Week 375 - Producers Of Gold, Silver And Copper In The 2017 Barron’s 500 List

Situation: Commodity producers have a dismal record. Spot prices fall whenever mining (or drilling or harvesting) becomes more efficient. To make matters worse, supply-chain management and investment has become increasingly global and professionalized. Nonetheless, copper sales remain the best barometer of fixed-asset investment, particularly the ongoing proliferation of industrial plants and equipment in China. Silver has a growing role, thanks to the buildout of solar power. And gold remains a check on the propensity of government leaders everywhere to finance their dreams with debt, as opposed to revenue from taxes.

Mission: Use our Standard Spreadsheet to highlight the largest companies producing gold, silver, and copper.

Execution: see Table.

Administration: Gold and silver prices remain stuck where they were 35 years ago but are characterized by high volatility. Commodity prices (in the aggregate) trace supercycles that last approximately 20 years. The most recent came from a 1999 low and fell back to that level in 2016; since then it has ever so slowly risen from that low.

Bottom Line: The basic rule for commodity producers is that 3 years out of 30 will be good years, and you’ll make a lot of money. But over any 20-30 year period, you’ll lose money (measured by inflation-adjusted dollars). Our Table for this week confirms these points but does show that copper (SCCO) is worth an investor’s attention. But beware! That company’s share price is falling because of a falloff in trade with China and could fall further if a trade war takes hold.

Risk Rating: 10 (where 10-Yr US Treasury Notes = 1, S&P 500 = 5, and gold bullion = 10).

Full Disclosure: I do not have positions in any commodity producers aside from Exxon Mobil (XOM), but do dollar-average into the main provider of mining equipment: Caterpillar (CAT).

"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com All rights reserved.

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Week 369 - High Quality Producers & Transporters of Industrial Commodities in the 2017 Barron’s 500

Situation: Here in the U.S., debt/capita is growing at an alarming rate and is now greater than $60,000. U.S. Government debt is almost $20 Trillion and has been growing at a rate of 5.5%/yr (i.e., twice as fast as inflation) since 1990. By 2020, the Federal budget deficit will start to exceed $1 Trillion/Yr and the dollar’s status as the world’s reserve currency will be threatened. The gold reserves that stand behind the U.S. dollar (currently worth ~$185 Billion) would have to be increased on a regular basis, as would foreign currency reserves (currently worth ~$125 Billion)

The US economy is no longer capable of growing fast enough to balance the budget for even a single year, without introducing draconian measures. Nonetheless, it is worth noting that those can be effective given that Greece appears to have emerged from that process successfully. But the U.S. could not go through that process and still remain the “top dog” militarily. So, the trade-weighted value of the U.S. dollar will fall at some point, and we will no longer be able to afford imported goods and services. Before that happens, U.S. citizens will need to gradually move their retirement savings into commodity-related investments, as well as bonds and stocks issued in reserve currencies other than the U.S. dollar. 

Mission: Use our Standard Spreadsheet to highlight large U.S. and Canadian companies that produce, refine and transport raw commodities, i.e., materials that are extracted from the ground. Select such companies from the 2017 Barron’s 500 list, but exclude any that issue bonds with an S&P rating lower than A- or stocks with an S&P rating lower than B+/M. 

Execution: see Table.

Administration: The S&P Commodity Index has the following components and weightings:
Natural Gas (17.66%)
Unleaded Gas (12.16%)
Heating Oil (12.13%)
Crude Oil (11.41%)
Wheat (5.15%)
Live Cattle (4.87%)
Corn (4.48%)
Coffee (3.88%)
Soybeans (3.84%)
Sugar (3.80%)
Silver (3.67%)
Copper (3.39%)
Cotton (3.22%)
Soybean Oil (2.98%)
Cocoa (2.79%)
Soybean Meal (2.57%)
Lean Hogs (2.04%)

53.36% of the index represents petroleum products, 32.71% represents row crops, 7.06% represents industrial metals, and 6.91% represents live animals. Ground has to be mined, drilled, or planted & harvested with the help of heavy equipment to yield raw commodities. Those have to be transported by barge, rail, truck, or pipeline before being processed for market. 

