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March 17, 2006

Commodities Bull Portfolio Design
by Adam Hamilton

After stealthily launching without fanfare in 2001, the Great Commodities Bull of the 00s is finally starting to pick up some steam. This powerful bull market, the first this realm has witnessed in decades, will probably prove to be the biggest commodities boom in world history.

How can I advance such a brazen assertion? Like a freak rogue wave in the open oceans, a nearly perfect confluence of smaller commodities waves is coming together at this peculiar time in history to produce a monster commodities wave. A rapidly growing world coupled with constrained commodities supplies is creating unparalleled opportunities for investors.

On the demand side, Asia is rapidly industrializing. Billions of Asians rightfully want to experience the material abundance that we take for granted in the West. Western lifestyles require enormous per-capita commodities consumption, and there are several times more people in the East than here in the West. Asia, which wasn't a major factor in the famous 1970s commodities superbull, will help drive radically unprecedented levels of global demand.

On the supply side, during the 1990s commodities infrastructure was woefully neglected. Commodities prices were contracting in a brutal secular bear, leaving few incentives to develop new supplies. On top of this investor capital abandoned commodities production to chase the lucrative superbull in general stocks. This left global commodities production capacity rusting and decimated.

As Economics 101 dictates, the only possible outcome for global demand growth far exceeding global supply growth is relentlessly rising prices. In most industries these rising prices would rapidly bring out new supplies, but capital-intensive-to-produce commodities like energy and metals defy this market-balancing characteristic.

Once commodities prices rise high enough to be very profitable to produce, they have to stay at these levels long enough to convince investors to put up the capital and companies to take the huge risks necessary to expand their production capabilities. It may take years of high prices before capital responds and starts to address the shortage. But even after these investment decisions are made, it can still take up to a decade more for new supplies to hit the market!

Why? Before producing a commodity, a company first has to explore for and discover a large economical deposit, which are getting increasingly rare on our already scoured planet. After the years it takes to find such a deposit, the company has to get approval from the local government to mine it. Permitting can take years regardless if it is in the Third World (corruption and bureaucracy) or the First World (environmentalists and bureaucracy). After approval, it can take a couple more years to actually build the physical mine operations.

So unlike most other industries, commodities prices can easily stay high for a decade or more before enough new supplies come online worldwide to meet soaring demand. Existing producers already supplying the strained world markets today will earn legendary profits in the coming years before supplies finally start catching up with demand. Investors who own the stocks of these elite companies will reap fortunes.

Interestingly, today the majority consensus seems to believe that commodities prices are already ridiculously high, that a bubble exists. This is great news for commodities investors as all bull markets must climb a wall of worries. The time to get concerned is when everyone thinks we have entered a New Era of higher commodities prices and all the financial media ever discusses is commodities 24/7. Today it is only a small fringe of contrarians who are believers in this young bull.

Young bull? Yes, it was less than 5 years ago in October 2001 when commodities bottomed out after a brutal multi-decade secular bear. In history great commodities bulls tend to run 17 years or so in duration, exactly out of phase with the 17-year bull and bear markets in general stocks. Not only is our current commodities bull probably less than a third over in duration terms, but in price terms too.

People are talking of all-time highs in the benchmark CRB Commodities Index, and technically they are right. The problem is the last great peak happened 25 years ago in 1981. A dollar today is worth vastly less than a dollar was back then so it is inherently inaccurate and misleading to compare early 1980s prices with today's straight up. A far better approach is to adjust for inflation. This chart includes the CRB in blue and a CPI-inflation-adjusted version in red. Believe it or not, commodities remain very inexpensive today!

The blue nominal CRB line is what the financial media harps on, feeding the wall of worries. But comparing nominal prices over decades is careless and irrelevant. In true purchasing-power terms, as the red real CRB line shows, commodities today are just now getting back to their levels of the early 1990s. They are finally starting to climb out of the wickedly low trough that marked the end of their multi-decade secular bear.

So not only are global commodities fundamentals awesomely bullish, but our current commodities bull remains young in terms of both average historical duration and real price levels. The best and biggest two-thirds of this bull is almost certainly yet to come and it will probably ultimately drive commodities prices up to new all-time real highs, north of 1000 on the CRB index. This is another triple from here! Commodities should continue to be the biggest and baddest bull of the coming decade.

