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The not-so-crazy case for commodities stocks

The worst of the declines may be over.

  • By Jeff Reeves,
  • MarketWatch
  • – 10/24/2013
  • Investing Strategies
  • Investing in Stocks
  • Commodities
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Looking around the market right now, as momentum darlings like Tesla (TSLA) and Netflix (NFLX) start to show signs of stress, it's worth wondering where the next hot investments will come from.

I'd like to stick my neck out and propose a crazy idea: Invest in commodities.

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Yes, there are a host of logical reasons to run screaming from commodity stocks — the deep declines in these players over the last year, the soft outlook for materials prices and the general sense that a multi-decade run in commodities has fallen apart thanks to stagnant emerging markets.

But commodity stocks have been slashing costs, finding efficiencies and plotting a way forward through the last few years of persistent challenges… and eventually, they will reach a point where there are "right-sized" for the lean times and poised for big growth once things turn around.

And it can pay off big if you buy ahead of that turn.

I don't pretend to know when the broader outlook for commodity prices will reverse, but I do think that thanks to decent valuations and the hopes of an eventual recovery that it may be worth shopping around for some bargain buys in the commodity sector. Even if you're early, there's a good chance that the worst of the declines are over.

The burden of making a case for commodity stocks should be less right now, considering the lackluster performance purportedly low-risk blue chips stocks like Wal-Mart (WMT), McDonald's (MCD), Coca-Cola (KO) and General Mills (GIS) have done recently. All of these supposedly stable picks are in the red since May despite a 10% rally for the broader S&P 500 (.SPX).

Oh, and by the way — since May 1, we've seen a 10% rally for aluminum king Alcoa (AA), a 20% gain for copper and gold miner Freeport McMoRan (FCX), and a 30% gain for U.S. Steel (X).

Still think commodity stocks are crazy?

Sure, there are risks to commodity stocks. But if you are banking on the frothy run in tech continuing or anemic utility stocks to protect your capital … well, it may be time to start entertaining at least a small position in commodity stocks.

To that end, here's my (hopefully) not so crazy case for commodity stocks.

Valuations

In the last year, basic materials as a group have delivered about 5% returns vs. about 22% gains for the broader S&P 500. However, materials stocks seem to have sat out the rally long enough that now they are at worst fairly valued.

Consider that, according to financial data provider Finviz, as a group, basic materials stocks are the only sector that currently trades for a price-to-sales ratio of less than 1. Also, forward earnings estimates show materials stocks trading on average for a P/E of less than 14 — less than the broader market's average and behind only financials and conglomerates.

When you dig into the individual players, it quickly becomes clear that those metrics are just the average. Take Gerdau (GGB), a Brazilian steel company that trades for a forward P/E of about 9 and a price/sales of a bit more than 0.7; The company is profitable and pays a 2% dividend that is very sustainable.

Or consider another South American materials stock, Vale (VALE). The company is projected to top $3 in earnings per share in fiscal 2014, giving it a forward price-to-earnings ratio just slightly above 5. And based on roughly $1.09 in dividends over the last year, the stock yields about 6.5% and is paying out just a third of its profits in distributions, meaning the dividends are quite sustainable.

There are reasonable reasons to be cautious about these stocks, but there are is also a fair case to be made that the worst is over for some materials stocks now that they are trading at these depressed levels.

Prospects of a (relatively) weaker dollar

The U.S. dollar has been persistently strong across the last several years through thick and thin. And while betting against the greenback has been much like betting against Yahoo (YHOO) or Tesla in the last year or so, the bearish case against the dollar is starting to look pretty viable.

Amid the financial crisis the U.S. dollar remained the safe haven of the world — and even in 2011 when S&P downgraded America's credit rating thanks to partisan squabbling over the debt ceiling, the currency of America remained favorable to that of the debt-riddled euro zone or stagnant Japan. However, in the second quarter the euro zone finally exited its longest recession in 40 years and Japan has been going like gangbusters in 2013, and now the U.S. dollar index, a measure of the greenback vs. a basket of global currencies could be headed to the lowest level in over a year.

With unemployment still stubbornly high and no sign of tapering in sight thanks to low inflation, there's a chance that the dollar could slip lower or at least stay at relatively depressed levels.

Given the inverse relationships between the dollar and commodity prices — that is, as the greenback declines dollar-denominated commodities from steel to corn to gold rise in price — it's reasonable to think that there's a floor in commodity prices and perhaps upside even with flat demand.

Recovery hopes

There are a number of encouraging signs on the demand front for commodities that include:

  • In August, permits for future home construction hit a five-year high, and while there are certainly signs of housing cooling and the October debt ceiling showdown will make more recent data even more disturbing, there seems to be at worst an equilibrium in housing construction after the Great Recession.
  • Auto sales are growing steadily thanks to pent up demand, and Edmunds has forecasted 16.4 million vehicles will be sold in 2014 — pushing new car sales to the highest level since 2006.
  • After two quarters of slowing manufacturing in China, things have hinted at a turnaround in the third quarter and at worst things are stabilized. That should provide decent baseline demand for commodities after the crash and burn of the last few years.

Look, I know it's easy to find reasons to bet against commodities and to refute any growth forecasts in China or anywhere else for the next year or so. And there remains a large group of investors out there who believe in the end of a two decade "supercycle" for commodities that will continue to drag on materials prices for many years to come.

But given the confluence of bargain valuations, a currency tailwind and the hopes of a recovery in the next few years, it may be prudent to consider moving out of frothy tech stocks and into some commodity exposure. Given the decent dividends and lean operations in many of these players, there is a very good chance that a floor has been found in some commodity stocks.

Some picks will undoubtedly shine brighter than others, and the path will not be clearly and consistently higher.

But don't write off the entire sector just yet.

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Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications and FICS-created content. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.
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