We find 8 companies that warrant inclusion in this week’s Table. Seven are obviously appropriate, but the presence of Berkshire Hathaway (BRK-B) needs some explanation (unless you already know it owns the Burlington Northern & Santa Fe railroad). Berkshire Hathaway is the largest shareholder of Phillips 66 (PSX), which has 13 oil refineries and supplies diesel for the largest marketing outlet of that fuel: Pilot Flying J Centers LLC. Berkshire Hathaway purchased 38.6% of that company’s stock on October 3, 2017, and plans to increase its stake in 2023 to 80%.

Bottom Line: Commodity futures haven’t been a good investment, given that their aggregate value is back to where it was 25 years ago, given that the most recent 20-year supercycle recently finished and another is just starting. Nonetheless, the companies that produce, process, and transport those commodities did well over those 25 years (see Column AB in Table). The problem is the volatility of their stocks (see Column M in the Table), and the extent to which their stocks get whacked when commodities become oversupplied relative to demand (see Column D in the Table). If you choose to own shares in these companies (aside from CNI, BRK-B and perhaps UNP), you’d be flat-out gambling. 

Risk Rating: 7-9 (where US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)

Full Disclosure: I dollar-average into UNP, ADM, CAT and XOM, and also own shares of CNI and BRK-B.

"The 2 and 8 Club" (CR) 2018 Invest Tune Retire.com All rights reserved.

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Week 338 - Alternative Investments (REITs, Pipelines, Copper, Silver and Gold)

Situation: You want to minimize losses from the next stock market crash. News Flash: The safe and effective way to do that is to have 50% of your assets in medium-term investment-grade bonds. Those will go up 10-25% whenever stocks swoon. But a plain vanilla form of protection won’t resonate with your neighbors after the crash hits. You’ll want to tell them about something cool that you did to protect yourself. And, while waiting for the next crash you don’t like the low interest income that you’d receive from a low-cost Vanguard intermediate-term investment-grade bond index fund like VBIIX or BIV. The exotic-seeming alternative is to bet on something related to land and its uses. Those bets carry valuations that track long supercycles, which overlap 3 or 4 economic cycles. But supercycles contain pitfalls for the unwary, and even for professional commodity traders.

Mission: Use our Standard Spreadsheet to examine Alternative Investments, and describe the pros and cons of owning those.

Execution: see Table.

Administration: The main bets are on real estate, oil/gas pipelines, copper, silver and gold. Traders mitigate losses during a recession by hoarding such assets until prices recover. Let’s look at the odds of success. The SEC (Securities and Exchange Commission) is responsible for guiding the average investor away from loss-making bets. For example, the SEC doesn’t allow a stock to be listed on a public exchange unless it has Tangible Book Value (TBV) and appears likely to continue having TBV after being listed. So, S&P identifies 10 Industries that have the structural profitability needed to maintain TBV and dividend payouts for retail investors. 

Real Estate is not such an industry. However, S&P has started evaluating Real Estate Investment Trusts (REITs) with a view toward someday including those. However, the Financial Times of London does not include Real Estate companies in either its FTSE Global High Dividend Yield Index, or the US version of that index, which you can invest in at low cost through an ETF marketed by the Vanguard Group (VYM). Nonetheless, we’ll list what we think are the 7 best REITs in the accompanying Table.

Oil and gas pipelines offer a way to capture tax-advantaged dividend income that transcends the ups and downs of the economy, but typically requires you to buy into a Limited Partnership. To do so, the SEC requires you to be an Accredited Investor. “To be an accredited investor, a person must demonstrate an annual income of $200,000, or $300,000 for joint income, for the last two years with expectation of earning the same or higher income.” You’re also liable for taxes levied by most states through which the pipelines run. As a retail investor, you aren’t going to buy shares of a Limited Partnership. So, none are listed in our Table. But a few “midstream” oil & gas companies issue common stock to help fund a large network of integrated pipelines. Those pay the same high dividends expected of Limited Partnerships, and two companies are listed in the FTSE High Dividend Yield Index for US companies (VYM): ONEOK (OKE) and Williams (WMB). This indicates that each company’s dividend policy is thought to be sustainable. ONEOK has the additional distinction of being an S&P Dividend Achiever because of 10+ years of annual dividend increases.

