Time to Rethink Commodity Cycles

When market mayhem erupts, it’s time to take a deep breath and harness every bit of analytical ability you have. And today, that puts a spotlight on an area I have often stressed: commodities.

Wall Street has long implicitly assumed that most commodities cycle around a “fair” value – essentially a flat line. Commodities sometimes cycle under it, and sometimes they cycle over it. But they always stay within reach of the line.

Today, that flat line is a rising line.

I think the long-term cyclicality of commodities is a thing of the past. While commodities still will experience setbacks and corrections, these will be less frequent. One important investment implication is that commodity stocks as a whole will be revalued relative to the market, making them a critical area for investors.

Commodities Bucking Historical Trend

It’s notable that, as the stock market has fallen due to inflation and recession concerns, commodity prices have held up better even after last Friday’s sharp drop. Usually, when the market is worried about a recession, commodities tend to underperform because it’s expected that demand will fall.

The strength in commodity prices reflects something I’ve written about repeatedly: growing resource scarcities. It’s not hyperbole to call fundamental resource shortages an existential crisis. Sharply higher prices of energy and food, two areas particularly impacted by the war in Ukraine, have gotten a lot of attention. But shortages in these areas, which encompass our most fundamental needs, are deeply intertwined with shortages in virtually any commodity you can name.

Commodities are used in everything, from food to semiconductors. Yes, even the latest advanced technologies require basic materials. Technological advances have been driven by the most powerful chips the world has ever seen. In turn, these chips require a long list of natural resources.

Inflation in commodities will flow down the supply chain to inflate the cost of everything. The result is that today we face a vicious circle in which interdependencies among commodities ensure that scarcities and higher prices in any one commodity mean scarcities and higher prices in all.

The war in Ukraine has further exacerbated an already existing situation. My hope is that, horrible as the war is, it may force global leaders to recognize the existence of resource interdependencies and the urgency of global cooperation to deal with scarcities. Worth noting is that, because tackling commodity scarcities will require a massive scaling up of renewable energies, it addresses climate change as well.

Positive Free Cash Flow Is Key

The most important metric in valuing any commodity company is free cash flow yield. Why? Because that figure – a no-nonsense number based on the actual cash a company adds to its balance sheet in a particular period – is the best way to value a stock. That’s especially true in tumultuous conditions like today’s, when numbers such as growth projections can be subject to sometimes arbitrary adjustments.

The free cash flow figure shows how much the company has even after all the cash outflows for dividends and capital expenditures. With cash on hand, companies have strategic flexibility.

During rough times, positive cash flow will improve a company’s cash position, allowing the company to meet its financial obligations and spend money the best way it sees fit. It helps to keep the company out of financial trouble.

And during good times, the company can invest the cash in growth projects without relying on external capital, such as through borrowing and secondary offerings. Debt increases the financial burden due to interest rates and often comes with covenants that limit what the borrower can do. Secondary offerings dilute existing shareholders’ ownership.

If used properly, both debt and equity issuances can result in positive returns for shareholders. But all things being equal, it’s preferable if a company has sufficient internal liquidity to fund all or most of its needs.

PS: Looking for the next big growth opportunity? Consider the latest findings of Dr. Stephen Leeb, chief investment strategist of our premium publication, Real World Investing.

Dr. Leeb’s in-depth research has pinpointed a handful of all-American technology underdogs that are on the verge of becoming titans of their respective markets. And investors who follow his instructions could soon see themselves sitting on more cash than they can shake a stick at. Click here for details.