Commodities and commodity stocks, such as explorers and producers, are cyclical. There is consensus on this. So this means that to earn excess returns on commodities, all you have to do is recognize the peaks and valleys of the cycle and buy and sell accordingly. Well, not so fast -- there are cycles within the cycles, and you want to make sure you know how long the primary cycle generally lasts. If you are going to invest in cyclical stocks, try to understand the key factors driving commodity prices and related company values.
Identifying Commodity Companies
According to valuation guru Aswath Damodaran, there are three types of commodity companies. First are primary producers – companies that explore and extract raw resources from the ground, such as mining companies. Next are companies that purchase commodities and process them into a refined end product, such as many food companies. The third type of commodity company is the service firm that serves both producers and end-users. Integrated oil companies, oil field services and some mining companies qualify as the third kind of commodity companies.
Normalizing Cash Flow
A company’s value boils down to cash flow and risk. A cyclical company’s free cash flow follows the broader cycles affecting the markets in which it competes. Be conservative when you model the free cash flow capacity of a company whose performance goes up and down over and over again. Instead of trying to guess at what point of the cycle the company is in, identify the broadest cycle and calculate a simple or time-weighted average of free cash flow throughout the duration of the cycle. To factor in growth, use expected long-term inflation.
The relationship between commodity prices and interest rates is complex. There are conflicting ideas regarding how shifting interest rates influence commodity prices, especially in the case of the prevailing climates in which global central banks continuously pump liquidity into global markets, propping up asset values. In the short term, rising interest rates can benefit commodities and commodity stocks. However, generally speaking, commodity prices rise when interest rates fall. During the 1980s, interest rates were historically very high while commodity prices were low. Rising rates result in lower commodity prices for several reasons. You may find it useful to think of interest rates as the cost of holding money and also as opportunity costs. Rising rates increase producers’ incentives to extract resources from the ground sooner rather than later. Rising interest rates are also reflected in the cost of transportation, so they decrease commodity producers’ desire to hold inventories. Finally, rising rates reduce the relative values of commodities relative to domestic currencies and increase the attractiveness of bond yields relative to commodity holdings.
The fundamentals surrounding China’s long-term commodity needs are stunning. One result of Chinese demand for industrial and agricultural commodities is that country’s entry into African markets at full speed. China has locked in long-term supply agreements with numerous African countries, guaranteeing them commodities ranging from timber to rare earth minerals at below-market rates. In exchange, China has paid kickbacks to African dictators and sent thousands of Chinese laborers into Africa to work on massive infrastructure projects. Chinese demand is so voracious that holding global demand constant, by 2020, annual copper production in Chile, which is the world’s largest copper producer by a factor of four, will need to triple. Meanwhile, additional crude demand will equal current annual production in Saudi Arabia.
Video of the Day
- Harvard Kennedy School of Government: The Effect of Interest Rates on Commodity Prices
- Forbes: Commodities Can Shine as Rates Rise
- New York University/Stern School of Business: Ups and Downs -- Valuing Cyclical and Commodity Companies
- Wall Street Journal: As China Goes, So Go Commodities
- Money Morning: The Scramble for Africa -- Profiting From World's Largest Cache of Commodities
- Hannelore Foerster/Getty Images News/Getty Images