Gold is the traditional Alternative Investment, which also brings copper and silver into play given that all 3 are found in the same geological formations. Any copper mine that fails to process the small amounts of gold it unearths is a copper mine not worth owning. The same can be said of gold miners who ignore silver deposits. The problem for investors is that mines are costly to develop and have an unknown shelf life. So, owning common stocks issued by miners has fallen out of favor: Dividends are rare and fleeting, and long-term price appreciation is neither substantial nor steady. Nonetheless, we have listed 4 miners in the Table: Freeport McMoRan (FCX) and Southern Copper (SCCO) both focus on mining copper; Newmont Mining (NEM, focused on mining gold), and Pan American Silver (PAAS). 

A better way to invest in precious metals is to buy stock in financial companies based on loaning money to miners on condition of being paid later either in royalties or ownership of a stream of product, should the mine become a successful enterprise. We have listed two such companies: Royal Gold (RGLD), which seeks royalties; Wheaton Precious Metals (WPM), which mainly seeks silver streaming contracts. See our Week 307 blog for a detailed discussion of silver. 

Bottom Line: If you want to venture into Alternative Investments, and would like to take a relatively safe and effective approach, we suggest that you buy shares in the REIT ETF marketed by the Vanguard Group (VNQ at Line 19 in the Table). Better yet, stick to companies in “The 2 and 8 Club” that represent more reasonable bets in the Natural Resources space: ExxonMobil (XOM), Caterpillar (CAT), and Archer Daniels Midland (ADM). One pipeline company is also worth your consideration: ONEOK (OKE, see comments above). 

Risk Rating: 9 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)

Full Disclosure: I dollar-cost average into XOM, and also own shares of OKE, CAT and WPM.

"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com

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Week 284 - Barron’s 500 List: Food and Agriculture Companies

Situation: There is some evidence that a new Commodity Supercycle is starting. For example, the Dow Jones Commodity Index recently recalled its 1998 low and is now rising. Corn and soybean prices have stabilized well above their 1999 low. We recently took a close look at all of the larger companies supporting Agriculture Production (see Week 279) and concluded that fundamental metrics are on the upswing, in spite of a February 2016 Bear Market in commodity-related stocks. Now 9 months have passed and we need to again look closely at the data while adding Agriculture Processing companies to our analysis. 

If, after closer study, you’d still like to buy stock in one of these companies, you need to understand that you’d be making a “risk-on” trade with multiple opportunities for loss. For example, the February 2016 Bear Market apparently arose because  “...investors’ appetite for riskier securities nose-dived early in 2016 [due to] concerns about an economic slowdown in China and the U.S., falling commodities prices, and the uncertain direction of interest rates were roiling global markets.”

Mission: Capture data on all Food and Agriculture companies in the 2016 Barron’s 500 List that have S&P stock ratings of B+/M or higher. Include columns that note whether the 200d moving average of a stock’s price is moving higher, and whether the 50d moving average has risen above the 200d average to lead it higher. Also include 2 columns that compare the 2016 brand rank to the 2015 brand rank among the top 500 global brands, and 3 columns to assess whether the company has a clean Balance Sheet.  

Execution: see Table.

Bottom Lines: Food and Agriculture companies have been struggling over the past 4 years, along with other commodity-related companies. Hundreds of billions of dollars were invested in expansion projects, which became monuments to futility as the buildout of China’s infrastructure suddenly sputtered. The world now has the capacity to produce, process, transport, and market more oil, natural gas, coal, gold, steel, aluminum and protein-rich foods than it needs. That means the prices that food processors are asked to pay for corn and soybeans have fallen, but the good news is that those prices are now coming off historic lows relative to inflation.

