Sunday, May 31

Week 204 - 2015 Barron’s 500 List: Commodity Producers with Improving Fundamentals

Situation: Commodities are priced in dollars but those prices reflect worldwide supply and demand, not US economic forces. To further complicate matters, agricultural commodities are priced to reflect regional climate events. The 2012 US drought was so severe that China decided to decrease its reliance on the US for corn and instead ramp up domestic production and source more corn from Argentina and Ukraine. This highlights how population growth is the main driver for commodity production, whether it is basic materials needed to expand infrastructure, energy for electricity production and transportation, or meat and grain for grocery stores. The problem for commodity producers is the necessity for a large up-front investment, whether for oil and gas exploration, mining operations, or the web of technology and infrastructure that brings the “green revolution” to farming. Such investments typically involve large expenditures for property, plant, equipment, powerplants, internet access, storage facilities, paved roads, pipelines, and railroads. In turn, those high initial costs drive research and development into innovations that promise to reduce up-front costs. The result is affordable food, construction methods, fuel, and electricity. Once in place, production efficiencies tend to overshoot; supplies exceed demand for a period, as we see happening now with oil and natural gas production. 

Investors in commodity-related companies always face a roller-coaster ride, one that is often out-of-phase with regional economic cycles. As a result, commodity-linked investments tend to follow supercycles. Their “non-correlation” with GDP serves to benefit investors. This week’s blog is occasioned by the just-published Barron’s 500 List for 2015. That list gives a grade to the 500 largest companies in the US and Canada by using 3 equally-weighted metrics:
   1) median 3-yr return on investment (ROIC),
   2) change in the most recent year’s ROIC relative to the 3-yr median, and
   3) revenue growth for the most recent fiscal year.
Each company’s 2015 rank is compared to its 2014 rank. There are 60 commodity producers; half were up in rank, half were down. We’re interested only in the companies that were up, since there’s no easy way to know why a company was down or when its rank will stop falling. And, since most of our readers are looking for retirement investments, we’re not interested in companies that have an S&P bond rating lower than BBB+ or an S&P stock rating lower than B+/M. Taken together, those restrictions remove all but 7 of the 60 companies from consideration (see Table).

These 7 stocks are different from those we usually think of as prudent for retirees. Notably, the average 5-yr Beta is high, and most are down one Standard Deviation from their 16-yr trendline in price appreciation (see Column M), whereas, recent pricing for the S&P 500 Index (^GSPC) is up two Standard Deviations. While we do like to invest in commodity-related stocks because of their out-of-sync behavior, extremes are a little un-nerving. 

It gets worse. In Column N of the Table, the downside risk comes into sharp focus. That’s where the BMW Method (see Week 193, Week 199 and Week 201) is used to predict your loss by incorporating 16 yrs of weekly variance in price trends. For example, a 47% loss is predicted for our group of 7 stocks in the next Bear Market, whereas, the S&P 500 Index is predicted to sustain a 32% loss. You’ll find this information in the BMW Method Log Chart for each stock. Start by using the S&P 500 Index as an example. Find ^GSPC at the bottom of the 16-yr series, click on it, and look for “*2RMS” in the upper left-hand corner. Subtract that RF number (0.68) from 100 to get the predicted 32% loss at 2 Standard Deviations below the price trendline. That degree of price variance is projected to occur every 19-20 yrs.

This price variance is important to be aware of because a high degree of price variance over time means the party can end quickly. When a commodity-producing company’s Tangible Book Value for the past decade gives it a Durable Competitive Advantage (see Column R and Week 158), there’s little likelihood that its earnings will grow more than 7%/yr over the next decade (see Column S), which we estimate by using the Buffett Buy Analysis (see Week 189). Only one stock passed that test, National Oilwell Varco (NOV). In other words, the very impressive returns achieved by this select group of 7 stocks (see Columns C, F and L in the Table) come with a very impressive risk of loss. 

Several academic studies have shown that the only way to legally “beat the market” is to take on a commensurately greater risk of loss. One example analyzed Jim Cramer’s success at picking stocks for CNBC’s “Mad Money” TV show. To make a long story short, you need to understand that over a 20-yr period you’ll probably be further ahead (on a risk-adjusted basis) by investing in a low-cost S&P 500 Index Fund (VFINX at Line 16 in the Table) than by investing in any combination of commodity-related companies. 

Think about it. Commodity-related companies depend on the infrastructure and sustainability needs of fast growing countries like China, Brazil, India, Nigeria and Russia. Such a heavy reliance on commodities in countries with such large populations will be reflected in the success of mutual funds that focus on international stocks or natural resource stocks. The Vanguard Total International Stock Index fund (VGTSX at Line 18 in the Table) and T Rowe Price New Era Fund (PRNEX at Line 17 in the Table), respectively, are good low-cost examples. Are either of those mutual funds a better (i.e., risk-adjusted) place to put your retirement savings than VFINX? No. The reason is that investing in commodities is a hedging strategy. Any effort to smooth out (hedge) returns does exactly that. It protects you from Bear Market losses while reducing your Bull Market gains. Stocks go up 55% of the time, so over the long term a hedging strategy will underperform the market.   

Bottom Line: Here at ITR, we like to call attention to investments that don’t track the S&P 500 Index. By having a few investments that are out-of-sync with the economic cycle, you may be able to limit the damage to your portfolio from a market crash. Our favorite non-correlated asset is the 10-yr US Treasury Note (when held to maturity), which you can obtain for zero cost. Our next favorite is stock in one or two commodity production companies, especially those where revenues reflect changes in the weather cycle. In particular, companies that supply farmers with tractors, center-pivot irrigation systems, diesel engines to power such equipment, fertilizer, herbicides, fungicides and ways to efficiently get crops and cattle to markets. 

Risk Rating: 7

Full Disclosure: I own stock in CMI.

Note: metrics highlighted in red denote underperformance vs. our key benchmark (VBINX); metrics are current for the Sunday of publication.

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