Commodities Make For Terrible Long-Term Investments

by FI Fighter on December 3, 2015

in Precious Metals

Screen Shot 2015-09-27 at 9.18.36 PM

Please note: Throughout this article, when I reference commodities, I am strictly referring to paper shares, NOT the physical form itself. For instance, physical precious metals (gold and silver) are a form of money and provide insurance in a portfolio (fear trade). Mining shares, on the other hand, are far more volatile and risky, but provide greater leverage (greed trade). It is important to segregate out the differences between paper shares and the physical commodity itself because they are NOT the same asset/investment!

As readers are well aware, lately, I’ve been heavily focused on buying up commodity stocks. In particular, I’m a big fan of gold and silver mining stocks right now.

I also love copper and uranium, but my own personal take is that the deflation for base metals and energy is only getting started… In other words, I think that we still have a lot farther to fall…

Why do I say that?

There’s simply too much inventory in circulation right now…

From Bull to Bear

Just think — When China was booming in the early 2000s, most everyone (especially those involved in natural resources) expected the good times to last for a lot longer than it did…

When demand is high, mining companies try and bring out every last resource available out of the woodwork to appease Wall Street. They can do this because in a roaring bull market environment, what previously looked uneconomical now looks pretty darn attractive!

And just like with real estate, banks are most willing to lend when asset prices are high (does that make sense to you?)! So, the miners can easily obtain the financing they need to ramp up projects in an upmarket.

But because it takes sooooooo long to bring a new resource into production, chances are that when the mine is FINALLY ready for prime time, market sentiment will have altered course yet again…

Copper, for example, rose from under $1.00/lb in 2000 to over $4.00/lb in 2011… And now we are barely over $2.00/lb!

From InvestmentMine:

Copper Prices

Going from $4.00/lb to $2.00/lb has enormous consequence to a company’s bottom line and a mine’s profitability.

And the reality of the mining world is simply this — You cannot increase supply or remove it from the markets at the flick of a light switch… Most investors and institutions probably don’t realize that it can take upwards of 5 to 10+ years to: explore, develop, permit, and construct a new mine before you can start operating it!

Let’s say a copper company, for example, was in the process of obtaining financing for a new copper mine back in 2011 when copper prices peaked at over $4.00/lb. Perhaps the economics on the feasibility study suggested that the mine was economical at $2.50/lb copper… By the time the mine was finished with construction in 2013, copper had begun its bear market descent. Fast forward to today and copper prices are trading at $2.00/lb and going lower by the week…

What looked so promising just a few years ago is now bleeding money on a daily basis! Of course, every company should use conservative numbers when they are running projections, but often times the market will dip even lower than anyone could have ever projected them to…

Predicting the future and Mr. Market’s future mood is tricky (impossible) business…

But once a mine is up and running, you can’t always shutdown production either. There are employees and salaries to pay! Many companies have streaming and royalty agreements in place that they can’t just walk away from… Ditto for the debt service. And for some companies, the new mine is the only revenue generator they have!

Often times, it’s even cheaper to continue mine production at a loss (for a period of time) as opposed to putting the entire operations on care and maintenance… because when you start laying people off, you have to account for all the severance packages that you will have to pay out…

It’s really just one big headache after another that many miners suffer through during brutal bear markets, like the one we are presently in right now.

And with each passing day, all that we hear from the media is how China’s growth is slowing down… which doesn’t help matters any.

So, you’ve got a glut of excess supply, but again, you can’t always just remove it instantaneously… which only causes the price of the commodity to continue to weaken, perpetuating the problem. The smart money obviously also knows this fact, so they of course bail… which only further smashes the share prices of the miners.

In turn, companies are forced into drastic actions to tighten their belts (reduce/eliminate exploration, terminate employees, sell off assets, etc.) in order to survive the harsh winter.

I don’t know if there is an exact rule of thumb, but my guess is that it typically takes a few years for the excess supply to be drained from the markets.

Which is why these share prices of mining companies stay depressed for so long and undershoot so far…

From Bear to Bull

On the bright side, though, the overshoot and price exaggeration on the rebound is also just as potent… Once the market finally consumes enough of the previously excess supply, or the market simply changes sentiment (for whatever the reason), eventually, demand will outstrip supply again.

As an investor/speculator, that’s when you start to get excited! Because what is to follow will indeed be spectacular!

Again, when times get rough, companies react and aggressively cut costs — This absolutely decimates exploration, which is the lifeblood of mining (a perpetually depleting business). What this means is that when a severe shortage develops in the future, there won’t be enough new mines readily available to put into immediate production to meet this newfound demand.

So prices start to creep up again…

Eventually, prices get high enough where we start the whole mania phase all over again…

History repeats itself… over and over again…

Commodities Boom and Bust Cycles (1976-2015):

150727CDDchart1

Freedom Fighter Point of View

As much as I find the entire world of mining ever so fascinating, point blank, I am a speculator who is in the interest of making a lot of money.

My allegiance is to financial freedom.

Period.

Commodities are wonderful, don’t get me wrong, but it is important never to lose sight of what the endgame is for any type of speculation.

