Just a few months ago, Jeremy Grantham was crying over spilled milk. Now he's pouring himself another glass.
Best known for catching the peak of the 1980s Japan mania, and for accurately calling a decade-long slide in U.S. stocks in 2000, the market maven had, by his own admission, completely missed the bubble in minerals. Worse, the chief investment strategist of GMO in Boston had in 2011 predicted a 10-year positive outlook for mining resources, which, as he conceded five years later, was a "major error."
That was in May. Now, Grantham is taking another shot at commodities, albeit a more modest one. In a recent report co-written with GMO partner Lucas White, the 77-year-old has argued that for all the short-term volatility in their share prices, the companies engaged in harvesting natural resources are "remarkably safe investments," and have rewarded patient investors in the past. They also provide a hedge against inflation, so considering their depressed valuations, buying them makes sense.
How strong is Grantham's investment case? He's certainly not trying to catch a falling knife. A market capitalization-weighted index of the world's top 88 publicly traded energy, materials, resources, and food producers has staged a fairly convincing recovery this year.
It's also true that analysts' forecasts of depressed commodity prices may be just as wrong as their past prediction of broadly stable oil, corn and copper. Though the same logic might also apply to Grantham's own conviction that "the prices of many commodities will rise in the decades to come due to growing demand and the finite supply of cheap resources." Starting with British economist Thomas Malthus's dire prognosis of population growth outpacing food production, forecasts based on scarcity have had a habit of being proved wrong.
Grantham is certainly right to contend that commodity futures are a poor way to profit from rising spot prices. The "roll" cost of getting out of an expiring contract and into a more expensive new one can easily wipe out returns.
Still, the real reason equity in resources companies may be a superior investment to the commodities themselves isn't so much absence of risk, as a surfeit of it.
However much the price of a commodity falls, it will always be worth something. But equity in commodity producers frequently ends up worthless or next to worthless, as investors in coal miners Peabody Energy and Arch Coal have discovered. That's because a company's fixed costs and debt make it a leveraged bet on the underlying commodity it sells. When prices slump it will suffer outsized losses, up to and including bankruptcy -- but when they recover, the gains will be equally disproportionate.
Take Canada's Teck Resources, which was looking like a near-certain casualty of the commodities bust just nine months ago. Bloomberg's proprietary model rated its one-year default risk as high as 2.3 percent in January, and both Standard & Poor's and Fitch downgraded its debt to junk. The stock plunged to less than 16 percent of book value, as strong a signal as you could expect that the market was fearing bankruptcy.
Bold investors who rushed in have been handsomely rewarded for their bravery. Thanks to Teck's heavy exposure to zinc and coking coal -- the two best-performing major mined commodities this year -- the stock is up 343 percent since Dec. 31.
That pattern has played out across the sector this year. Have another look at that market cap-weighted index of big commodities companies, and compare it to the Bloomberg Commodity Index, which tracks the return on the underlying futures. While the futures index is up 15 percent since hitting rock bottom on Jan. 20, the equity index is up 32 percent:
Whether that makes resource companies safe investments, as Grantham argues, is debatable. While no major miners outside of coal have gone bankrupt, a position in the Bloomberg World Mining Index would still be underwater if taken out at almost any point in the last decade .
But every portfolio needs a bit of risk to balance out all that low-growth safety. And if it's risk you're after, commodities will happily oblige -- in markets both up and down.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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