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Are commodity stocks poised for a rebound?

Like a lot of investors, Ben Willis spent much of the last two years closely watching the dramatic drop in commodity prices. Since April 2011 the MSCI Commodity Producers Index, which tracks a number of global commodity companies, fell 22 percent, while metals such as copper, aluminum and plummeted by more than 30 percent.

While many people have dumped their materials stocks during the free fall, this Bristol-based investment manager was waiting for the right moment to jump in. "I had to see a catalyst that would turn these stocks around," said Willis, head of research at Whitechurch Securities Ltd.

That moment came late last year when it became clear that China's gross domestic product growth—the country is a major commodity user—wasn't stalling, as many people feared, and may in fact be expanding. In a few weeks he went from having zero exposure to commodity stocks to a 10 percent allocation.

Although Willis may be buying, a lot of other investors are still worried that commodity prices will continue to fall. In 2013 nearly $50 billion flowed out of global commodity funds, a major reversal from the $20 billion that went into these funds a year earlier.

This is the type of sector that contrarian investors love, said James Sutton, a portfolio manager at JPMorgan. "It's contrarian because it's been so hated," he said, and that can be a good thing.

Stocks are much cheaper than they were before the recession, and if you believe that this sector will rebound, as both Willis and Sutton do, the gains could be huge.

In a high-flying market where most sectors have risen in value, commodity investments could be one of the best—and only—contrarian plays of 2014.

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Chris Ratcliffe | Bloomberg | Getty Images

So long, supercycle
There's a good reason why many investors are more bearish on commodities: Days of massive year-over-year price increases are over.

For most of the last decade, everything from oil and gas to copper and zinc were on an upswing, and the MSCI Commodity Producers Index climbed by a whopping 247 percent between May 1999 and May 2008.

It's unlikely we'll see gains like that for a while, said Sutton.

The commodity supercycle was due, in large part, to considerable Chinese growth. For much of the 2000s, its GDP grew by double digits, and near constant infrastructure projects kept demand for commodities high.

"The cycle was really driven by China's industrialization," said Sutton. "Now that commodity intensity has started to plateau and prices have pulled back."

To make matters worse, a lot of commodity companies overinvested during the boom times and operated on the assumption that prices would be high forever, said Willis.

"A lot of management teams wasted money on capital expenditures," he said. As a result, stocks have fallen along with commodity prices.

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A 2014 turnaround
Many contrarian investors, though, think the market has been too spooked by falling commodity prices and that the sector is poised for a rebound this year.

David Ford Jr., a New York–based managing partner at Gatemore Capital Management, doesn't concern himself with supercycles. He looks at the long-term picture, and from that view commodities look attractive.

The story is simple, he said. The global population is expanding and urbanizing. As emerging-market incomes rise, demand for Western-style living increases. There will be more cars on Chinese roads, more buildings being built, more goods being made, and doing that requires a host of commodities.

That story hasn't changed in years, but because emerging-market growth has slowed lately, people aren't as enamored by commodities, he said. That presents a buying opportunity.

"The mad rush to own commodities isn't there like it was in 2006 and 2007, and therefore it's an appropriate time to be building an allocation in this sector," Ford said.

Many commodity stocks are undervalued, added Willis. The price-to-earnings ratio on a number of these companies is around 10 times earnings, which is well below the 19 times earnings they were trading at before the recession and lower than the S&P 500's 15 times earnings.

"This is telling you that compared to the broader market, this area of the market is looking cheap," he said.

A number of commodities are also seeing supply and demand move back in balance, said Eric Marshall, a portfolio manager with Hodges Capital Management, who helps run the company's Hodges Pure Contrarian Fund.

That overinvestment has slowed, so in general, fewer commodities are being developed, and industry consolidation means fewer companies are mining.

"In a lot of cases, you had 20 different major players out there, but now there's five or six that control 70 percent of the market," said Marshall. "Then you end up with a more rational supply to meet demand and pricing improves."

The mad rush to own commodities isn't there like it was in 2006 and 2007, and therefore it's an appropriate time to be building an allocation in this sector.David Ford Jr.managing partner at Gatemore Capital Management

Investment options
There are two ways for contrarian investors to play this market: Buy the commodity or own a materials company.

Buying into the commodity spot price, either with an exchange-traded fund or a futures contract, could result in bigger gains, but Willis said it's a more volatile and more speculative way to invest.

He'd rather own a business because decisions can be based on company fundamentals. "You get information, they regularly release reports, and you can get feedback from executives," he said.

Companies can also pay dividends, where a commodity can't, said Sutton. He likes businesses with strong free cash flow yields that will either increase dividends or buy back shares.

Free cash flow yields had been in the single digits, but with companies spending more prudently and improving their balance sheets, he expects those yields to enter double-digit territory this year and next.

He also points to a Citigroup report that said free cash flow yields on large-cap diversified miners will see a 24 percent annual compound growth rate between now and 2020.

While 2014 could be kind to commodities, investors will need to be patient, said Marshall. He usually likes to see gains between 12 and 18 months after purchasing a stock, but since contrarian investments are so deeply out of favor, it could take two or three years before things turn around.

Nevertheless, be careful about allocating too many assets to this up-and-down sector, said Ford. Somewhere between 5 percent and 10 percent should be sufficient, he explained.

As for which commodities investors should be exposed to, base metals have taken the biggest hit, which is why Sutton is overweight that part of the market. He's also keen on diversified large caps, and he's "modestly" overweight oil and gas.

He's not interested in owning gold. "We're nervous with the price at $1300," he said. "It's too risky."

While this contrarian play hasn't yet paid off for Willis—the MSCI Commodity Producers Index is down more than 1.5 percent year-to-date—he's willing to wait until it does.

"I hope we can get our money in 12 months, but we're not expecting to sell out of our position [by then]," he said. "We're prepared to hold."

—By Bryan Borzkowski, Special to


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