So far this year, I have discussed steadily growing shares, turnarounds, dividend-based investing and fast growers. This week, I look at the roller coaster of all sectors: resource or commodity shares.
The price volatility of commodity shares is both tempting and terrifying. For example, during the past 20 years, Anglo American's share price regularly declined by between 30 and 50 percent in a relatively short period of time, while it doubled in value during most up-cycles, with an appreciation of 50 percent at the low end of an upward move. That information alone gives you some indication of the difficulty attached to deciding whether to invest in a resource share.
In this column I will deal with the non-gold commodity shares - in other words, base metals, platinum, oil and so on.
The main differences between the behaviour of resource shares and the rest of the market are:
- The cyclical nature of the price movements of commodity shares. In other words, they undergo sharp movements in a relatively short space of time. Resource stocks are definitely not "bottom-drawer" shares.
- Resource shares are dependent on the global commodity markets.
While commodity shares can provide the lure of the fast buck, this is one sector where timing the market outweighs time in the market.
The five key points to consider when investing in commod-ity shares are:
1. The global commodity cycle
- Resource companies tend to be price-takers. This means the prices they are paid for the raw materials they mine or produce are linked to the global economy. Individual resource companies have limited influence over the prices they receive.
It is possible that the share prices of resource companies can appreciate while United States dollar-based commodity prices fall, especially when the rand is weak. However, they generally need rising dollar commodity prices to make money on a sustained basis.
It is important to note that the prices of different commodities can move differently within the overall commodity cycle. If you have a clear understanding of the cycle as a whole, but do not have the time to follow individual commodities in detail, rather stick to diversified companies, such as BHP Billiton and Anglo.
- You can either pre-empt the upturn in the commodity cycle and buy early or you can wait until the upturn is clear and then invest, as there is usually still quite a lot of momentum left in share prices once commodity prices have turned.
2. The rand
- Commodity companies tend to export their wares, and therefore prefer either a stable or weaker rand. However, they can make money when the rand is strong, especially if it is accompanied by strong commodity prices.
A good example of this occurred between April 2003 and July 2004 when Anglo's share price improved by 50 percent despite the rand being 12 percent stronger. The key factor was that commodity prices, as measured by the Commodity Research Bureau (CRB) index rose by 18 percent in US dollar terms. The CRB ( www.crbtrader.com) is a leading provider of information about commodity markets.
- The combination of these first two factors - movements in the dollar commodity prices and the rand - is the most important consideration when buying commodity shares. Your investment premise is very weak if you buy resource shares purely on a view that the rand is going to weaken.
- You need to establish to what extent the rand is important to the company you are considering, as many resource companies, such as Anglo and BHP Billiton, produce their goods all over the world.
Bear in mind, however, that the currencies of the countries that dominate the production of commodities often move in similar cycles. Thus, although you may think you are immune to rand strength if you avoid Anglo and buy Billiton, which has a larger exposure to the Australian dollar, you may find that the Australian dollar mimics the strength of the rand from time to time.
3. Supply and demand
Your next level of analysis is to monitor the global stockpiles of the commodities that a resource company is producing, as well as any plans by the major players to expand their output and put more of their products on the market.
This affects global supply and, ultimately, prices. Demand is essentially determined by the global economic cycle, and, in particular, by developing economies, which tend to need commodities such as steel for construction and improving infrastructure. China is a good example of a developing economy that has fuelled demand for resources.
4. Costs
On a more stock-specific level, you need to look at how well a company is containing its production costs, as this is one of the few factors over which resource companies have some influence. Runaway costs are generally not a good sign.
5. Valuation methods
Be wary of slavishly applying conventional valuation methods, such as the price earnings (p:e) ratio, when deciding whether or not to buy a resource share.
In some cases, a share's p:e ratio can be at its highest because the company has just reported its lowest level of profits for the cycle, making the share appear unattractive. These poor profits can be followed by a strong recovery in profits, which can justify the apparently high p:e number, even if the share price rises.
For example, at the beginning of 2000, Anglo's p:e was 19, making the share appear expensive. Two years later, both profits and the share price had doubled, and the p:e ratio went to 21.