Personally I have been tremendously blessed as minds far wiser than my own helped me understand the vast potential for commodities back in 1999 and 2000 as the stock-market bull was peaking. I first laid down my definitive case for a new great commodities bull back in April 2001. But even before that, since 2000, I have been researching and buying elite commodities producers, recommending them to our subscribers, and pondering optimal commodities bull portfolio design strategies.

Some of the most common questions I hear today revolve around how to design a portfolio to ride this magnificent commodities bull to great wealth. Veterans and folks new to commodities alike are rightfully curious as to how to optimally deploy their capital to minimize their risks while at the same time maximizing their returns in this commodities bull. I'd like to offer my thoughts on these critical questions in this essay.

I believe the greatest investment and speculation opportunities lie in handpicked stocks, in the elite companies that are already or will soon be commodities producers. This tends to surprise people because futures are most often associated with commodities in the public psyche. While futures certainly have their place in a commodities bull portfolio, stocks are far less risky with far greater potential, a potent combination.

Commodities stocks' greatest attribute is their extreme leverage to underlying commodities prices. I used an example last week while discussing copper that drives this home. For years in the early 2000s, copper prices languished around $0.75 per pound. Copper producers were forced to get lean and mean, cutting costs to the bone so they could survive. Let's imagine a miner that produces copper for $0.65 and was selling this metal for a modest $0.10 profit in 2002.

Regardless of how high copper prices rise, the costs for this mine are still relatively fixed, or at least costs rise vastly slower than commodities prices. Today this same miner might be able to produce copper for $0.75 due to inflation and rising labor and energy costs. While this would have been devastating when copper was selling for $0.75, today this essential base metal is running around $2.25. Using these numbers copper is up 200% in the last 4 years!

Now the natural assumption to make is that commodities stock profits move up in proportion with commodities prices, so if copper is up 200% then copper miners' profits must be up 200% too. In reality due to largely static fixed costs though, this relationship is exponential. In 2002 our miner pulled copper for $0.65, sold it for $0.75, and earned a $0.10 per pound profit. But today this same miner is pulling copper for $0.75, selling it for $2.25, and earning a massive $1.50 per pound profit!

In this leverage example a 200% increase in the copper prices yielded a 1400% increase in profits for our miner! And stock prices ultimately follow profits, over the long term nothing entices in new capital like soaring profits. This extraordinary profits leverage is why commodities stocks with unhedged production are such a magical opportunity during a secular commodities bull. Their profits, and hence stock prices, rise far faster than the commodities they produce.

But making commodities stocks the core component of a commodities bull portfolio does limit us in one way and increases risks in another that we need to mitigate. Generally only the producers of very capital-intensive commodities are publicly traded. It takes hundreds of millions or billions of dollars to pump oil or mine metals. The only practical way to raise this kind of capital is to float a stock. So most of the commodities stocks out there produce commodities like energy and metals that have very high barriers to entry.

So a stock-based commodities bull portfolio will necessarily be largely comprised of energy and metals producers. This is fine though, as these commodities are where the greatest opportunities exist. Soft commodities, like wheat, are much more responsive to price changes with low barriers to entry. If wheat prices had quadrupled like copper has nearly done, every farmer in America and Europe and Russia would be growing wheat next year with new supplies arriving in a year or so rather than a decade.

The more capital intensive a commodity is to produce, the harder it is for its supply to respond to price. As such, commodities investors really aren't losing out by concentrating their exposure in hard-to-produce energy and metals resources rather than easy-to-grow plants. As an added bonus, governments do not tend to subsidize energy and metals production like they subsidize farmers. Farmer welfare wreaks havoc in bull markets and vastly reduces the ultimate potential of the subsidized and hence overproduced commodities.

But unlike an oil futures contract that is only exposed to oil, buying oil-producer stocks adds some major layers of risk that must be mitigated. Commodities are a tough industry and company-specific risk is high. Commodities deposits are local and cannot be moved, so commodities producers are at the mercy of their local governments. Whenever a new anti-free-market government comes into power as recently happened in Bolivia, a company with heavy exposure in such a country can be sold drastically. In addition to political risk, disasters can happen. Mines can flood, oilfields can burn, and resources can deplete faster than expected.

Thankfully these company-specific risks are easy to mitigate through prudent diversification. The best piece of investment advice you will ever get was uttered several millennia ago by the ancient Israeli King Solomon, one of the wisest men who has ever graced world history. Quoted in the Bible in chapter 11 of one of the books he wrote, Ecclesiastes, Solomon tells us...

