Picking natural resource investments

It’s hard to avoid headlines about the price of natural resources.

Oil has been hitting new highs almost every day this week. Iron ore and coking coal have become hot investments because they’re major inputs for steel production. Even stodgy agriculture is seizing the headlines.

So, how should one go about picking a natural resource investment to benefit from the boom?

First, it’s probably too late to join the party because prices reflect a lot of the boom already. There may be some bargains to be had, though, if the global economy continues to slow down.

What should one look for in a natural resource investment?

The first thing I like to find is low costs. Low cost producers, especially in commodity products, have a huge competitive advantage. The companies with the lowest costs to extract oil, gold and iron ore, or produce wheat, soybeans and corn will exhibit higher profit margins and returns on capital.

Scale may be one reason for such an advantage. Another may be a proprietary production process or unique access to geologic locations. Yet another may be a management team that can motivate and hire more productive employees. One of the most important advantages is a management team that knows how to allocate capital to the best returning projects.

The second thing to consider is the sustainability of such costs. Some advantages are easily competed away as soon as others recognize them. To benefit from a specific cost structure, it must be sustainable over time.

One example is oil sands. Oil sands have much higher costs of production than other oil extraction projects. But, they have reserve lives of 50 years versus reserve lives of 10 to 15 for most large, integrated oil companies. (full disclosure: my clients and I own a position in an oil sands company)

Low costs and the sustainability of a cost structure are very important in looking for natural resource investments. Does that mean you should find the company with the lowest, most sustainable cost structure and purchase it? Emphatically: NO!

It depends on the price you pay for that company. The math behind investing is simple, but not easy to implement. To find the best investment, you have to compare the economics of a business to the price you pay for it. Frequently, this means buying a second tier company whose price doesn’t currently reflect its cost structure and sustainability. The best company in an industry rarely goes on sale for a rock bottom price.

Picking a natural resource investment requires a focus on the economics of a business and its sustainability, its management, and its price relative to economics and management. If that sounds like a generalization for picking any investment, that’s because it is.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Food prices run amuck!

There’s been a lot of interest in food prices spiking, and there are many opinions on why food prices are running.

The most popular “cause” is, of course, speculation by hedge fund managers, futures traders, etc. Although this may be causing some of the short term spikes we are seeing, I don’t believe it’s the real, underlying cause.

In my opinion, there are significant, fundamental, underlying trends that are causing food prices to run up.

The first, and one I’ve written about before, is underlying inflation. When the central banks of the world print money to fight various economic problems, the result is almost always inflation.

Another major cause is government policy encouraging (read: subsidizing) bio-fuels production. When almost 20% of U.S. corn production goes to produce fuel instead of food, then food supply decreases and prices will rise (all things equal)–welcome to Economics 101.

Demand itself–especially from the rapidly growing developing economies in Asia, Latin America, the Middle East, etc.–is indeed a major factor in food price increases. We in the developed world cannot expect those in the developing world to continue living on the same amount and type of food they’ve been living on forever. This trend isn’t going away any time soon.

Another less talked about reason is water. Yes, water. Water for growing crops is not as easy to come by in many parts of the world. Saudi Arabia is a great example of a country that must spend tremendous amounts of resources to produce water that can be used for growing food.

A bad crop in Australia is also to blame. Bad crops are not that unusual, though. In fact, they are quite predictable (that they will happen, not when). This only exacerbates the problem. It’s not a primary cause.

So, food prices are going up and there are underlying, fundamental causes that probably won’t make this issue go away quickly. So what?

If the global economy slows down, as it looks to be doing, then look for food prices to fall back a bit. But, as long as the underlying causes mentioned above persist–central bank money printing, bio-fuel subsidies, demand from developing countries, difficulties in producing usable water–food prices will probably remain higher than in the last 20 years.

Higher food prices matter because they have led to many wars throughout history. This isn’t a prediction, merely an observation that when things get bad enough–people don’t have enough food to eat–they can become angry enough to go to war.

Food prices don’t seem like that big of a deal in the developed world like the U.S., western Europe and Japan, because food makes up only a small portion (10-15%) of the developed world’s family budgets. In the developing world, though, food is a huge portion (80%). If 80% of our costs doubled or tripled, as food prices have in some parts of the world, you’d even see Americans ready and willing to go to war.

What’s a poor investor to do? Prepare for this possibility. The forces of capitalism will tend to drive prices of commodities down over time. When these forces are interrupted, as described above, you get price spikes, shortages, surpluses, etc.

The backlash caused by food price spikes will, eventually, lead to the removal of the barriers to capitalism. Until these barriers are removed, expect food prices to remain high and perhaps even continue to climb.

As an investor, you can protect yourself by investing in areas with pricing power. Businesses with pricing power can do okay during difficult periods periods, and, if/when food prices decline, they will thrive. Win win.