Multi-decade commodity cycles have been with us forever and a new one appears to be starting, now that a number of production companies have gone bankrupt and all of those remaining have drastically curtailed their expansion plans. “Dr. Copper” is the generally accepted as the main barometer for expansion vs. contraction in commodity production. Freeport-McMoRan (FCX) is the largest company that mainly produces copper (see Line 24 in the Table). Caterpillar (CAT) is another widely-accepted barometer (see Line 10 in the Table). With regard to stock prices, the 200 day moving averages for both companies bottomed in the early summer and have been rising steadily since the late summer (see Columns AE-AF in the Table).

Risk Rating: 8 (where a 10-yr US Treasury Note = 1, and gold bullion = 10).

Full Disclosure: I dollar-average into MON, and also own shares of CAT, HRL, KO, and ADM.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 27 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256. Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = average stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 3-Yr CAGR found at Column H. Price Growth Rate is the 16-Yr CAGR found at Column K (http://invest.kleinnet.com/bmw1/). Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 33 in the Table.

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Week 225 - How are the 20 Largest AgriBusiness Companies Doing?

Situation: Commodities have fallen steadily in value since the Lehman Panic. A recent further decline is related to a slowing in the pace of modernization in China, where 40% of commodity production had gone for the past 20 yrs. This has greatly compounded the problem because the rapid pace of modernization there had required remarkable growth in the production of all commodities. Now that China’s infrastructure buildout is largely complete, those upgraded mining and exploration assets in Australia, Brazil, Chile, and South Africa have been idled, and over a dozen billion dollar projects have been aborted. But those aren’t the only commodities out there. What about agricultural products? Demand for soybeans and cereal grains (e.g. barley, corn, oats, rice, rye, wheat, sorghum) is different because close to 20 million people emerge from poverty each year and are able to afford better food, which translates into a protein intake of at least 60 gm/d. The volumes of food involved in meeting that increased demand make it necessary to combine the “green revolution” with “factory farms.” That combination has come to be called “AgriBusiness.” AgriBusiness is focused on efficiently getting water to soil that has been prepared to support the germination of designer seeds through “agronomy.” Agronomy is shorthand for the scientific use of fertilizers, insecticides, and fungicides to optimize plant growth around weather patterns and irrigation systems that meet water needs.  

Mission: Assemble data on stocks representing the 20 largest AgriBusiness companies, and compare their aggregate performance with broad commodity indices--as well as narrower indices that reflect the performance of farming, mining, and energy companies.

Execution: AgriBusiness companies are high risk investments, and each has only a small piece of the pie. In order to compete against one another, each has to maintain a market for its goods and services in dozens of countries. Only 4 of the 20 identified AgriBusinesses are stable enough to warrant inclusion in a retirement portfolio by even the most basic criteria (see Table). These criteria are 1) Dividend Achiever status, 2) an S&P bond rating of at least BBB+, and 3) an S&P stock rating of at least B+/M. The 4 companies that make the cut are: Monsanto (MON), Deere (DE), Hormel Foods (HRL), and Archer Daniels Midland (ADM).

Bottom Line: If you think your portfolio requires exposure to commodities, then you’re in for a rough ride. But “long cycle” investments such as commodities can be quite rewarding if held for two or more market cycles. The safest approach is to own stock in a few of the larger AgriBusiness companies, as opposed to owning stock in mining or energy companies (see Week 221). This week’s blog takes a closer look at those agricultural producers. Be aware, however, that overproduction to meet China’s needs over the past decade has expanded agricultural production capacity along with that for oil, natural gas, coal, iron ore, bauxite, and copper. This is being reversed now that China’s “buildout” has begun to plateau.  

Risk Rating: 8

Full Disclosure: I own stock in CF, HRL, MON, DD, DE, and ADM.