"Cast your bread upon the waters, for you will find it after many days. Give a portion to seven, or even to eight, for you know not what disaster may happen on earth." - Ecclesiastes 11:1-2

As King Solomon wisely pointed out, you and I are mere mortals and we cannot see the future or know in advance which companies or regions or countries will face disasters. So we should divide our capital up, at least 7 or 8 ways, so if one of the stocks we own suddenly suffers a precipitous decline our whole portfolio won't be dragged down in the maelstrom. And with no disrespect to Solomon, one of my heroes, in the risky commodities realm I think 20-way diversification is more appropriate.

Since 2000 I have been stopped out of many commodities stocks resulting from a variety of unforeseeable events. I have lost gold-stock positions when flagship mines flooded. I have seen great companies plummet like meteors when a Marxist government takes over in the country that hosts their main projects. I have seen higher-than-expected costs torpedo quarterly results and lead to selling stampedes.

As such, I firmly believe that no more than 5% of one's total capital should ever be exposed to any one company. And if you aren't yet as battle-scarred as me and think this is way too conservative, at least please run no more than 10% in any one stock ever, under any circumstance.

The reasons are psychological too. Once an investor has more than 10% of his exposure in a single company he falls in love with that company and ceases to make rational decisions regarding it. Once clouded by irrationality, an investor is doomed to failure. You should own your stocks, but if you have too large of position in any one company they can instead own you. By staying sub-10% odds are you'll never grow too attached to any one company.

The next thing to do is decide if you are primarily an investor or speculator. We all have a bit of both in us, but one inevitably dominates at various stages in our lives. Investors are patient long-term players, deploying capital crucial to their happiness in strong companies so it can gradually and safely grow over many years. Capital for your retirement, your kids' educations, or to buy a house should only be invested. The basic rule is if you are attached to any particular block of capital, then do not speculate with it!

Speculators are adrenaline-loving short-term gunslingers, looking for big gains riding major 6 to 12-month tactical swings within this secular commodities bull. Speculators only bet with risk capital not essential to their future happiness and hence are never afraid of the inevitable losing trades between big wins. The best speculators are not enamored by money, but they grow rich anyway because they play for sheer love of the game.

One thing I find really interesting about this dichotomy is that folks who are primarily investors still need some speculations and folks who are primarily speculators still need some investments. Investors need speculations because it gives them something to do in the long years it takes investment seeds to grow into a ripe harvest. Even if you have 95% of your portfolio in investments, 5% you can actively trade is a good idea because it keeps you occupied so you don't constantly molest and overtrade your core investment capital.

And speculators need some investments. I've been a speculator for decades and speculation is infinitely fun and rewarding on countless levels. But it can be a brutal and unforgiving game. Those who choose to live by the sword can also die by the sword. The worst-case scenario for a speculator is to have all his speculations crumble at once so he blows up, has no more capital. Thus every speculator should have some core investment capital that is safe and untraded so even if his speculative account goes to zero he isn't completely wiped out.

In terms of commodities bull portfolio design, the question of whether you are primarily an investor or speculator is resolved by allocation proportions. There are four major classes in which to deploy capital, a foundation, investments, speculative investments, and pure speculations. Investors have much more capital in the former while speculators have much more in the latter.

This pyramid outlines this concept visually, as well as has suggested portfolio allocations amongst these four classes for both a conservative investor and an aggressive speculator. The higher up on the pyramid you travel, the higher both the risks and potential rewards become. After you digest this model, I will discuss each major category in turn from least risky to most risky. And of course these major allocations should be fine-tuned by you alone for your own personal levels of risk tolerance.

No portfolio is complete without a foundation, and in our brave new Information Age where most of our assets are merely electronic blips stored in some computer, this foundation must be physical. For six millennia of human history the ultimate stores of wealth that have survived all governments, all technologies, all wars, and all markets are gold and silver. They are the ultimate insurance against the unthinkable.

For foundation purposes, I believe the best gold and silver to buy are the nationally-minted coins that are instantly recognizable and perfectly liquid worldwide. Bullion coins, which offer the most metal per dollar invested, are absolutely the way to go. Coin dealers are forever trying to steer investors into high-profit-margin rare coins, or numismatics, instead of cheap bullion coins. But rare coins are for speculators speculating on perceived scarceness trends while bullion coins are for investors.

