The Optimal Time To Buy Commodity Companies

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Includes: DBC
by: HowMuchValue

Summary

Future commodity prices will be higher if commodity prices drop lower now; same for lower commodity prices if prices increase higher now.

A good way to understand whether current commodity prices are high or low are by looking at the financial statements of companies in the industry.

If commodity prices are low enough to cause some companies to slow down production and reduce future investment, it is a good time to buy.

Commodities are products such as: oil, natural gas, coal, wheat, potash, silver, copper, gold, lumber, etc. You can tell if a company is a commodity business because the price received is not set by that company. Commodity companies are cyclical, although their ups and downs do not necessarily follow one another in a predictable time frame. However, each change in the industry conditions for that commodity creates a force pulling the future returns of the commodity in one direction or another. Sometimes, the drastic changes of the future of the companies involved in the production of that commodity have their stock prices changed to reflect this information.

However, it is quite common for the stock market to under or overreact for the many different companies in the short term when there are big changes in a commodity industry because of the many simultaneous moving parts. One of the good times to begin to buy shares of companies in a specific commodity industry is when new projects across the industry all begin to be shelved because the return on investment isn't high enough due to the low prices and/or high costs in the industry. An even better time to buy is when the commodity is trading near or below the cash operating costs alone of the production and transportation to market for many firms. As always, you have to choose the ones that have enough balance sheet or expense reduction flexibility to ride out the pain longer than competitors or a low cost producer that might still be profitable (barely) while others drop out.

One of the most fantastic things about low commodity prices relative to the cost of production is that low prices themselves encourage and force less production of that commodity. Companies that are higher on the cost curve become unprofitable and many companies will stop or slow down unprofitable production. If expenses were growing rapidly for the few years prior due to utilization of required equipment or skilled labour, these tend to decrease. The opposite of this also occurs where high prices encourage more production of the commodity. Companies in the industry generally reinvest their profits into the industry to expand future production so when prices are high they are investing much more money expanding the industry than usual.

When investing in a commodity business, look at the financial statements of a handful of large, medium, and small firms to get a sense of the average cost per unit of the commodity and growth investments. If the current price of the commodity is much higher than the average total cost of production (i.e. 2 to 5 times), the commodity likely isn't in the pain zone, and it is your optimal time for investing. However, you must keep in mind that a low cost of production sometimes comes with a very high initial investment. In these cases, even very low commodity prices might still be profitable but not high enough to justify a good rate of return on the capital employed. In those cases, it is probably better to do your research on the rate of return for new projects to produce/mine/extract/grow the commodity. If many of the new projects do not make economic sense and are not going to proceed, you are investing at the right time.

Possibly even more important than knowing the good times to invest is knowing when the terrible times to invest are. When a commodity industry has grown disproportionately for many years, many investors assume it will continue into the future (i.e. investor: "It's grown 20% a year for the past 10 years! How much more consistency can you get? Of course that will continue for the next 10 years!). This also affects the management of these companies looking at the company and industry's recent history because they become so confident that they often take on debt to fund future expansion. If most companies in an industry are talking about their confidence in 30%-40% internal rates of return on new projects, the commodity is likely overpriced and not currently a good candidate for intelligent investing.

Fortunately, as an investor, there are a lot of different commodities, each with many companies to choose from. There are high cost producers, low cost producers, highly leveraged companies, no debt companies, and companies of many sizes. There are companies that operate in riskier countries and those that operate in a very niche portion of their industry. Their expenses and investments are publicly available in their financial statements which allows you to get a grasp on their cost of production and future growth investments. This will make it obvious when times are bad and it is a good time to invest or times are good and it is a bad time to invest.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.