Could the recovery continue?
✔ Commodity stock performance reversed course, notching strong gains in 2016.
✔ Agriculture stocks, in particular, may offer potential amid a global economic recovery.
✔ Regardless of short-term performance, commodity stocks may offer potential benefits in a portfolio.
After suffering a brutal 23% drop in 2015, commodity stocks rebounded in 2016, notching a 30.4% return.* Fidelity® Global Commodity Stock Fund (FFGCX) manager Joe Wickwire thinks there is the potential for that rally to continue—as long as the world avoids recession—and that agriculture stocks, U.S. exploration and development energy companies, and the select metal and mining companies look especially attractive.
What’s more, Wickwire thinks that investors may want to consider whether commodity-related companies deserve a place in a diversified portfolio. That’s because commodities have had an imperfect correlation to stocks, particularly during times of high inflation, which means that incorporating some commodities in a portfolio has the potential to provide diversification benefits.
Commodity stocks may also be worth considering because of their past performance during times of rising inflation. When mounting demand stokes broad inflation, commodity prices tend to rise, along with the prices of other goods and services. The companies in commodity-linked industries, such as those in the energy and materials sectors, benefit from the same trends as commodities and have the potential to further magnify the positive impact of rising prices by also growing earnings. As a result, commodity stocks have outperformed stocks overall and investment-grade bonds in historical rising-inflation periods, on average.
The commodity stock universe
Wickwire divides the commodity sector into three broad categories:
- Agriculture, to feed the world
- Energy, to power the world
- Metals and mining, to build the world
The three categories follow similar but separate cycles. When prices rise, producers usually try to find a balance between investing back into the business to ensure longer-term viability and profitability and rewarding shareholders with dividend payouts. But if commodity producers wind up investing too much in additional production capacity as prices rise, then they run the risk of bringing on too much supply. After a while, supply outstrips demand, causing prices to fall. Companies then curtail production to cut costs, eventually leading to tighter supplies and higher prices. “There’s an old adage,” notes Wickwire. “The cure for low prices is low prices, and the cure for high prices is high prices.”
The commodity complex as a whole is currently enjoying an upcycle. According to Wickwire, from 2000 to 2011, increased demand from China and other developing countries drove commodity prices higher, as emerging markets built the roads, airports, militaries, telecommunications networks, and other infrastructure that create the foundation for modern economies. Producers across the commodity complex built out capacity as if demand would climb indefinitely. “During the tail end of that supercycle, a lot of commodity producers had overbuilt, chasing production at the expense of profitability,” Wickwire explains.
After China’s economy started slowing around 2012, prices of metals, oil and gas, and food items plummeted. Oil plunged from more than $100 a barrel to about $28, and commodities from copper to corn suffered drops of similar magnitude on a percentage basis. The declines weren’t simultaneous: The correction hit metals and mining first, then agriculture; oil’s downturn didn’t begin until mid-2014.
These corrections laid the foundation for a recovery in commodity equities, Wickwire says. “The oil industry just doesn’t work when oil sells for less than $40 per barrel, and the same goes for the farmer when corn goes below $4 a bushel, or for the miner when copper sells below $2 per pound or when gold goes below $1,100 per ounce,” he says. “When prices are that low, some investors begin growing confident that companies will have to reduce production, leading to less supply and eventually higher prices. The market tends to anticipate all this, and stock prices often rise accordingly.” Commodity stocks have broadly outperformed most other sectors and indexes since January 2016, with energy and metals and mining stocks leading the way.
Wickwire says he believes these trends may continue. He notes that demand should stay healthy as long as the global economy remains generally solid, and that commodity supplies and production remain generally in check. Moreover, he says, many of the stimulative fiscal policy proposals being discussed by the new administration are likely to support higher inflation and lead to greater spending on infrastructure and defense, all of which would be good for commodity companies.
“The duration and size of the upcycle will depend on two factors: the health of the global economy and company execution,” he says. “Companies could shoot themselves in the foot if they over-invest in production—but I don’t think most management teams will be in a hurry to do that after the recent downturn.”
Given this backdrop, Wickwire thinks the most appealing parts of the global commodity equities market are shares of agriculture companies, U.S. energy exploration and production (E&P) firms, and select metal and mining companies. “The agriculture cycle has lagged the recovery in metals and mining and energy,” says Wickwire. “It hit bottom only recently, because record harvests caused supply to be too abundant. Current prices don’t justify planting much more corn, wheat, or soy—the three big global crops—so supply is going to tighten at some point, and that should help prices rise.”
Wickwire expects rising food prices, coupled with agriculture stocks’ low current valuations, to support higher prices for stocks of fertilizer, bio-seed, and food processing companies. He points to a flurry of M&A activity as another positive sign. Some current examples: ChemChina is attempting to purchase Syngenta (SYT) after Monsanto tried and failed to purchase the Swiss farm chemical and seed company; Bayer is attempting to buy Monsanto (MON); Canadian fertilizer giants PotashCorp (POT) and Agrium (AGU) are joining up; and Dow (DOW) and DuPont (DD)—chemical companies with large agriculture businesses—are considering marriage.
M&A among commodity stocks typically happens near the high and low points of a cycle, says Wickwire—but this clearly isn’t the peak, in his view. These corporate actions, coupled with the likelihood of sustained demand and restricted supply, make him bullish on agriculture-related equities, especially given the stocks’ relativity low valuations, their free cash flow potential, and the fact that agriculture tends to be the least volatile of the broader three commodity categories.
He finds U.S.-based E&P stocks attractive for a different reason: “I think that many of the world’s economies are only going to get more volatile, so the location of energy assets is going to become even more important. Companies that have a disproportionate amount of their assets and deposits in more stable markets, such as the United States, should receive a premium from the market.”
Wickwire’s fund has invested in Anadarko (APC), which produces the majority of its oil and gas in locations in Texas, Colorado, and the Gulf of Mexico. “Anadarko has demonstrated a well-thought-out management strategy that has focused on owning the right assets in the right amounts,” Wickwire says. “I think what they’ve been doing across their portfolio of assets has made the company very attractive and underappreciated. They are very good portfolio managers.”
He is quick to note that no one can pinpoint the timing of commodity cycles, so it’s important to identify a strategic allocation in one’s portfolio rather than trying to time the cycles. “But long-term investors can count on cycles turning up eventually and invest accordingly,” Wickwire says. “Meanwhile, they can benefit from the potential inflation-protection benefits that these stocks can bring to a portfolio.”
- Joe Wickwire manages Fidelity® Global Commodity Stock Fund (FFGCX).
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