These foundational physical assets, which can include some national currency for the country in which you live, should be physically stored in your own immediate possession. Gold or silver held in third-party storage elsewhere is fine as an investment, but not as a foundation. The foundation component exists as insurance for the worst-case scenarios, if for some reason all of your intangible paper assets including third-party gold are inaccessible.

While such ugly events are all very-low-probability scenarios, it is good to be prepared just in case. An example? What if Washington's incessant imperialism motivates some other country to lob a single nuclear ICBM into space to explode 250 miles above Nebraska. The resulting electromagnetic pulse would collapse the entire continental US electrical grid and fry almost all electronics, including computers and cars, in the US. The resulting Stone Age would mean all of our intangible assets would be inaccessible for years at best.

A physical foundation in your own immediate possession and control is also good to have for more mundane reasons as well. What if someone trips on your sidewalk, smashes his own skull, and sues you. Then he hires some parasitic lawyer that convinces some liberal judge to freeze your assets while the case is ongoing. While governments at all levels can block access to your intangible assets in a nanosecond, they cannot cut your access to physical metals or currencies in your own possession. Chance favors the prepared.

After your crucial foundation is laid, then you can lay in investments. For investors obviously this is the largest portion of your total commodities bull portfolio, maybe up to two-thirds. There are several major categories of commodities stocks that are generally strong, healthy, and safe enough to be considered core long-term investments.

The first is major commodities producers with low price-to-earnings ratios. The general stock markets meander in great 34-year cycles from undervalued levels to overvalued levels and back again. The only time investors are virtually guaranteed to win big in the next decade or two is when they buy at undervalued levels, around 7x earnings. When you can find major commodities stocks that are trading at these traditionally very low valuations, it is the best of all possible worlds.

Today most of these valuation bargains in commodities stocks are occurring in the realms of oil and copper producers. Our investments portfolio outlined every month in our newsletter currently includes a major oil producer trading at 7.4x earnings and a major copper producer trading at 8.6x earnings and yielding 13%+ dividends! Since the centuries-old historic average fair value level is around 14x earnings, companies like these ought to double even if commodities prices traveled no higher. And over the course of this secular bull their gains should be stupendous as both commodities investors and value investors pounce on them.

Other great investments are world or regional leaders in commodities production. Companies big enough to dominate the globe or a region are often well diversified with many different production operations. Some commodities have global markets, like oil, while others are largely regional due to ocean-shipping limitations, like natural gas. Our portfolio currently contains the best major independent US oil producer and another company that is among the biggest major independent US gas producers.

Along these lines there are a handful of true global mining conglomerates, massive single companies that operate on all populated continents and mine everything from base metals to precious metals to energy. One is worth a huge $110b in market capitalization, comparable to Google but trading at less than 1/5th of Google's valuation! Such conglomerates are so well-diversified that they are not overly exposed to any one commodity or government. They are like self-contained commodities mini-mutual funds.

After investments are laid in, then speculative investments can be acquired. As their name implies, these are riskier than pure investments but less risky than pure speculations. They have higher risks with higher potential rewards than the mammoth commodities leaders that make up the pure investment class. And one type of major producer qualifies for this class simply because it is overvalued.

Sometimes major commodities producers become market darlings early before their profits catch up to their stock prices. While these companies still have great potential to thrive since they dominate their commodity, their high valuations make it imprudent to consider them as safe as pure investments. Both the largest uranium miner and largest gold miner on the planet today, two great companies, are currently each trading near 70x earnings! While I own and recommend both, until profits rise high enough to drive valuations down these are just too risky to be considered pure investments.

After major producers, the next level is known as intermediates. These are much smaller companies that are in the middle ground between tiny explorers and giant major producers. This realm is often very exciting because the best names are not yet widely known creating great opportunities for investors. Great intermediates have solid fundamentals, they are growing their production, and they are largely unhedged. Since these companies usually only have a handful of major projects, you want to make sure your intermediate exposure is diversified geographically among different countries.

The most speculative of the speculative investments are producers-to-be. These are smaller companies that graduated up from the explorer stage and are bringing major mining projects into production within the next two years. In our weekly newsletter for speculators, we have plays in this category specializing in uranium, zinc, and lead. One interesting thing about producers-to-be is they often get a US stock listing (in addition to their primary one, usually Canadian) when they have a project that is moving towards production. Thus investors have opportunities to buy low before most US investors are aware of the new listing.

