new investors in this space might note that the wheat run through Saskatchewan's Wheat Pool is no different to the global markets from the wheat sold by AWB out of Australia. Wheat producers don't have any differentiating products that allow them to hold up if demand falls off. Copper from Indonesia's mines is no different than copper from Canada or Nevada.

Personally, I do own some commodity producers and some related companies, but I like to remind myself that - in contrast to many other companies I invest in or research - many of them are "nothing special."

Perhaps if someone is investing in many of these companies just to gain exposure to the rapidly inflated market for various commodities around the world, one might be better off simply buying the commodities themselves. The investor could either buy the futures, the physical stuff (for gold or silver, at least), or the ETFs that hold physical products and track futures instead of owning companies. The companies that produce and sell commodities have often been priced very cheaply because they produced a product that was high volume, usually low margin, and priced according to demand cycles that the producers couldn't control.

Maybe they will again become cheap someday for those same reasons, but those waiting for that cheap price might have to be very patient if the cycle takes a long time to swing. I certainly have a very hard time swallowing the high prices that you still have to pay for the PowerShares DB Agriculture Fund (NYSEARCA:DBA) or Van Eck Market Vectors Agribusiness ETF (NYSEARCA:MOO) agribusiness ETFs, even though they certainly have every chance of riding the agriculture boom internationally for many years.

I'm just thinking with my fingers - as you'll see from the disclosure below, as these thoughts haven't necessarily guided many of my investment decisions just yet.

Disclosure: In the commodity space writ large I own shares of a grain distributor (ABB Grain), a gold miner [Centamin Egypt (OTCPK:CELTF)], a metals miner [Lynas (OTCPK:LYSCF)], a meat packer [Sadia (NYSE:sda-old)], and a timber REIT [Rayonier Inc. (NYSE:RYN)]. I also own a small bit of physical gold and silver. I don't own any other investment mentioned here.