Note: Metrics in the Table that are highlighted in red denote underperformance relative to our key benchmark (VBINX); metrics are current as of the Sunday of publication.

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Week 200 - Agronomy Companies on the Barron’s 500 List

Situation: I know, you’re already bored. But we really have to talk about commodity-related stocks occasionally because those are the high-risk, high-reward, high-cost stocks that anchor the world economy. Their prices usually reflect a megacycle that lasts for decades, starting with supply shortages (relative to demand) and ending with overproduction that persistently exceeds demand for a time (e.g. today’s oil & gas markets). The pricing of such stocks correlates with global demand, not with the typical 5-7 yr economic cycle of individual countries or regions. Some commodities are so adept at reflecting the global economic cycle as to earn special respect, like “Doctor Copper”. You’ll want to own two or three of these “non-correlated” stocks that dampen the ups and downs of the economic cycle. In particular, consider production agriculture companies because those have special advantages: 1) Their profits are driven more by the weather cycle than the economic cycle; 2) ten million people per year enter the middle class in Asia and Africa who can finally afford to consume the 60 grams/day of protein that is required for good health and a long life.

Livestock has been the best-performing commodity sector over the past year. Let’s think about what goes into livestock production: grain, hay, and soybeans are the most important inputs. (Four pounds of feed is needed to make one pound of Grade A meat.) Production of those crops requires certain inputs: tractors and combines (see Week 197), irrigation equipment (see Week 129), and this week’s topic about the tools of an agronomist (seeds, fertilizer, insecticides, herbicides, and fungicides). Agronomists work “on call” for individual farmers (or a farmer's cooperative) to address issues of plant genetics & physiology, soil science, and meteorology. Think of them as general practitioners overseeing the crop. Increasingly, this role is played by “seed analysts” from one of the major seed production companies (Monsanto, Syngenta, Bayer or Dupont). Seed analysts also look for farmers who will allow part of their fields to be used for plant research.

This week’s Table has all of the large, publicly-held agronomy companies in the United States and Canada. Stocks in these companies are not suitable for inclusion in a retirement portfolio. But several are suitable for a portfolio of non-correlated assets, i.e., those where prices don’t follow the economic cycle. The pricing of agronomy companies is mainly driven by weather cycles, and the worldwide growth rate for workers who are paid enough to provide their families with an adequate protein intake.

Bottom Line: You need to have a few investments that don’t track the S&P 500 Index, so-called "non-correlated assets." Inflation-protected Savings Bonds epitomize this concept, and you should have a Rainy-Day Fund that is mainly invested in those or Treasury Bills (see Week 162). But there are other, more rewarding non-correlated investments. Most are commodity-related and come with a lot more risk. We like large companies that focus on the needs of farmers and ranchers. This week's Table has 8 of those.

Risk Rating: 7

Full Disclosure: I own stock in MON, CF, and DD.

NOTE: Data are current as of the Sunday of publication; red highlights denote underperformance vs. our key benchmark (VBINX).

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Week 134 - Food-related Stocks Found in Our Universe of 55 Companies

Situation: Yes, I know. You’d like to put a little zip into your retirement savings by investing in commodities. Here at ITR, retirement is our end-game so we eschew risk. That means we don’t talk about investing in raw commodities through futures or exchange-traded funds (ETFs) like CORN. Instead, we talk about investing in companies that turn those commodities into value-added products. Buying stock in production companies has two advantages over investing in raw commodities: 1) if the raw commodity is rising in price, that increased cost is passed on to the end-user; 2) if the raw commodity is falling in price, that reduction in CGS (cost of goods sold) serves to increase the profit margin. (However, in a competitive environment those savings are passed on to the end-user.) We look at  food-related companies in this week’s blog because we expect world food prices to grow 1-2%/yr faster than world GDP. Other commodity-related investments appear less attractive. For instance, companies that produce fossil fuels are likely to grow slower than world GDP, since growing atmospheric carbon dioxide now has to be mitigated by substituting carbon-neutral energy sources, such as solar, wind, nuclear, hydroelectric, and geothermal. Companies that mine minerals from the ground (or make products from those) are likely to grow with GDP, given the key roles that copper, iron, zinc, nickel, and aluminum play in the building of infrastructure. 