And finally we enter the fourth and most exciting class, pure speculations. Companies that fit into this category can double their stock prices each year for years on end in the best cases. While these speculations have the most potential, they also have the most risk. As such, investors really need to be careful with how much overall capital they allocate to the risky apex of this commodities bull portfolio pyramid.

Small commodities producers are our favorite speculation that we like to search for at Zeal. These companies are not yet big enough to be considered intermediates but since they are actually producing commodities on a small scale they have positive cashflows that can finance their evolution towards becoming larger companies. Since these small producers often only have one mine, even more so than intermediates it is important that they be politically diversified. Make sure you don't have a bunch of small producers with full exposure in any one particular country.

Explorers are an even riskier category of speculation. They aren't producing any commodities yet but they are actively searching the planet for the next big deposit. If companies like these strike it big they can soar 100x or more. But not surprisingly most of these explorers never strike it big and their prices languish for long periods of time. One common mistake I have seen many of my consulting clients make is to assume an explorer is an investment. This is never true, they are all speculations until they have found major deposits.

An advanced-stage explorer is a company that found a deposit and is moving towards production but is over two years away from opening its first mine. These are often excellent speculations in a commodities bull since overall investor interest grows as the bull marches on. A little-known company today that is several years away from opening its first mine could become a market darling down the road as more investors start searching for small miners. We currently own an excellent base metals play in this category.

Finally, the riskiest of the risky in speculations is the derivatives. These include stock options, futures, and futures options. Options, of course, are extremely risky because a 100% loss in six months or less is guaranteed if the speculator makes the wrong bet on the price underlying the contracts. Options exist on both the stocks of producers and the underlying commodities themselves in the futures markets. Options are for hardcore speculators only who totally understand the massive risks involved.

Futures are similarly risky because they are almost always traded on margin. If a speculator puts up 10% of the value of a futures contract as margin in order to control it, a 10% adverse move in the underlying commodities price wipes out 100% of this capital he put up and guarantees him a margin call if he wants to keep his position. Margin is a form of debt financing and only appropriate for the most sophisticated speculators. Personally I loathe and avoid margin like the plague. The greater the margin used, the higher the chance the trade will be wiped out by a contrary move in the markets.

While there are certainly more types of commodities investments and speculations that can be included in the four major classes of this pyramid, I hope this brief summary gives you an idea of what to look for. The foundation, investments, speculative investments, and speculations are defined by their levels of risk. The safer plays form the fat foundation of the pyramid while the riskier plays form its small apex.

If you build such a portfolio of your own, it is best to start at the bottom and work your way up. I know that everyone wants the speculations, the sexy gold or uranium juniors, but prudence dictates that you protect your capital by building from the ground up rather than from the top down. The problem with starting at the top is most folks who do it never get to the bottom. They become addicted to buying the hyper-fun pure speculations and end up with 100% of their capital tied up in these risky plays. Then a commodity temporarily turns against them, they lose big money they couldn't afford to lose, and they get discouraged and miss the rest of this awesome bull.

Finally, the most important part of building wealth is not losing a lot of it along the way! Since capital is so emotional and fraught with difficult decisions, running trailing stop losses is absolutely essential on every stock in your portfolio that classifies as either a speculative investment or speculation. Buying is easy but selling is always very hard so it is best to let the markets decide when you need to sell a particular position and then have your broker make the sale automatically. Stops let wins run but cut losses as soon as possible, ultimately maximizing long-term returns while minimizing demoralizing short-term stress.

Unfortunately in this very long essay I didn't have room to go into specific companies, but we are constantly researching and adding positions in stocks that fit in all three stock categories in this pyramid. If you want cutting-edge analysis on the overall commodities bull, individual commodities within it, and the elite producers stocks that are most likely to thrive, please subscribe to our acclaimed newsletter today. New e-mail PDF-edition subscribers will receive a complimentary copy of the current March issue with several new recommendations that ought to thrive.

The bottom line is this commodities bull continues to look awesome fundamentally and remains young and low in light of historic precedent. With probably another decade or so to run yet, the greatest gains are yet to come. Prudent investors and speculators who understand these strategic trends and build their own commodities bull portfolios are likely to earn fortunes. This should be the biggest bull market in the world over the next decade.

But zeal for commodities stocks must be tempered with timeless and prudent portfolio management techniques. Risk should be diversified by owning many different companies producing many different commodities in many different countries around the world. And mechanical protection in the form of trailing stops should be in place to arrest the inevitable periodic losses as soon as possible.

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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