Investors can benefit from this long-term growth story through investing in companies that benefit from the trend. By investing in the right commodities companies, investors can get direct exposure and stand to gain attractive returns.
As the price of their product rises with inflation, these stocks also have the advantage of being natural inflation hedges. Investors often choose between accessing commodities through equities or direct investments, for example via futures.
Commodities equities offer several advantages over direct exposure. Foremost is that they allow investors to avoid the negative roll yield or the cost associated with rolling futures positions into the next available month upon expiry.
Over time, this cost can cause a serious disconnect between actual returns and expected returns based on the spot or headline price.
The clearest example of this phenomenon is the natural gas market, where the spot price of gas rose more than 50 per cent between end July 2009 and year-end 2009.
Over the same period, one futures-based investment fund, United States Natural Gas, lost more than 20 per cent due to negative roll yield arising from the steep upward slope at the front-end of the natural gas futures curve.
Performance of fund vs sector over 5-months
Source: Financial Express Analytics
In contrast, investors could have benefited from investing in a company that is highly leveraged to the gas price, such as ATP Oil & Gas, which rose by more the 130 per cent over the same period.
Secondly, if selected carefully, commodities equities can be more valuable than the commodity itself. For example, relative to physical gold, investing in gold equities brings with it a range of risks relating to financing, execution and socio/political factors.
While at first this may appear more risky than simply holding a physical asset, many of these risks can be mitigated through adequate research or appropriate position-sizing within an investor’s portfolio.
Investors then have the potential to hold something that offers very similar risks to physical gold, but with a much higher expected return.
The nature of the commodities equities market is such that there is the opportunity to buy a company that may have a market capitalisation of less than $50m today, but could be worth $500m or more in less than three years’ time.
Investors can get access to broad growth stories such as iron ore and highly attractive niche markets such as palm oil, specialty metals (for example scandium/molybdenum) and tea.
Mining companies can often be a popular investment, but in an inflationary environment a producer will naturally have to deal with rising input costs, which can compress margins. However, these can be dealt with via hedging and effective mine management.
For example, the company may choose to temporarily mine a higher-grade zone in order to drop overall operating costs. It is important, however, that investors see the market as more than just miners and drillers.
The universe spans the full spectrum of industries that benefit from commodities demand; they allow investment in companies that potentially hold the key to supplying ample clean water in emerging nations (metallic catalysts/processing technology), making jet engines more efficient (specialty metals) and ensuring growing countries are able to provide sufficient food for their population (fertiliser/seed technology).
Naturally, for companies that can provide solutions to these problems, the returns will be large.
Jason Webster is the fund manager of VAM Commodities Equities. The views expressed here are his own.