How to invest in the commodities supercycle
Investment Trust Insider columnist David Stevenson explains how the resumption of economic growth after last year’s pandemic shock and the challenge of climate change have caused demand for mined resources to soar in the past nine months.
To put it simply, they’re not making any more of some of the basic materials we use in our daily lives, such as construction sand, creating profitable opportunities for suppliers in these important niches.
In addition, regulation and the drive to make companies operate in environmentally, socially and governmentally sound ways, is making investors picky about where they invest, pushing some companies to premium valuations if they prove their ESG credentials.
Lastly, he picks one investment trust and – as an alternative – one exchange-traded fund if you are interested in investing in this area.
Many investors assume that a period of reflation and rising inflation is automatically positive for resource stocks and pure-play spot commodity prices. While this is certainly not wrong, it is an oversimplification.
Without wanting to sound boring and academic, I prefer to think that the forces driving commodity prices and thus resource stock valuations are a little more complicated and dare I say, multi-variate?
Having uttered that dread term let me map out my explanation as to how to think about the resources spectrum which takes in everything from agricultural commodities through energy stocks to mining equities.
On the demand side there is a simple cyclical reality. As the economy grows, aggregate demand increases and that in turn sucks in more resources to feed production.
That said we need to be aware that we are midway through a little noticed dematerialisation process where we are consuming much less in terms of commodities and expending more money on services. For a great explanation of this dematerialisation trend read Andrew McAfee’s wonderful book More from Less.
Anyway, dematerialisation aside, we can safely say that demand is cyclical and that in the depths of a recession demand for materials falls. But my point about dematerialisation also hints at another driver of demand – let’s call this tailwind megatrends.
These are long-term drivers which move almost independently of the broader economic cycle. The simplest one to explain is the rise of the zero-carbon economy and the shift to decarbonise, prompting massive investment in wind turbine blades and speciality chemicals that go into batteries.
These megatrends, usually focused on specialist metals, though not exclusively, are hugely important and arguably growing in importance as we shift to a service-led, technology enabled economy.
The last driver of demand is financialisation. This is another piece of jargon which simply argues that as investors become more interested in resources they start to turn individual commodities into objects of investment value.
Again, an easy-to-understand example of this is gold. We have been financialising gold for centuries, as a hedge against inflation and government confiscation but in the last few decades that interest has grown exponentially. Every time the markets shake with worry about hyperinflation, you can feel the gold bugs emerging from their burrows.
On the supply side we have a smaller number of factors. The first is what I call the abundance paradox. Cynics will remember the idea that we would soon encounter peak oil supply. It didn’t happen and that’s because if demand drives up the price of a commodity high enough, then amazingly the market finds a way of satisfying that demand at the lowest marginal cost.
Mothballed oil wells are restarted and abundant profit margins serve as a way of driving up supply, eg North American unconventional shale gas and oil.
But the constraint argument against abundance is not without some merit. Take sand. The excellent Sunday Briefing intelligence publication – aimed at chief executives – ran a cracking story this month reminding its readers that there is a growing shortage of the right kind of sand for construction.
It quotes one statistic that up to 50 billion tonnes of sand is used every year but not a lot of it is being created. This can cause what economist call in-elasticities in supply which can push up prices for long periods of time, lasting many years. All of which perhaps helps to explain why fracking oil services and sand specialist US Silica Holdings has seen its share price rise by over 1,000% in the past year.
Arguably we are, at a global level, in one of those supply crunch episodes where big miners with the right resources in the right places have under invested for many years and can’t simply flick a button and increase supplies.
I will finish my overview with a last set of factors – call them overlays which sit beyond supply and demand. I would break them into two categories.
The first is global regulation and the simplest example is the push to decarbonise which will have an inevitable long-term impact on oil equities. On a side note, it’s also why I would be long carbon emissions trading trackers.
But there’s also a governance and political dimension. More and more investors now insist on ESG (environmental, social and governance) standards which is reshaping the global supply and demand picture – think of a more modern version of the row over blood diamonds. But this also edges into another reality – national governance.
You may have the most wonderful mine with all the right ESG standards but if it’s in the wrong country where governance is weak, investors will be wary to say the least. One reason why Chilean mining stocks tend to be popular is that they are based in a country which investors trust. The flipside of this is that some countries decide to gang up and try and control supply such as through Opec, the oil producers’ cartel.
So, if we step back from this confusing array of factors one can begin to see why investing in commodities is complicated and a tad more complicated than more inflation equals higher commodity prices. And I have not even bothered to mention unpredictable events such as extreme weather or boring old management execution risk. You might have the best supply of the right sand in the world but if the management muck it up, you’ll lose money.
My point for labouring all of these drivers is that my sense is that you need a smart active fund manager to be able to navigate this spectrum of resource stocks. One year’s favourite metal can be another year’s most hated.
In this global reflation cycle I think a focus on metals and mining makes most sense. I accept that energy stocks are cheap, but I think there are some significant headwinds in this space which makes a full-throttle bull case much trickier over anything except the short term.
Within mining I would also want to be long the speciality mining stocks where the megatrends are obviously at work. In addition, I would want to be mindful of the financialisation argument and be long the large, low-cost precious metals miners who can make money as investors worry about inflation.
One coda to that last point is that I’d actually want to be most bullish about established mid-cap precious metals miners who have spent a fortune building viable mines and are now watching cashflows increase. My last observation is that I would want to be invested more in resource equities, where you can evidence real earnings cashflows and take advantage of real dividends rather than purer play commodity funds.
So, which funds to invest in? Three stand out for me. The first is probably the most obvious and certainly the most established, namely the BlackRock World Mining (BRWM) investment trust managed by Evy Hambro and Olivia Markham (pictured).
This has already experienced explosive returns over the last year. In the 12 months through to mid-March this popular fund was up over 100% in share price terms and 77% in net asset value. Analysts at Winterflood report that the investment trust is already up 31.8% this year, but still yields 3.4%. It’s also trading at around par, or net asset value, against a longer-term average discount which is usually closer to 10%. The overall cost of ownership is around 1%.
The trust’s biggest holdings include all the usual large-cap diversified miners: Vale, BHP, Anglo American, Rio Tinto, Freeport McMoran, Newmont and Glencore collectively account for nearly half the value of the fund.
In terms of commodities, exposure to gold stocks is running at around a quarter of the value of the portfolio, against copper at 19%, but in truth the biggest lump is with those large, diversified equities.
In annual results this month the trust’s chairman David Cheyne reiterated how the team took ESG extremely seriously and were pressing companies in the portfolio about their preparations for net zero carbon emissions to address climate change.
I think the trust is a great long-term bet, but I’d also be a tad cautious about timing an investment at this exact moment after its re-rating. So despite my point about the advantage of active fund managers, I offer up an excellent passive alternative.
If like me, you think the opportunity is in large to mid-cap metals miners then why not look at an index-tracking exchange-traded fund (ETF) which has largely been running under the radar here in the UK from VanEck.
It is called the VanEck Vectors Global Mining ETF (GDIG), with current assets under management of $87m. The total expense ratio is a lowly 0.50% and over the last year to date, the share price is up 63%.
This isn’t that far off NAV returns from the BlackRock World Mining trust, but there’s no concerns about the share price falling to discounts or premiums in the future. Also, the same gaggle of large cap diversified miners in the BlackRock fund are present in the ETF. This grouping represents around 43% of the total value of the fund versus BlackRock’s circa 50% exposure.
So, in the ETF you get materially similar economic exposure at lower cost but without the active management you do at BlackRock of moving back and forth between precious metals and metals miners.