There are three types of companies that support food production. Those that: 
   a) provide inputs to the farm like seeds and fertilizer, 
   b) provide tools for the farmer to use, and 
   c) take farm commodities out to the food chain.

This week’s Table lists 12 stocks that cover all three items listed above. Inputs come from Monsanto (MON), tools come from Deere (DE) and Caterpillar (CAT). Farm products enter the food chain via rail and trucking companies like Canadian National Railway (CNI) and Sysco (SYY). In the United States, almost 40% of corn goes to ethanol producers like Archer Daniels Midland (ADM). Meats are produced by Hormel Foods (HRL); snack food and beverages are produced by Coca-Cola (KO) and PepsiCo (PEP). Much of the final distribution occurs through restaurants like McDonald’s (MCD) and hypermarkets like Wal-Mart Stores (WMT) and Target (TGT). We picked those 12 companies are from our “universe” of 55 high-quality companies (originally 51, see the updated Table for Week 122). “High-quality companies” means those that a) are found on the Barron’s 500 list of companies with the best growth in sales and cash flow over the past 3 yrs; b) have increased dividend payouts for 10 or more consecutive years, e.g. companies called Dividend Achievers by Standard & Poor’s, and c) have a Standard & Poor’s credit rating of A- or higher. Red highlights in the Table denote metrics that underperform our benchmark, Vanguard Balanced Index Fund (VBINX). The history of total returns in Column C goes back to 9/1/00 because that’s when the lowest-cost S&P 500 Index fund (VFINX) peaked before the “dot-com” recession. That Index of price performance remains “underwater” by inflation-adjusted accounting, but on a total return basis (price appreciation plus dividend reinvestment) it has beat inflation (bottom of Column C). 

Bottom Line: Looking at all 6 benchmarks in the Table, and comparing those to the average values for 12 companies in each column, you’ll see that that stock in those companies handily outperforms the benchmarks, in terms of both performance and safety.

Risk Rating: 6

Full Disclosure: I own stock in WMT, MCD, MON, HRL, CNI, KO, PEP, DE, and CAT.

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Week 99 - Gold and Copper Miners

Situation: Commodities are having a bad year. People who regard gold as a currency, or a safe haven in times of market turmoil and recession, are finding that the US economy is recovering. The great fear that “inflation is just around the corner because the Fed keeps printing money” hasn’t materialized. The Federal Reserve’s preferred inflation indicator (personal consumption expenditures) continues to moderate and is now 1% (year-over-year). People who regard copper production as being so essential to infrastructure investment that they refer to it as “Dr. Copper” are again correct. 

Taken as a whole, the economies of the world are slowly emerging from a slack period. (Dr. Copper reflects that fact.) Yes, the US economy is growing at 2%/yr but European economies are shrinking 2%/yr and Asian economies are struggling to grow 4%/yr--somewhat slower than their former pace.

The great mining companies of Australia (BHP Billiton and Rio Tinto), which mainly export iron ore to China, are shelving their expansion plans (read this link). Whereas the production of most commodities couldn't keep up with demand just a few years ago, supplies now exceed demand. Spot prices continue to fall and production cutbacks are reported almost monthly. Copper production mainly gets warehoused. What to make of all this? Input costs are facilitating the production of finished goods instead of constraining production.

But investors know that infrastructure spending has to increase soon, given that the world’s population increases by 220,000 a day. They also know that governments will engage in deficit spending, and central bankers will engage in “easy money” policies, as long as sub-par growth crimps tax revenues. So gold and copper producers aren’t about to close up shop. Spot prices for gold and copper are simply in the downward phase of what economists like call “reversion to the mean.” The upward phase will resume when economic growth returns to Europe because that's where the bottleneck is located. The BRIC countries (Brazil, Russia, India, and China) are the engine of globalization; those countries cannot grow unless they export a growing volume of goods to Europe.

