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All That Glitters: How to Trade Resource Stocks

Commodities markets have become increasingly popular with investors in recent years as they have embarked on what many believe to be just the start of a secular bull market – or super-cycle.

Quarry site
Stephen Mallon | The Image Bank | Getty Images
Quarry site

However, investors wishing to tap into commodities must still decide whether to hold underlying assets or invest in commodity-related stocks, for exampleminingor oil companies.

Investors may prefer to invest in resources stocks because they pay dividends, unlike commodities themselves which do not and also incur storage charges.

Better data exists for equities, providing a greater number of systematic buy and sell triggers.

Commodities only allow for price-momentum related factors, along with supply-demand fundamentals in the underlying physical space, for buy and sell triggers.

These data are often infrequently and inconsistently available.

Equities are easier to hedge and are usually levered to the underlying assets, meaning potentially better performance, albeit with higher volatility.

But equities are also likely to be influenced by broader equity market moves, and the correlation between the stocks and the underlying commodities break down for short periods.

Investors that judge equity investment to be the more appropriate route will find London offers access to an unparalleled range of large cap resources companies, with the London Stock Exchange giving them access to major institutional investors.

However, it is not as popular as Canada or Australia for listing smaller commodities stocks, due to the costs associated with setting up and maintaining a London operation.

“As the global debt overhangs, manifested by negative real interest rates around the world forces, investors try to protect their capital by looking for hard asset investments,” said Irakli Menabde, fund manager of M2 Capital Partners’ Precious Metals Fund. “Natural resources, particularly precious metals, are the ultimate form of risk mitigation in light of sovereign debt defaults and currency debasement policies.”

It is always risky to deploy capital without appropriate research in any sector, but the volatility associated with commodities makes the danger especially acute.

In the last 10 years, the volatility of the returns from most commodities, commodity indices and resource equity indices have been around 30 percent on average, according to Investec.

Some commodities, such as zinc, have been even more volatile, though others, like gold, have been more stable. Some investors find this volatility hard to live with.

“Selling out too soon is a mistake that many of the seasoned fund managers have made, particularly in gold, at the very early stages of this bull market,” said Menabde.

Amateur investors or late entrants into the market are often particularly likely to exit a trade at the first sign of trouble.

That can be exploited by the professional investors, so it is vital that investors have the courage of their convictions. Having a pre-determined investment horizon can be invaluable.

Active management is the key to maximizing the returns derived from a portfolio of commodities stocks, although this can be a risky strategy for amateur investors without significant resources devoted to investment research.

“Taking short positions in commodities or resource equities that are expected to fall in price can protect a portfolio from significant negative movements, thus reducing volatility and smoothing returns,” said Bradley George, head of commodities and resources at Investec Asset Management.

The rewards – and, if executed badly, costs – of active management are even greater in periods of such macro-economic upheaval.

“Continuing uncertainty about the strength of the economic recovery, with differences between growth in OECD markets and growth in emerging markets, make it difficult to accurately predict demand for many commodities,” explained George.

“Today’s markets are more driven by government announcements than by free markets,” said Menabde, making it “an extremely fragile period in commodities and resource-related equities in the short term.” However, it is also a period of considerable opportunity.

“As the officials try to delay the inevitable market readjustment, there is no telling what sort of news flow we can expect from the politicians that try to paper over the cracks of a collapsing monetary system, instead of letting free markets dictate the prices,” Menabde added.

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