6 Ways to Profit from Commodities

“Goodness is the only investment that never fails.” Henry David Thoreau

In the latest issue of the monthly communique that the Oxford Club sends to its members, Steve Sjuggerud says, “At a time when stocks appear both boring and expensive, commodities are hot and don’t look like they’re going to cool off anytime soon.”

According to Steve, there are six ways to profit from commodities.

1. You can invest in a broad-based, no-fee mutual fund that holds commodity-type companies. Steve’s top choice is the T. Rowe Price New Era Fund (PRNEX), which rates 5 stars with Morningstar.

2. You can get more specific and own a narrowly based fund, such as a gold fund. Steve’s recommendation here is Frank Holmes’ U.S. Global Gold shares (USERX), which has been around for 30 years.

3. You can get broader and limit your fees through I-shares (www.ishares.com), which act like index funds. There are three different natural-resource/energy-based I-shares, Steve points out, all of which could benefit from an increase in commodity prices.

4. You can go the managed-futures route by investing in funds that attempt to profit from both the rise of and the fall of commodity prices. Managed futures are not investments in stocks but trades on the futures market. The historical track record of these investments, Steve says, is fantastic. (“Literally stock-like returns with less risk over the very long run.”)

5. You can trade commodities directly (instead of through a fund). The most common way of doing that is by trading futures or futures options. Oxford Club members, Steve says, have been “happy” with Sue Rutsen’s 20 years of options experience and good personalized service (srutsen@foxinvestments.com).

6. Finally, you can buy an individual stock poised to benefit from the sector. As a general rule of thumb, Steve says, “the smaller the company offering the stock, the more speculative the opportunity is — but that also means you stand to make a lot bigger profit as the commodity rises. You are not going to make six times your money in Exxon Mobil in a year, but you might in a small commodity-oriented stock.”

To that, let me add this: If you are thinking of getting into commodities, be sure to avoid the two most common (and most devastating) mistakes new commodity investors make:

1. Don’t believe in the long-term value of commodities. Contrary to what many people think (and many experts say), the long-term trend of commodity prices (relative to incomes) is down. This has been true for all the major commodity groups (agricultural, mineral, and energy) throughout the 20th century and is likely to remain so. This is demonstrated in a study by Julian Simon titled “The Greatest Century That Ever Was: 25 Miraculous Trends of the Past 100 Years.”

For example, the study shows that wheat prices have fallen by 95% relative to wages in the 20th century. For metals, the prices of many “have fallen an average of fivefold since 1900.” This is due mostly to technological innovation, Steve says, which has outpaced the depletion of reserves. According to Steve, “the ultimate point to remember is that, while commodity prices may rise in the short term, the historical trend of commodity prices relative to wages is lower.”

2. Don’t fall for the “cost-of-production” argument — the idea that a commodity’s value is equal to at least as much as its cost of production. That sooner or later the price of oil, for example, must equal the cost of producing it. This line of thinking is specious. Steve illustrates that with this example: “What would it cost you to make an old-fashioned typewriter? What would be its cost of production? (A lot of moving parts and heavy metal.) A few hundred dollars? In the age of computers, what would that typewriter you built actually be worth? Certainly not the cost of production. The same is true in commodities. Since the mid-1970s, sugar has sold below its cost of production much of the time.

“Commodities are hot now,” Steve says. “There is a place for them in your portfolio. By knowing the six major ways to invest in them, as well as the two pitfalls to avoid, you have the basic tools you need to begin adding them to your portfolio.”