If investing in commodities involves taking a bet against human ingenuity, then buying natural resource equities is hedging that bet by going long productivity gains at the same time.
That’s because, unlike building exposure to raw commodities, if you buy the shares you get that exposure while also capturing improvements that producing companies make in their reserves, their processes and their overall gains in efficiency.
There is no getting around it: the move by large investors into commodities over the past 10 to 15 years has not been what they hoped. Attracted by a track record of lower volatility and low correlation with equities, investors have been stung as their own presence in commodities markets cranked up both effects.
In other words, once big investors got into commodities, those assets started to behave like the rest of the financial markets, a point borne out by research from the Bank for International Settlements. (www.bis.org/publ/work420.pdf)
As well, that old bugbear human ingenuity has been driving down the price of energy due to advances like fracking and the discovery of new reserves.
The S&P Natural Resources index, although up 15 percent over one year, has recorded annualized losses of 5.85 percent over five and 1.34 percent over 10 years.
It says something about the beaten down and despised nature of natural resource stock investing that Jeremy Grantham and Lucas White of value investors GMO titled a note advocating them “An Investment Only a Mother Could Love.”
Ugly they may be, but resource stocks are reasonably priced by many metrics and offer diversification and inflation protection (a trait which will look particularly attractive if inflation ever returns and bonds and stocks are hit).
“Here’s an investment that delivers equity-like returns with low to negative correlations with the broad equity market over long periods of time,” Grantham and White write.
“Hedge fund investors generally accept lower-than-equity returns in order to gain access to uncorrelated returns, so getting equity returns with low to negative correlations should be very exciting. In fact, it’s not obvious that you need to know anything else in order to get excited about investing in commodity producers.”
GMO notes that not only have energy and metals stocks outperformed the rest of the U.S. stock markets over the past 46 years, but a combined portfolio of half resources/half the rest outperforms with markedly lower volatility.
The devil of deflation
Commodity stocks have dramatically outperformed their products over the long term. While oil has risen just 0.5 percent annually in real terms since 1925, oil and gas company shares have gone up more than 8 percent a year, adjusted for inflation. In industrial metals the pattern is the same over the same time horizon. Copper is up 0.2 percent annually, in real terms, and aluminum is down 1.7 percent, but industrial metals have returns of 8.6 percent.
That not just because of gains in efficiency but more broadly because the market offers a considerable equity risk premium for those who hold natural resource shares. Investors are shy of natural resource shares, which, as we’ve seen recently, can see huge volatility in the prices of their products, as well as being levered to economic cycles. That’s kept a lid on valuations and driven up the equity risk premium.
Buying into natural resources at a time of very low inflation and, in large parts of the global economy, the threat of deflation, is not an easy thing to do. As well, there are concerns, well reflected in current prices, that future economic growth will be tepid, especially in places like China which have been huge consumers of raw materials the past 20 years.
The flip side of this fear is that natural resources stocks do offer some inflation protection.
Resource equities have not only protected against inflation historically, but have actually significantly increased purchasing power in most inflationary periods. During the last eight episodes of U.S. inflation over 5 percent, natural resource shares have returned more than 6 percent a year while the S&P 500 lagged inflation, thus destroying purchasing power, by 1.6 percent.
Remember too that, for good or ill, this time will be different. We’ve never emerged from an episode of low inflation like this, one which came along with massive central bank asset buying and the resulting inflation of valuations of financial assets.
Not only would bonds be hammered by inflation, as they always are, but the broad stock market may underperform its past results during inflation, as equities feel sharply the removal of central bank support.
A bit of diversification into an ugly, unloved sector may well pay off.
James Saft is a Reuters columnist.