Financial freedom.

And when it comes to commodities, knowing that they typically only boom and bust over and over again, I can find no reason to hold shares of mining companies for an indefinite period of time.

Rather, I simply want to exploit the insane volatility that this particular asset class just so happens to possess. What that means is ONLY buying at or close to a market bottom, and selling out COMPLETELY once the next bull market takes full flight.

Mining stocks (as a whole) have NEVER been and should NEVER be considered as a suitable Buy and Hold Forever investment.

They are far too volatile… and unreliable.

If you can accept that upfront, you will probably make a lot more money in this sector then someone with an opposing viewpoint.

I always get a kick when someone likes to point out how “gold mining stocks have underperformed the S&P 500 over X amount of years…

Again, you DON’T Buy and Hold gold mining stocks… If you do, no doubt, your returns will suck after X amount of years! 😉

Dividends Are No Exception

But what about commodity companies that pay a dividend? Frankly, I don’t see any difference… These stocks can be just as volatile, so I am not going to go out of my way to make an exception for them.

Just look at how two of the most popular commodity stocks (who pay dividends) have performed lately:

BHP Billiton:

BBL

Kinder Morgan:

KMI

In this article, we are primarily focused on discussing about mining stocks, but the same general analysis can likely be applied to the oil sector as well.

Please note: I don’t mean to pick on any companies, I am just using BBL and KMI as examples.

In fact, just earlier this year I picked up shares of KMI for the dividend…

But for the longest time, income investors defended BBL and KMI as being exceptions to the rule (BBL was an industry giant and KMI was a “toll booth” that was immune to oil price fluctuations).

As such, these companies were somehow believed to be superior and able to withstand the typical volatility that you’ll find in other commodity stocks.

Well, if we look at the year to date (YTD) charts, BBL is currently down 45% and KMI is off 54%. For income investors, most definitely, these stocks represent a MUCH BETTER buy at these lower prices and higher yields (granted the dividends aren’t cut… which is now what everyone is speculating, as is the nature of brutal bear markets).

Personally, when I am researching commodity stocks, I couldn’t care less about any dividends… As I have alluded to before in previous posts, I am drawn to mining stocks because the sector has been absolutely decimated…. So, I wouldn’t expect (or really even want) a company that I am investing my hard earned dollars into to have to struggle through the hoops of paying a periodic dividend… Rather, I would prefer a company shore up its balance sheet, fund exploration work (internal or prospect generators) for the inevitable upcycle rebound, or go out and aggressively look for acquisition targets.

In a down market, to me, that is a much more prudent use of capital.

This most recent downturn should be an affirmation that no commodity stock is ever safe in a bear market (dividends or no dividends)!

A lesson that I have learned myself is this — I will NEVER again purchase a commodity stock when shares are trading at historic norms, or at record highs… In fact, commodities as a whole will ONLY interest me when their respective shares are trading down 80%+ from their most recent highs (like right now).

That, and I would need to see historical lows in some form or fashion like the following chart:

HUI/Gold Ratio:

Screen Shot 2015-09-20 at 8.53.29 AM

With that said, if this ends up being the only commodities cycle I ever partake in, I’m perfectly OK with that! This sector is ABSOLUTELY RUTHLESS  You must have an iron stomach if you insist on playing!

If I can do well in just a SINGLE cycle, quite frankly, I’m not sure if I would have the incentive to play another round in the future…

When it comes down to it, I am a chicken, and I would much prefer buying your conventional Buy and Hold Forever investments!

Just being honest… 🙂

What to Expect?

Speculators who are buying mining stocks at the depths of a brutal bear market should be doing so with the expectations of hitting a home run (there are no guarantees, of course!)… If you can get the timing right (the hardest thing to do!), a basket of carefully selected (high quality) mining stocks should easily produce: 2x, 3x, 5x, and if you’re really lucky, 10x+ returns on the way back up…

When we are talking about total returns greater than 100%, 200%, 400%, and 900%+ (potentially), again, any dividends that might trickle along the way will look/become completely irrelevant! 🙂

Do these type of returns sound far-fetched to you?

They really shouldn’t… not in the world of mining stocks, particularly junior mining stocks

McEwen Mining:

McEwen_Stock

McEwen Mining (MUX) is an example of a junior mining stock that peaked around $9.58/share back in 2011 when gold was very fashionable. Today, the stock is trading at $0.92/share.

That’s a 90% decline! On a relatively “lower risk” mid-tier producer with an outstanding management team! We aren’t talking about some random junior exploration companies (with no proven mineral resources) who are down and out, but even the really high quality, proven producers are in deep pain…

That’s like taking:

Before: $1.00

After: $0.10

 

When a stock is down 90%, you need it to rise back up 10x, or 900% just to get back to break even!