For this week’s Table, we’re using the recently released Barron’s 500 list as our guide. That list weights 3 items equally: 
   a) sales growth for 2012, 
   b) median "cash-flow based" return on investment (ROIC) for the past 3 years, and 
   c) cash-flow based ROIC for 2012. 
Here at ITR, we view those factors above all others in assessing current Finance Value.

All of the mining-related companies on that list are in the Table. We have also included two railroad companies that play key roles in North American commodity production--Canadian National (CNI) and Union Pacific (UNP)--as well as Caterpillar (CAT), which is the dominant manufacturer of mining equipment. Three gold producers also make the list: Goldcorp (GG), Barrick Gold (ABX), and Newmont Mining (NEM). In addition, the two largest copper producers are included: Freeport-McMoRan Copper & Gold (FCX) and Southern Copper (SCCO). Remember, where copper is found there will also be some gold (and vice-versa). Pure gold emerges as a by-product when copper is purified by electrolysis. 

Bottom Line: Commodity producers have large fixed costs, and that kind of investment only happens when a commodity becomes expensive because it is in short supply. This raises input costs, putting a brake on production and driving up the cost of finished products. Once production expands, however, the opposite happens. This “commodity cycle” typically last for ~15 yrs. For gold and copper, we’re at the end of one cycle and looking to start another when Europe emerges from recession. 

You, as someone who is saving for retirement, probably have a shorter horizon and shouldn’t be investing in commodity producers. The price swings are simply too great. But if you can’t resist the temptation, stick to a low-cost commodity mutual fund such as T. Rowe Price New Era fund (PRNEX in the Table). Better yet, invest in the lowest-volatility railroad stock (CNI) or the lowest-volatility oil stock (XOM).

Remember, the whole point of commodity investing is to participate in the long and strong up-periods of the commodity cycle. The problem is that the down-periods get recognized belatedly and suddenly. That means you probably won’t be able to sell in time to realize a good profit. You'll want to find a company that lives off commodities but also makes money during recessions. For example, railroads haul everyday essentials; integrated oil companies operate gas stations and produce petrochemicals that are used to make plastics.

Risk Rating: 9.

Full Disclosure: I have stock in CNI, XOM, and CAT.

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Week 53 - Commodity Producers in the S&P 100 Index

Situation: We’ve discussed commodity-related companies in broad strokes in a number of previous blogs (see Weeks 10, 20, 26, 34, 35, 40, 42, 45). In terms of Finance Value (Reward minus Risk) and prospective future reward vs. risk only 4 companies, Exxon Mobil (XOM), Chevron (CVX), Occidental Petroleum (OXY) and Hormel Foods (HRL) stand out. All 4 are already on our ITR Master List (see Week 52) of stocks recommended for DRIP investing. In this week's blog, we’ll try to determine which commodity producers have a chance to meet the qualifications for our Master List in the next few years. Given that risks relating to debt and cash flow tend to diminish as a company grows larger, and given that this blog is for risk-averse investors, we’ll begin our analysis with the largest companies which are also commodity producers, i.e., those found in the S&P 100 Index.

The accompanying Table lists 15 such commodity producers found in the S&P 100 Index. There are 12 petroleum-related companies, including 9 drillers (OXY, APC, CVX, APA, XOM, SLB, NOV, COP and BHI) and a pipeline company (WMB). There are also 2 that produce commodity chemicals (DD, DOW). There is only one mining company, Freeport-McMoRan (FCX), which produces copper, gold, and molybdenum. Monsanto (MON) produces genetically-engineered seeds and growth supplements for agriculture. Caterpillar (CAT) produces mining equipment as well as equipment used in agriculture and drilling. Three of the 15 are already on our ITR Master List (XOM, CVX and OXY), so we’ll sift through the remaining 12 companies looking for any that might to be able to join the Master List within the next 5-6 yrs. We see that one, MON, is almost ready. It only needs to increase its dividend yield from the current 1.5% up to the yield on the S&P 500 Index (currently 2.1%). Apache (APA) is attractive in most respects but would have to increase its dividend annually for another 8-9 yrs to qualify. 