Trying to bet on commodity price swings is risky business, and I wouldn’t recommend it. If you don’t know who the patsy is, then it’s you.

Instead, look to quality businesses that can raise their prices without crushing the demand for their products. Such companies will always do well over the long term.

Another idea is to invest in areas of the food market that haven’t yet benefited from price run-ups. First it was energy, then base metals, now food crops. As inflation works its way through the system each player along the way goes from being hurt to being benefited.

For instance, pork, chicken and beef producers have been hammered by higher input costs–corn, soybeans, wheat–but the price for their end products haven’t climbed, yet. They are facing the perfect storm of higher costs and lower product prices! Perhaps this will change as marginal producers go bust and large producers trim back production until it’s profitable again. It’s Economics 101 again!!! (full disclosure: I and my clients are invested in a large pork producer).

Don’t let higher food prices get you down. Invest wisely and you can benefit!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The returns you get on your money matter…A LOT!!!

Although I understand clearly the argument for low cost index funds, especially for more risk averse people, I want to briefly make the argument for going after above average returns.

Why? Because it can have a HUGE impact on your quality of life. Getting above average returns can greatly improve your safety and security both before and during retirement.

Let me give you some a examples to clearly illustrate my point.

Suppose Bob starts saving at 30, retires at 65 and dies at 95. Also, suppose he saves $100 a month from the time he’s 30 until he reaches 65. Finally, suppose he gets 7% returns from age 30 to 95. How much will Bob have to live on? Around $13,400 a year from the time he’s 65 until he dies at 95.

Now, suppose Fred does the exact same thing as Bob, except he gets 8% returns from 30 to 95–only 1% better than Bob! Fred will have around $18,400 a year to live on from the time he’s 65 until he dies at 95. That’s 37% more a year to live on!

Using slightly different savings inputs, that’s the difference between having $50,000 a year in retirement versus having $68,500 a year! That’s HUGE!!!

You can plug any numbers you want to in the scenario above, and you’ll get the same general answer. Getting better returns–even mere 1% better returns–can hugely raise your standard of living in retirement, thus giving you more peace of mind, safety and security.

More provocatively, let’s suppose you don’t know when you’re going to die–most people don’t! How long will your money last when your retire?

Let’s use the same numbers above, except let’s assume both Bob and Fred don’t know when they are going to die, so they spend $17,500 a year. How long will their money last if Bob gets 7% returns and Fred gets 8% returns? Bob’s money will last 17 years–he’ll run out of money at age 82. Fred’s money will last 38 years–he’ll have money until 103 years old!

Can you imagine running out of money at 82 versus having enough to last to 103? That’s a huge change in safety and security!

My point here is not that everyone should try to get above average returns. My point is that getting above average returns may REALLY be worth it if you have the tolerance and ability to go after above average returns.

I’ve been beating the market, after fees, by around 3.5% a year for the past 12 years (past results are no guarantee of future performance). Want to guess what my retirement projections look like? Want to guess how much peace of mind I have?

If you have the right temperament and the right financial situation to go after above average returns, it can have a huge impact on your current and future lifestyle. In my opinion, it’s well worth going after.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

It’s stimulus check time!

That’s right, boys and girls, it’s that time again to get the economy going with stimulus checks!

But, wait a minute. Where do those stimulus checks come from anyway?

Does the government have a magical money tree that creates value? No, probably not that.

Does the government take in more money in tax revenue than they spend? No, not that, either.

Does the government borrow from others by issuing government bonds? Yes, that’s the one.

Okay, so who buys those bonds? Is it savers, foreign and domestic? Yes, indeed.

So, that means the money is going from people saving to people spending, right?

So, the way to get the economy going, forever after, is to stop saving and start spending? Hmmm…that’s some interesting logic.

Let’s take this to its logical conclusion. Growth comes from consuming, according to this thinking.

So, if we just consume everything we’ve produced, we’ve maximized growth?

That doesn’t seem to make sense.

Oh yeh! Now I get it! The way to grow is to save some of what you produce, and then use those savings to produce more next time around.

For example, the farmer who eats his seed corn will never grow production. But, the farmer who saves a bit his corn each year as seed for the next year will produce larger and larger crops each year as he saves more and more seed corn.

The only way to have growth is not to consume all you produce, but to save some of it over time and plow that saving back into production. You can’t eat corn you haven’t produced. You have to produce before you can consume. Production, built from saving, is the way to growth–not consumption.

So, what in the heck is borrowing money from savers and giving it to consumers going to do? Reduce future growth. Does that sound like a good plan for getting the economy growing again?

Only if you measure growth by adding up consumption.

I think I’ll put my stimulus check into savings. Then, maybe, we’ll have a snowball’s chance in hell of competing with the foreigners we’re selling the asset of our country to.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.