With many of these mining stocks, it’s also arguable that even though shares have been obliterated, the companies are far superior to where they were 4-5 years ago when gold was thriving. Although the market won’t recognize that fact today, at some point it will…

 

And if you take the time to ask around, you’ll very quickly find that even the experts in the world of natural resources have already started to ramp up their buying… It’s no secret to anyone that prices are low and there are plenty of deals to be had…

Of course, I’m not suggesting that prices won’t go lower, and I have no way of knowing when we will reach full capitulation (rock bottom), but as I’ve said all along, the merchandise is cheap enough that I’ve been willing to back the truck up…

I have so much conviction that gold and silver (to a lesser degree copper and uranium) stocks are ridiculously undervalued, that outside of the USD, I have no other investment ideas at this time!

 

That means that every spare penny that I have is going into mining stocks…

 

Please note: As ALWAYS, I am NOT offering any investment advice or recommendations! I am only sharing with you what I am doing with my own capital. Please do your own due diligence and research before making ANY investment decisions.

 

Tread carefully!

 

And enjoy the ride back up (hopefully sooner rather than later)! 🙂

 

Fight On!

 

Photo Credit: First Mining Finance

{ 5 comments… read them below or add one }

1 HristoNo Gravatar December 3, 2015 at 10:08 pm

Hi FI Fighter,

Really very good summary and explanations about the market cycles, especially with the focus on the commodity sector.

What concerns me is that that sector is so much hated that we might not have seen the real bottom yet. Actually, as Rick Rule said – we might be far from it as we haven’t seen any real capitulation and mines being shut down yet. For example, McEwen is 95 cents right now that that is 90% down from 2011 peak. But I think we might have the share down to 65 cents as Mrs. Yellen is set to raise interest rates by ridiculous 25 basis points later this month. That increase might be calculated in the current prices but might not be. I don’t know. If the price go down to 65 cents that will be only 93% below the peak but it will be 30% paper loss for an investor that bought at current prices.

So, my attitude is that at least some portion of money should be hold in cash and wait if the market offer to average down the price.

Regards!

Reply

2 mikeNo Gravatar December 4, 2015 at 7:17 am

And if there is any deviation, lets say she postpones the hike like the fed always has done for the past 10 years. Or lets say she doesn’t raise it a quarter and only a tenth. Then you missed your boat Hristo. You are not a hedge fund manager, your not a savant. The best you can do is what Fifighter is doing and making an educated guess based on the macro enviornment. He knows fundamentally there is a price mismatch and he is preparing himself for price to readjust. Its very possible and realistic that he could be 1-5 years off and if thats the case he is sitting on dead money. In 5 years the hope is that his money will have made more money than had be stayed in stocks over those 5 years. Time will tell.

best

Reply

3 FI FighterNo Gravatar December 4, 2015 at 7:43 am

Mike,

Yes, absolutely it’s possible my timing is off and the this brutal bear market extends for another few years…

And like you said, we just have to make educated guesses… So when I see governments across the globe printing money like it’s going out of style, and our own Fed struggling to raise rates even 25 basis points, I know that a rebound in gold is inevitable…

The dollar cannot strengthen for perpetuity, and at some point it will strangle businesses… As if earnings this past quarter weren’t bad enough, what will export numbers look like when the DXY reaches 120? 150? 200? It’s not sustainable…

If we look outside domestic borders, gold is performing fabulously in many other countries (Brazil, South Africa, Russia, Japan… it’s even holding up decently in Canada and Australia)… The world extends beyond just the US, although it’s easy for citizens to lose sight of that, especially since commodities are traded in USD. And now there’s even more talk about further yuan devaluation…

The one constant throughout history? Gold. It always has been and probably always will be money. Unlike all fiat currencies, it’s the only asset with intrinsic value that cannot be debased.

Those are some of the reasons why I have no fear with this trade. I’m betting on money, not a tech start-up that may or may not gain mass adoption.

Gold will NOT become the next Blackberry!

Take care!

Reply

4 FI FighterNo Gravatar December 4, 2015 at 7:28 am

Hristo,

Yes, the sector could definitely head lower but it’s really anyone’s guess… Where we are now, irrespective of where prices will go, I think you’ll find a pretty clear cut consensus from ANYONE who knows the sector that these stocks are severely beaten up and undervalued right now.

Your comments are encouraging me to write a follow up post on my own strategy on how to play this downmarket…

In any case, a speculator should only enter into this space if they have full conviction that things will eventually turn around. Psychologically, for almost everyone, the scariest time to buy is when assets are at a nadir…

For myself, I don’t mind lower prices and I have learned to embrace them. I have no problem averaging down on 20%+ declines on each position I own as long as the fundamental story for the company hasn’t changed.

Lastly, with extremely volatile stocks such as these, a “safer” approach is to buy in tranches, a little at a time. I also like to DCA ONLY on down days so I don’t chase the market up (like this morning). I’ve been burned buying on rallies too many times…

Take care!

Reply

5 Jason @ Islands of InvestingNo Gravatar December 4, 2015 at 5:03 pm

Love the in-depth analysis here FI Fighter. While you might not want to buy and hold these sort of stocks forever, I think a company like BHP, with high quality, low cost assets, is about as close as you can get, and I can definitely see it being worth far more in 5, 10 or 20 years from now, regardless of what booms or busts happen in between.

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