Commodity stocks are among one of the easiest and widely adopted vehicles to park an investment into the commodities market without exposing the investment to the additional risk of the global events, which influence the commodities market and causes high volatility.
Why Invest in Commodity Stocks?
Commodity stocks give an indirect exposure to the real assets, and investors look for commodity stocks to earn risk-adjusted superior returns against the return from the direct exposure in the commodities.
An investment in the commodity market can be landed through two major approaches, namely direct and indirect investment approach. Direct exposure is defined as buying the physical commodity and store them with both a defer and a current consumption right.
Components of Direct Exposure
Many industrial players take a direct approach and buy the physical commodities to lock in the consumption rights at one point of time and defer the consumption amid price volatility. The direct approach is an effective way only if the physical consumption of a commodity is required.
However, only 20 to 30 per cent of the global commodity markets witness actual delivery of the commodity, and about 70 to 80 per cent of the volume in the commodity market comes from the indirect exposure.
Components of Indirect Exposure
Many investors take the route of indirect exposure to enclose the benefit of the demand and supply mismatch dynamics, which generally drive the medium- to long-term price movement of a commodity.
Market speculators also adopt indirect exposure to take advantage of the misinformed market over the short-run to gain superior returns.
An investment with an indirect exposure (no physical delivery) could be made by taking future and options of the commodities, buying the stock of the companies that deal in the commodity production and supply, or via commodity ETFs.
Commodity Future and Options
Investing in commodity futures and options provide an investor with an opportunity to take exposure in the commodity price movement indirectly. An investor can either go long or short these positions as per their estimated future projections.
However, investing in the future and options of commodities have some disadvantages like time period restrictions, high volatility, etc. The future and options both carry an expiration date, which makes them a short-period investment vehicle, and high roll-over cost is a major disadvantage.
To maintain a long-term exposure, which typically offset the high volatility risk, requires rolling-over of the current series to the series of a future expiration date, which partially offset the returns from the price gain.
Another disadvantage of commodity future and options is the leverage, all future and options provide high leverage to the investors, and commodity future and options are no different. Thus, high leverage magnifies the profit and loss of an investor.
Buying shares of the companies engaged in the production and supply of a commodity is an effective way to park an investment into the commodity segments, albeit, it brings additional equity-related risk to the investors.
Despite the additional risk, the perpetuity feature of equity allows the investors to avoid short-term volatility of the commodity market, and it does rectify the roll-over cost issue. Thus, many commodity investors prefer investing in the stock of a company engaged in the production and supply of a commodity.
Smart Ways of Investing in a Commodity Stock
- Select your commodity
Commodities are broadly classified into two major categories- One, which is mined (aka Hard Commodities) and second, which are grown (aka Soft Commodities). The hard commodities are further broadly classified as below:
Not all commodities move with the same underlying fundamentals, so knowing the segment, in which investor wants to park his/her investment is the first step.
- Dig Out for Fundamentals
The demand and supply dynamics constitute the major portion of the fundamentals in the commodity segment apart from the global economic scenario.
The demand and supply and the overall global economic conditions do not impact all commodities equally.
- Look for Negative Correlation
Gold tends to move up when economic conditions are not favourable, while base metals tend to move down in the same scenario. Thus, both segments exhibit a negative correlation.
Maintaining exposure to negatively correlated commodities, make investing in the commodity market less daunting, as it partially offset the loss coming from one commodity via profit from the other.
Post applying the smart ways into the commodity market, the investor should move towards selecting a commodity-related stock.
How to Select the Commodity Stock?
- Understand the type of resources a company holds
Despite having exposure to the same commodity, the stock prices of commodity miners show high variability amid the quality of the resources present across their respective tenements.
Mineral resources are broadly classified into- Inferred, Indicated, and Measured.
Inferred Mineral Resources
An Inferred Mineral Resource quantity and quality (in terms of grading) can be anticipated on the basis of geological evidence and limited sampling. The grades are reasonably assumed but not verified, and it is the lowest-ranked type of mineral resource.
The estimation of Inferred Mineral Resources are based on limited information and sampling gathered from locations such as outcrops, pits, drill holes, etc.
Indicated Mineral Resources
Indicated Mineral Resources quantity and quality (in terms of grade), shape, physical characteristics (such as density) can be estimated with a higher level of confidence as compared to the Inferred category.
The estimated level of confidence for the Indicated category is enough to support mine planning and evaluation of the economic viability of the deposit.
The Indicated Mineral Resources are ranked better than Inferred; however, lower than Measured category, and the estimation of Indicated Mineral Resources is based on detailed and reliable exploration and testing information collected from the outcrops, pits, drill holes close enough for geological and grade continuity to be reasonably assumed.
Measured Mineral Resources
Measured Mineral Resources are the top-ranked mineral category and the quantity and quality (in terms of grade), shape, and physical characteristics (such as density) can be estimated with the highest level of confidence.
The estimation of Measured Mineral Resources are based on limited information, and sampling gathered from locations such as outcrops, pits, drill holes that are close enough to confirm the geological and grade continuity.
Once the mineral and ore profile of the company is clear, the investors can apply the equity-related valuation methods to identify the intrinsic value to take advantage of any mismatch between the true value and the market value.
In many jurisdictions such as Australia, United States, etc., the government organisation sets the guidelines to classify the minerals into the sub-categories. In Australia, the Joint Ore Reserve Committee has designed code (JORC 2012) to subdivide the Mineral Resources into categories.
Getting acquainted with such codes and understanding the grade of minerals a company holds is among the key aspect of the commodity stocks investing.
- Check equity-related factors
Post knowing the quality and quantity of grades a company holds, investors should look for equity-related factors such as the management structure, profitability, ESG, etc.
- Avoid higher reliance on the cash flows
Cash flow analysis comprises a substantial part of the analysis of conventional assets such as equities, fixed income, etc., and commodity stocks are no different from conventional assets.
However, the type of business, a commodity producer does, requires higher cash outflows with a large gestation period, as the commodity miners or explorers put cash in undeveloped land for the mineral rights, and the commodity prices are not always supportive.
At times, the lower commodity prices also make miner and explorers defer the production, which generally leads to lower cash inflow from the operations.
- Check for Feasibility Studies
Feasibility studies are generally published by miners over their commodities prospect, and the studies include various substantial information such as life-of-mine, estimated capital expenditure, future cash flow, the estimated average price of the underlying commodity, net present value, internal rate of return, etc.
Understanding the basis of the feasibility studies constitute a significant chunk of smart investing in the mining sector.
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