At the moment, inflation is raging at levels not seen in four decades even as interest rates remain near historic lows:
Moreover, the economy appears headed for - and may already technically be in - a recession. As a result, cash and most equities are most likely imprudent places to allocate capital as inflation will destroy the purchasing power of the cash much at a much higher rate than current long-term interest rates. In the current environment, investing in vehicles that pay high single digit interest rates are highly risky, especially with a recession potentially right around the corner.
On top of that, equities such as the S&P 500 (SPY)(VOO) and the Nasdaq (QQQ) are also wading through choppy waters right now. High inflation is dinging corporate earnings on two fronts: input costs are rising rapidly and consumer demand is beginning to show signs of pulling back as wages are failing to keep up with inflation, leading to reduced consumer purchasing power.
Furthermore, interest rates are rising and appear set to rise even further as an exasperated Federal Reserve continues to try to tame inflation. This will hurt equities on two fronts as well: (1) higher interest rates reduce the value of equities - all else being equal - because it increases the discount rate that should be applied when calculating their intrinsic value and (2) it makes it more difficult for companies to invest in growth projects since the cost of capital increases.
Between declining consumer purchasing power and reduced corporate growth investments, a recession is looking increasingly likely. If we enter into a recession, corporate earnings will likely enter a downward spiral for the foreseeable future, which will very likely lead to even lower stock prices than we are seeing today.
Our view is shared by the founder of leading hedge fund Bridgewater Associates Ray Dalio. While at the Davos World Economic Forum he told CNBC:
Of course, cash is still trash. [Do] you know how fast you're losing buying power?...equities are trashier...You're going to have an environment of negative real returns. Everything can't go up all the time. That system won't work that way.
Instead of buying stocks or hiding in cash, the billionaire recommended that investors search for "real-return assets."
We believe that the recent sharp pullback in commodity producer stock prices offers investors a golden opportunity to buy aggressively into commodity producers as it is a sector that could benefit immensely from the current macro environment. We say this for several reasons:
We will now look at each of these four reasons in more depth as they apply to each of our top picks in this space:
Rio Tinto (RIO) is a leading global miner of iron ore and other metals and minerals. It boasts a stellar balance sheet along with sector-leading returns on invested capital, world-class assets, a proven management team, and a very shareholder friendly dividend policy.
Over the past five years, earnings per share have significantly outstripped share price performance:
While this is somewhat due to a sharp pullback in the Iron Ore price since the beginning of 2021, the trailing twelve-month earnings do not include the peak pricing seen around the end of 2020/beginning of 2021, and the current share price is meaningfully lower than it was when Iron Ore was selling for well below $100 during mid-2021.
With inflation still raging at high levels and China laser-focused on reigniting its economy after its severe lockdowns a few months ago, RIO looks like an attractive risk-adjusted bet in the short term.
On top of that, even if the short-term environment does not pan out and we fall into long-term recession, RIO remains a solid value with very strong long-term prospects as iron ore will be in high demand as the global economies will need a lot of steel for manufacturing electric vehicles, much-needed investments in infrastructure, and the all-but certain military arms race in the coming decade.
Southern Copper Co (SCCO) is a debt-free low-cost producer of copper that also pays out a very generous dividend to shareholders. The company is well set up to profit from the electrification of the world in the coming decades and - despite very impressive recent results, it is trading at a very reasonable price:
While it is true that copper prices have plummeted in recent months, this is largely due to recession fears and not a result of a changing long-term demand profile for the metal. On top of that, SCCO boasts a very robust organic production growth profile over the next decade and likely beyond, so it is not overly sensitive to short-term price volatility. Now looks like a great time to invest in a high yielding blue chip copper producer.
Newmont (NEM) and Barrick Gold (GOLD) are among the bluest of the blue chip gold miners in the world. While gold prices have held up relatively well in the face of major market headwinds and rising interest rates, both NEM and GOLD are looking quite cheap:
Gold miners - especially lower risk blue chips that are gushing free cash flow, paying out attractive dividends, and actively growing their growth profiles like GOLD and NEM - are leveraged to the price of gold (GLD). With gold prices up meaningfully over the past half decade, GOLD and NEM should be up by an even larger amount. However, GOLD's share price is actually in the red and NEM's has underperformed the gold price over that span.
Furthermore, if we end up in a recession, the Federal Reserve will likely be under pressure to reverse course on its rate hiking path which will be good for gold prices. Last, but not least, if geopolitical tensions continue to escalate, gold will very likely benefit. As a result, we believe now is a great time to add these two blue chip miners.
Energy Transfer (ET) is our top pick in the energy production supply chain. While not an energy explorer or producer, it is a midstream infrastructure business that plays a key role in bringing energy to market. It is severely undervalued despite growing its distribution rapidly over the past year and a half while also paying down debt very aggressively. However, its unit price has barely budged over that span:
Even more baffling is the fact that oil prices have soared and North American energy infrastructure has become even more valuable over that time span:
As a result, ET looks like a great way to play the energy sector right now.
While soaring inflation and economic uncertainty are making cash and most equities look like very poor bets for the foreseeable future, investors can still find very attractive looking real return opportunities. In particular, at High Yield Investor we are buying high yielding blue chip commodities hand-over-fist on the latest pullback. We believe these are "heads I win, tails I don't lose much" investments as if inflation persists and we manage to avoid a deep recession, they are likely to deliver market-crushing returns, and if we do end up in a recession, the long-term demand profile for each of these commodities is still outstanding. In the meantime, their strong balance sheets should enable them to weather a downturn.
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This article was written by
Samuel Smith is Vice President at Leonberg Capital and manages the High Yield Investor Seeking Alpha Marketplace Service.
Samuel is a Professional Engineer and Project Management Professional by training and holds a B.S. in Civil Engineering and Mathematics from the United States Military Academy at West Point. He is a former Army officer, land development project engineer, and lead investment analyst at Sure Dividend.
Disclosure: I/we have a beneficial long position in the shares of RIO, SCCO, GOLD, ET, NEM either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.