What are commodity stocks? We aim to answer not just that question, but also which ones are best for a well-balanced portfolio

What are commodity 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.)

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.

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Meanwhile, if people generally believe the price of a commodity is sure to go up, the reverse often happens because both suppliers and users of the commodity also read the newspapers and follow online sites. They both take steps to protect themselves and profit from the situation. The suppliers try to increase supplies, and the users try to become more efficient or find alternative commodities.

What are commodity stocks: Savvy investors look to see if mineral and energy resource companies have this hidden asset

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 even more important as resource technology advances.

 Here are five tips for selecting commodity stocks in the resources sector for long-term investment gains

Look for well-financed companies with no immediate need to sell shares at low prices. These stocks typically have strong balance sheets with low debt. If they’re junior mines, we like to see a major partner who can finance the mine to production.

• Avoid “over-the-counter” trading. Regulatory reporting is lax in over-the-counter trading.
• Avoid unsustainably high prices. Unsustainably high trading prices in relation to a company’s assets are often a result of broker hype or investor mania.
• Find experienced management teams. We seek an experienced management team with a proven ability to develop energy. We make sure they’re not in any insecure or politically unstable regions such as the Congo and Venezuela, or in countries with little respect for property rights and the rule of law such as Russia or Mongolia.
• Look at the market cap and the estimated value of the resource. For instance, we look at the market cap of mining stocks versus the estimated value of the resource they have in the ground. Sometimes, a company’s marketing efforts are so successful that they drive the stock up too high in relation to the size of its reserves. We like a stock’s market cap to be no more than half the value of those reserves. We assume that the company will be able to expand its reserves with more exploration, but if the current reserves are double the stock’s market cap, it provides a margin of safety.

What are commodity stocks? Find out how you can profit in precious metal stocks

We feel that investing on the basis of price changes for gold in the form of bullion, instead of in shares of gold companies, is more of a gamble than an investment. Bullion doesn’t earn income, but instead consumes funds for storage fees, insurance and so on.

A better way to profit from rising gold is by investing in the stocks of gold mining companies. That way, you benefit from increases in the price of gold, and you give yourself the potential for both capital gains and income. You also save on the higher trading fees and commissions associated with buying physical gold.

Even so, because of their volatile nature, we continue to recommend that gold stocks make up only a limited portion of your portfolio’s resources segment.

Use our three-part Successful Investor approach when you select stocks—including commodity shares

We feel that investing on the basis of price changes for commodities themselves instead of in commodity stocks is more of a gamble than an investment. These activities don’t earn dividends or interest, but instead consume income for storage fees, insurance and so on. You also don’t profit from the buildup of capital that you get through investing in stocks and some trusts.

All in all, we think that most investors should have some exposure to resource and commodity investments in their portfolios, in reasonable amounts.

To build your overall portfolio, we recommend following TSI Network and using our three-part Successful Investor strategy:

• Invest mainly in well-established, dividend-paying companies;
• Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
• Downplay or avoid stocks in the broker/media limelight.

How much of your portfolio is dedicated to commodity stocks?

What do you look for in commodity stocks to find safe investments?