Three vital things you must know about commodities
John Stepek Oct 05, 2012
Buy ‘real’ assets.
This is an argument you’ll often hear these days. With governments around the world printing money, there will be a lot more paper money than ‘stuff’ in the world. So the ‘stuff’ will only become more valuable.
For investors, one very important category of ‘real stuff’ is commodities.
The big, big commodity that’s often in the news is oil. Without it, the global economy would come grinding to a halt. So fluctuations in the supply or the price have huge consequences. But there are many other commodities too.
There are agricultural, or ‘soft’ commodities – foodstuffs such as grain, or material such as cotton. There are industrial, or ‘base’ metals, such as copper. There are energy resources, such as oil and natural gas.
And then there are precious metals, such as gold, silver, platinum and rhodium. (NB: As I said last time, I don’t see gold as a commodity, I see it as a currency. I’m not going to talk about gold and silver here).
The dangers of buying commodities
So how do commodities fit into your portfolio?
Up until the turn of the century, most commodity prices had been falling for years. It wasn’t really seen as an investable asset class. Nobody was interested in ‘stuff’ – they were more interested in ‘virtual’ assets, like tech stocks.
But with the rise of emerging markets, and China in particular, came the ‘commodity supercycle’. As more people moved to cities, developing countries built lots of houses, roads, railways, office blocks – and as a result, demand for commodities soared.
As a result, they’ve gradually come to be seen as an investment asset all on their own. Exchange-traded funds (ETFs) have been launched to track commodity prices directly, for example.
However, I don’t think you should consider commodities as a separate asset class at all. Here’s why.
There are two key problems with investing directly in commodities. Firstly, it’s not that easy to do. You can spread bet, but that’s highly risky, and certainly not for beginners.
Alternatively, you can buy an ETF. But some of these use futures, which means – to cut a long story short – that they don’t follow the price in the way that you might expect them to. Physically-backed ETFs track the ‘spot’ price more closely.
Sign up for a 3-week FREE trial of MoneyWeek
and get the following free as well
"The only financial publication I could not be without."
John Lang, Director, Tower Hill Associates Ltd
But that brings us to the second, more significant problem, which is this: investing directly in commodities is pure speculation. You are betting on a price either rising or falling. Commodities themselves produce no income. So it’s not a long-term investment. It’s a punt.
And over the long run, commodities have generally tended to fall in price. That’s because as prices get higher, there’s more incentive to invest in technology that either creates cheaper substitutes, or enables us to produce more of the commodity that’s in demand.
Natural gas is a classic example. New ‘fracking’ technology has enabled companies in the US to access once irretrievable reserves of gas. The resulting supply glut has sent the price of natural gas plunging in the US, and encouraged power stations to switch to using gas rather than coal.
In short, a direct investment in commodities is a trade, not a ‘buy and hold’ position. So my view is that you shouldn’t allocate a specific place to commodities in your long-term portfolio.
If you want to profit from a bull market in commodities, you should buy shares in the companies that produce the commodities in question. If you think that copper will become more expensive, buy a copper miner, or a mining fund.
If you think that food prices will rise, buy companies that will help us to grow more food – such as fertiliser producers, or companies involved in genetically modified crops.
But these would all count as part of the ‘equities’ section of your overall portfolio. You are buying these companies because you believe they will profit from the underlying rise in commodity prices.
What to buy if you are worried about currency debasement
If you are instead looking for exposure to ‘real’ assets to protect yourself against currency devaluation and money printing, then the answer to that is simple. Buy gold.
Why do I say this? Well, copper, for example, has lots of uses. Copper demand is largely based on the fact that it’s used for generating power, or producing car components, or in air conditioning units.
So people aren’t buying copper because they are worried about paper money losing its value. They are buying copper because they need it to wire up their homes. If the Chinese decide to build fewer houses – which is what’s happening now – then that’s going to be a drag on copper prices, regardless of how much money is printed.
Gold on the other hand, has negligible industrial use. So it’s only real function is as a store of wealth. And that’s why it is the asset you need to hold if you are worried about currency debasement.
In short, if you believe there’s a bull market in a given commodity, then you should allocate some of the equity portion of your portfolio to companies that will benefit from this. Just as you would buy retailers if you thought a country was heading for a consumer boom.
But if it’s ‘real’ assets you are looking for, I’d suggest sticking with gold.
• This article is taken from our beginners' guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week.
Sign up to MoneyWeek Basics here