Bottom Line: We like to invest in commodity producers because commodity prices usually keep up with both inflation and population growth. However, these companies have high fixed costs and long lead-times before investments pay off. There is often a sharp fall-off in revenues during recessions, the effect of which is compounded by the inability to raise prices. So you have to do a lot of research before buying stock in a commodity producer and have a lot of patience during recessions, before benefiting from their outperformance over time. Of the 15 commodity producers in the S&P 100 Index, only 4 appear to be suitable for a risk-averse portfolio of long-term investments: ExxonMobil, Chevron, Occidental Petroleum, and Monsanto.

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Week 49 - Commodity Index

Situation: Before investing in commodity producers, it is useful to look at an index of economic activity in countries with the highest demand for commodities (US, China), and an index of commodity prices (e.g. Dow Jones UBS Commodity Index). Commodity prices are extra-vulnerable to economic winds because the costs for up-grading production are large and lead-times are long. Commodity prices therefore depend not only on the strength of the economy in end-user countries but also on a ~35-yr “supercycle” that reflects expansion of production when commodity prices are high, and “slack” when the supply of the commodity finally becomes plentiful. This slackening usually coincides with a fall-off in demand that is frequently related to constraints on credit. You, however, are a long-term dividend re-investor who is interested in owning stock in commodity-related companies, not futures contracts. As such, you need an index of stock prices that includes dividend payouts. 

To construct our index, we selected 8 of the most solvent, well-established and dominant players among commodity-related companies tracked by Standard & Poors (for background info see Week 40, Week 42, Week 45 & Week 48). Two are based in Canada (SU & CNI) and the rest in the United States. Four are oil & gas producers: Suncor Energy (SU), ExxonMobil (XOM), Chevron (CVX), and Schlumberger (SLB). One company mines gold and copper (Newmont Mining - NEM), one produces heavy equipment used on farms and at mining and drilling sites (Caterpillar - CAT), one is a railroad that gets ~90% of its revenues from transporting commodities (Canadian National Railway - CNI), and one produces genetically engineered seeds and matching herbicides (Monsanto - MON).

The baseline investment for the ITR Commodity Index is a "virtual" purchase of 100 shares of each of these 8 companies at the close of business (COB) on 7/1/02 (transaction costs not included), which had a cost of $30,353. At COB on 6/6/12, that “virtual” investment had a market value of $109,256, and had generated $13,043 in dividends over 10 yrs, for a total return of $122,299 (15.0%/yr). During the bear market of 10/1/07 through 4/1/09, stock in those 8 companies fell an average of 32.0% in value. The dividend yield for the index is currently $2,448 (2.24%/yr), which means the original investment of $30,353 now pays 8.1%/yr. Presently (and since the beginning), CVX, CAT and CNI have been the most valuable components of the index and now pay 62% of the dividends. Because of stock splits, the index now holds 200 shares each of SU, CVX, CAT, MON, SLB and 300 shares of CNI, as well as the original 100 shares each of XOM and NEM.

Bottom Line: Commodity-related companies anchor most portfolios that outperform a broad-based stock index. However, the ups and downs can be disheartening so it helps if the investor has some idea of why that is happening and whether it is attributable to “the usual course of doing business”. To assist readers of our blog, we have set up a stock price index for 8 prominent commodity-related companies. The index started at a value of $37.94/share on 7/1/02 and has a current value (6/6/2012) of $72.83/share, thus it has grown almost 14%/yr. For comparison, the Dow Jones UBS Index of raw commodity prices has grown 3.8%/yr. In other words, someone who owns stock in companies that turn raw commodities into useful products is likely to accumulate wealth much faster than someone who invests in commodity futures.

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com