Here at Materials Risk we try not to over-complicate things. It’s very easy to construct a credible thesis about the direction of a particular commodity market and then go headlong into buying one company after another. Before you know it, your portfolio is bursting at the seams with companies that you are no longer able to manage effectively.
There are 5 factors that I advise investors to be mindful of if they want to be a successful commodity investor: time preference, be conscious of inter-dependencies, concentration, develop an exit clause and know your edge. In short, be clear on what you are betting on and find the best way to express that view.
I believe that understanding the time-period that you are investing in is crucial to success with any investment, but especially commodities.
Investing in commodities can be a grinding experience. Waiting patiently, for years at a time for the bottom in the market to form and other investors to come around to your bullish view. All too often, such an experience means that investors then snatch at quick returns without considering the bigger picture.
It’s also important to learn the lessons from history. The adage ‘the cure for high prices, is high prices’ holds true today. Some commodity markets are more prone to short, sharp, violent upswings followed by a quick return to Earth. For some commodities (and the companies exposed to them) therefore it may be a case of investing for less than a year, while for others it can pay to stay invested for several years.
Many investors look to diversify into commodities without thinking about their relationship with other components of their portfolio.
For example, if a portfolio includes a large exposure to emerging market equities then the investor could be multiplying their exposure without even realising it. This could involve being invested in equity funds with a high exposure to major commodity producing nations such as South Africa or Brazil. It could even occur through a general exposure to emerging markets; movements in the US dollar and emerging market currencies / commodities tend to be inversely correlated.
Interdependencies also arise on a sector or even company specific level. For example, airline shares and oil companies are linked through the price of jet fuel. Meanwhile, the share price of food manufacturers can be affected by the price of key agricultural production inputs. They may move in the opposite direction most of the time, but not always. An investor, thinking they have diversified their commodity price direction exposure, may be in for a surprise if they haven’t considered the degree to which two investments are related.
It can be very tempting to park some of your hard-earned cash into the next attractive company that comes across your radar promising fantastic returns. Before you know it, your portfolio is a mismatch of companies more numerous to count, let alone manage. While you may reassure yourself at night that spreading your chips thinly across many companies counts as diversification, the reality is that you may be doing your portfolio a disservice.
“Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.” – Charlie Munger, Berkshire Hathaway
Knowing when to reduce your exposure to a particular company or commodity market is a very difficult skill for any investor to master. In truth it isn’t possible to do it perfectly. In the same way that it is pointless and impossible to try and time your entry to a market at the bottom, the same challenges present themselves at the top. The major returns will always be in the middle.
Having a plan – before you invest – is crucial. The plan may change, and that’s fine but it’s important to be clear on your intentions. Revisit the plan, understand the markers in the sand and decide on whether you should increase, or decrease your exposure. This is why not investing in too many different companies is so important.
What edge do you bring? For many commodity investors that may be by developing a detailed knowledge of all the companies exposed to a particular commodity market. In the same way that a professional commodity focused fund tends to focus on precious metals, or oil or cocoa you as an investor will develop a knowledge edge that others in the market have neither the time, nor the patience to develop.
Another type of edge relates to time outlook. Professional investors tend to be focused on short time period – the next week, or at most the next quarter. Being able to focus on a longer time period is also a source of edge. There is less competition.
Whatever your aspirations from commodity markets and your source of edge its important to be clear on what it is, and crucially remain true to it. That means not being drawn into the perspectives of other investors with a different edge or time output.
If you would like to discuss your portfolio in more detail, and how commodities fit then please get in touch.