Morningstar Advisor - February/March 2013 - (Page 65)

for commodities that have a high value/weight ratio, such as gold. 2. Buy Commodity Futures Investors hold futures contracts that obligate the purchase or sale of a set quantity of a commodity, at a set date in the future, and at a set price. There are three main return drivers of futures-based investments: spot return, collateral yield, and roll yield (gains or losses incurred when a contract expires and is rolled into the next one). A good futures-based strategy attempts to optimize these return drivers. But the futures market can be multifarious, requiring investors to have a thorough understanding of how roll yield works. 3. Purchase Equity of the Producer Choosing the equities of commodity producers has broad appeal for investors. Equity vehicles, such as stocks, are convenient, easy to access, and are less complex than playing the futures market. Using commodity equities also widens the opportunity set to gain exposure to the asset class. Not all commodities have futures associated with them, such as iron ore, timber, water, and coal. It’s also feasible that commodity equities will outperform the commodities themselves in a rising-price environment. For any given percentage increase in price, a producer’s profits will increase by a greater percentage, all else equal. This leverage to commodity prices is greater for higher-cost producers (those with lower profit margins). Furthermore, higher prices usually mean that more of a company’s resources are economical to produce. The investment growth performance of AK Steel AKS and Nucor NUE during the runup in steel prices (which occurred between the recovery from the Asian financial crisis and the peak before the global financial crisis) illustrates the greater leverage to commodity prices for higher-cost producers. A $10,000 investment in AK Steel in 2004 returned more Exhibit 1 Total Assets in Commodity Mutual Funds and ExchangeTraded Funds (U.S.): Commodity-related investment offerings have experienced rapid growth over the past decade. Bil $ Futures & Physical Mutual Funds Equity Mutual Funds Futures & Physical ETFs Equity ETFs 350 300 250 200 150 100 50 2000 2001 2002 2003 2004 2005 than $190,000 by 2009; Nucor returned $70,000 over the same period. AK Steel is one of the highest-cost steel producers in the United States. The company must purchase costly iron ore, and it has significant legacy and financial costs. In contrast, Nucor is one of the country’s most efficient steel producers. The firm has low-cost electric arc furnaces and doesn’t need to purchase iron ore. It has no legacy liabilities and lower financial costs. While AK Steel’s disadvantaged cost position is a serious threat during weak industry conditions, its shareholders benefit from its high degree of leverage during boom times. Commodity Producers—An Analyst’s View There are several elements investors must consider that are unique to using a strategy of buying equities of commodity producers. 1. Cost Profiles As the price of its product changes, a commodity producer’s position on its industry cost curve can have a tremendous effect on its financial performance and, hence, 2006 2007 2008 2009 2010 2011 the performance of its shares. Small, marginal producers with extremely unfavorable cost profiles will tend to see very volatile movements in their share prices from movements in the prices of their commodities. This is because relatively small movements in the prices of the commodities (and in the company revenues) can have an outsized effect on these firms’ earnings. 2. Financial Leverage Highly indebted commodity producers (much like high-cost marginal producers) will tend to see more volatility in their share price performance in response to changing fundamentals. 3. Operational Diversification There are very few pure-play commodity producers of meaningful size in existence. Most producers have exposure to a number of different commodities or end markets. Take BHP Billiton BHP, for example. The firm produces a wide variety of commodities ranging from coal to diamonds. An investment MorningstarAdvisor.com 65 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2013

Morningstar Advisor - February/March 2013
Contents
Contributors
Letter From the Editor
Social Media, the Old- Fashioned Way
Do You Use Active Strategies?
Youth Appeal
How to Buy the Unloved 2013
Morningstar Managers of the Year
Investments á la Carte
Investment Briefs
Approaches to Absolute-Return Investing
In Agriculture, It’s Good to Be Strong
Yes, There Are Good Active Funds
The Decoupling
Where It Could Pay to Be Active
The Active Fund That Defies Obsolescence
The Epitome of an Active Manager
Lines of Communication
The Existence of Market Timing ‘Intelligence’
A Route to Commodities that Bypasses the Futures Market
Best Positioned for Health-Care Reform
Diversified Stock Funds That Earn Their Stars
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
A Twisted Debate

Morningstar Advisor - February/March 2013