Q. How do you make a small fortune in commodities?
A. Start with a large fortune.
If you've been investing for a while, chances are you've happened upon that maxim, or a variation of it. I first heard it on the trading floor of the Chicago Mercantile Exchange, where I was a cub reporter covering the commodity markets for The Wall Street Journal in the late 1970s.
Not a lot has changed since then. Commodities -- and the companies that dig them up or process them -- are still sensitive to boom-and-bust cycles.
A retailer like Wal-Mart (NYSE: WMT) or a consumer products vendor such as Starbucks (Nasdaq: SBUX) might be able to deliver relatively consistent growth year after year. But raw materials like copper, coal and platinum are different -- they are susceptible to the types of peaks and valleys you see in the chart below.
This cyclicality doesn't mean there is no place for commodity stocks in even the most conservative portfolios. Investors of all stripes are profiting from commodities today -- sometimes in dramatic fashion, as you'll see below.
Here's how we explained the phenomenon in the pages of Scarcity & Real Wealth a little over a year ago:
It's pretty simple, really. Whenever a commodity price starts to soar, more people are anxious to dig it up. New miners enter the game, while existing ones pour cash into expansion projects to ramp up their output. Before long, everybody and their cousin are bringing in new supplies and glutting the market.
When that happens, prices inevitably begin to fall. When they get low enough, financial incentive disappears and producers decide it's no longer worth it. Mines begin to close. New projects are delayed or canceled. In time, the supply surplus thins and turns into a deficit -- causing prices to reverse course and move higher.
And if that's the case, reasons Scarcity & Real Wealth Chief Strategist Dave Forest, the argument can be made that investing in commodities can actually be less risky -- when it's done right.
"The industry has a reputation for risk precisely because history tells us that what has gone up will go down," Dave says. "But this also implies that what has gone down will eventually go up."
And therein lies the opportunity. "Buying commodities that are down comes with much reduced risk of further losses -- and increased likelihood of profit," says Dave.
Remember Ivanplats (OTC: IVPAF)? That's the down-and-out junior exploration company Dave recommended to readers of his Junior Resource Advisor newsletter on Aug. 19.
When I wrote about Dave's recommendation four days later in the Aug. 23 issue of StreetAuthority Insider, Ivanplats had already posted a 25.8% gain. This past week Ivanplats had tacked on another 19 percentage points, making for an incredible gain of 45% -- in less than three weeks.
In the current issue of Scarcity & Real Wealth, Dave identifies several "defensive" commodity sectors where he'll be looking for similar opportunities over the next few months.
Chief among them: precious metals. In gold, for example, the metal price fell about 35% between October 2012 and July 2013. But equities -- as measured by the PHLX Gold/Silver Sector index (Nasdaq: XAU) -- plummeted nearly 60% during the same period.
If timing is everything, this is an opportune time to join Dave and the Scarcity & Real Wealth readership.
Why? Since taking over the advisory two months ago, Dave has undertaken a comprehensive review of the Scarcity & Real Wealth portfolio, "injecting new eyes and new macro-views into the mix," as he puts it. Dave has sold those holdings that don't meet his objectives, and kept those that do.
By the time the October issue is published at the end of this month, Dave and his readers will be starting anew with a revitalized portfolio consisting of the most promising natural resource companies money can buy.
In the meantime, here's more from Dave...
Bob: Are precious metals and uranium the only sectors on which you'll be focusing the next few months?
Dave: I'm continuously analyzing all sectors in the commodities space. In the end, I'm pretty agnostic about what I invest in. Too many commodities investors fall in love with a certain sector -- and focus on it to their detriment.
The thing is, you have a better chance of finding those kinds of value propositions when investors have a reason to hate a company or a sector. This is where the macro-picture comes into play for me. All segments of the resource business eventually swing from boom to bust, from love to hate for investors. Fund manager Don Coxe famously said that the best opportunities come in sectors where those who know it best love it least because they've been hurt the most. And right now those who know the gold business well are exceptionally bearish on the sector -- worried about lower metals prices and high costs.
When I see that kind of aversion, it signals to me that good buys are more likely to be had here. This happens all the time in cyclical businesses. When the sector is rising, investors make a lot of money. Others join in, trying to duplicate the performance -- except they end up buying at the top of the cycle. When it turns down, they go into fear mode and sell irrationally, driving stocks lower than their intrinsic value. That's time you want to be buying.
Bob: In the most recent issue of Scarcity & Real Wealth, you recommended a gold mining stock that you referred to as your "hands-down favorite." Out of fairness to current subscribers I don't want you to name the stock, but please describe one of the key characteristics that you look for in gold stocks in general.
Dave: The gold producer you mention today represents one of the best value propositions I've seen in years in this space. It's one of the most financially stable firms in the industry, both by virtue of strong cash flows and having a substantial cash reserve in excess of $1 billion (the market capitalization is only $6 billion).
And yet, investors hate the stock. Management made a big project acquisition in Africa, which has underperformed. The company had one of its main development projects basically repossessed by the government of Ecuador. And they've been forced to cut their dividend completely. These are all good reasons for investors to cringe.
But the result is that today, the company is selling at just over four times its yearly cash flow. That's an incredibly low multiple. Yet many investors will tell you they won't touch the company because of the reasons above. But none of those factors substantially affect the company's income stream. What's more, this company is actually one of the few gold producers that makes enough cash to cover its capital expenditure needs. Most other producers are actually losing money after capital. So you get one of the most financially stable gold companies in the business, at one of the lowest valuations on the market. I like that combination a lot.