Our Successful Investor approach has a long track record of helping investors profit from commodities

Commodity investments include raw materials, like oil, copper, tin and aluminum, as well as agricultural products such as corn, cocoa, coffee and sugar.

For investors wondering how to invest in commodities, we believe the best way is to purchase shares of commodity producers. The best commodity stocks are those of well-established and well-managed companies that will benefit from a rise in commodity prices.

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How to invest in commodities: Background information every investor needs to know

Commodity investments are subject to wide and unpredictable swings in prices. In the rising phase of the business cycle, when business is booming, resource demand expands faster than resource supply, so resource prices shoot up. This balloons profits for commodity investments. When the economy slumps, resource prices fall, and this drags down the prices of resource stocks.

There are four primary categories of commodities currently traded on the market: Energy (gasoline, oil, etc.), Metals (gold, silver, platinum, copper, etc.) Livestock (pigs, cows, etc.) and Agricultural (corn, cocoa, coffee, cotton, etc.)

Note that resource and commodity stocks in general should make up only a limited portion of your portfolio—less than 20% for a conservative investor. For Pat’s thoughts on more aggressive investing in oil stocks, in particular, click HERE. 

How to invest in commodities: Look for stocks with these characteristics in common

Top commodity stocks often share these characteristics:

First, these stocks typically have strong balance sheets with low debt. If they’re junior producers, we like to see companies with the funds to finance their reserves into production. These stocks are also from companies with experienced management teams. We look for an experienced management team with a proven ability to use the latest technologies.

The best of these stocks don’t trade “over-the-counter,” or OTC, because regulatory reporting there is lax.

Next, avoid unsustainably high prices when buying mining stocks. These prices are often the result of broker hype or investor mania.

Finally, we look at the market cap of commodity stocks versus the estimated value of the resources they have in the ground or the commodities they produce. Sometimes, a company’s marketing efforts are so successful that they drive the stock up too high in relation to the size of its assets. We like a commodity stock’s market cap to be no more than half the value of those assets.

Resource stocks, though volatile, tend to rise with inflation

In addition to rising and falling with the business cycle, however, resource stocks have a history of rising along with long-term inflationary trends. This gives them a rare ability: they provide a hedge against inflation.

You may feel resource stocks could languish for years. You may think it’s best to stay out of them until inflation moves up further. But these stocks could give us an early warning of coming high inflation. They may shoot up long before inflation becomes a problem.

Bonus Tip #1: Avoid investing in fungible goods 

The markets for fungible goods like oil and gold are inherently unpredictable.

Fungible goods are interchangeable within their class or category; after they hit the world market, there’s no way to tell where a barrel or ounce of the stuff came from. Markets like these are so enormous that there is no practical limit to how much you can trade in them.

It follows that if you could predict their prices movements, you could wind up acquiring a measurable proportion of all the money in the world, and nobody ever does that. That’s why it’s a mistake to invest in such a way that you have to accurately predict the future direction of fungible goods like oil, interest rates or gold.

Bonus Tip #2: Choose mineral and energy resource companies that invest in developing expertise 

Today’s resource projects call for a great deal of engineering, financial and political expertise. The top resource companies acquire a lasting competitive advantage by developing their expertise in these areas.

This expertise is another type of hidden asset. It doesn’t appear on the balance sheet, but it gives resource stocks an advantage in every project they undertake. The top resource stocks also create their own hidden assets. They accumulate rights to promising acreage or properties long before the land rush starts. They have the technical and political skills they need to foresee and deal with environmental and political obstacles.

This expertise becomes more important as resource technology advances.

How much do environmental concerns about some resource stocks affect your interest in investing in them?