Commodities: To Buy or Not to Buy

Financial media has focused lately on investing in commodities. Commodities are basically the raw materials used as production inputs for the finished goods we consume everyday. As a group, commodities include industrial and precious metals, coal and oil among others.

Commodities tend to increase in price relative to other investments during recovery from recession (the early stage of the business cycle), periods of U.S. dollar weakening and during significant expansion in emerging markets. With the recent financial turmoil and ensuing recession and falling dollar combined with China and India expanding, it is not a surprise that commodity prices have been rising. However, looking at them over a longer period shows what we believe is their true nature.

Performance

The table below shows price appreciation of several basic commodities as well as the U.S. Consumer Price Index (CPI) and the S&P 500 and the Standard & Poor’s Goldman Sachs Commodity Index (SPGSCI) as of March 31, 2011. The CPI measures economic inflation in the United States. The S&P 500 is a commonly used benchmark for the U.S. stock market. The SPGSCI is a portfolio of commodities commonly used as a benchmark for global commodity prices.

Looking at the five and 10-year periods you will notice most individual commodities and the SPGSCI have outperformed both the CPI and the S&P 500. Looking at the longer term numbers, you will see stocks as measured by the S&P 500 significantly outperform commodities and inflation.

Dividend Returns

Let’s focus on the note included in the S&P 500 regarding dividends. Commodities do not pay an investor dividends or other cash flows except upon sale. In fact, if you should invest in the actual commodity, you would be forced to pay storage. In the case of precious metals you may find it necessary to pay for security as well. Stocks on the other hand, often pay investors a portion of their earnings. The dividend historically provided by stocks in the S&P 500 Index amounts to about 3% annually on average. Dividend return alone rivals the 30-year return on the commodity index and only slightly trails inflation without accounting for price appreciation.

Valuation

Financial analysts use expected cash flows to determine the fundamental value of a stock. A history of management ability, dividend payment and economic growth coupled with current events and specific company news can be used to determine those expectations. While one could use the same economic news to determine potential supply and demand for commodities in the short term, their long-term value is difficult determine. This leads us to fall back on historical long-term returns. Looking at historical returns for a guide, one would have to believe commodity performance will not continue at recent rates.

Short-Term Investments in Commodities

The returns presented above show commodities have given investors attractive returns over the short term, but investing short term always brings new investment decisions. When do you buy? When do you sell? Timing is the key to performance when investing short term. Things to consider before deciding to buy would include the U.S. dollar near all-time lows (remember a strengthening dollar is likely bad for commodity prices), and China’s infrastructure growth has slowed since the 2008 Olympics. These could prove negative for a commodity investment.

A Theoretical Note

Let’s look back at a point made at the beginning of this paper about commodities being raw material inputs to finished goods. Consider what happens as input costs increase. The manufacturer may absorb input cost increases for a short time, but at some point they will be forced to pass the increase to consumers. This should sound familiar as I just described inflation in short form. Price increases tend to reduce the demand for goods. Demand reduction is the first step toward recession (negative GDP growth). In a recession, prices tend to decrease and demand for raw materials decreases. As you have probably guessed, this economic mechanism keeps commodity prices in check with inflation over the long term.

Investment Methods

If, after reading this, you remain convinced commodities are necessary in your portfolio, consider the investment vehicles to get you the exposure. It is not likely you would be willing to buy the commodity at market price and deal with the pains of storage and security, but you may think buying options are a good idea. Keep in mind, when you buy in the options market, you are the speculator who allows companies who use the commodities as inputs to hedge against cost fluctuations. These companies and many of the other speculators are professionals who make a living in these markets. Options markets are a zero-sum game, meaning in order for one party to win, the other party must lose. Who do you think is most likely to lose?

A common way to buy anything financial these days is through the purchase of an Exchange Traded Fund (ETF). Many are available and while we do not recommend one specifically, I will warn you to look at their portfolio before you buy. Many ETFs use options and derivatives for commodity exposure. This would be fine as long as the manager keeps leverage relatively low. Also beware ETFs often do not track the performance of their stated benchmark so check the performance against the commodity or basket of commodities you wish to buy.

The more favorable way to gain commodity exposure, in our view, is through stocks in the Materials sector. The S&P 500 is made up of ten industry sectors. The Materials sector comprises approximately 3.6% of the total index. The Henssler Recommended Portfolio holds the Materials Select Sector SPDR Trust (symbol: XLB). The ETF provides a relatively diversified portfolio of Materials sector stocks and we prefer it to purchasing individual companies as it would be difficult to properly diversify such a small portion of the portfolio with individual stocks. Note the difference between buying commodities and buying commodity-based stocks is the stock is in a company which earns money in the mining, manufacturing or marketing of commodities. These companies, while closely correlated to the price of commodities, are not totally reliant on market price appreciation of commodities for their income. They also provide cash flows in the form of dividends (although admittedly not uniform) to investors, unlike the underlying commodity.

If you have additional questions or would like more information on commodities, contact Henssler Financial at 770-429-9166 or experts@henssler.com.

Disclosures

This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.