Editor's note: Yesterday, we kicked off our guide to making a fortune in resource stocks by sharing the most important aspect of the sector. We're continuing today with an essay that originally appeared in Growth Stock Wire in December 2011. In it, Matt Badiali breaks down the best ways to invest in natural resources...
Tuesday, August 23, 2016
Yesterday, I showed you that you must master the resource cycle in order to succeed as a commodity investor.
Now, let's say you understand "you're either a contrarian or a victim." And you've found a specific sector – like gold or oil – that allows you to take advantage of contrarian bargains.
Next, you need to "get long." And the decision you have to make is what tool to use for the job.
There are several ways to make a bullish bet on commodities. Each has its pros and cons... its particular risks and rewards. One investment might be a great idea for some folks, but terrible for others.
Today, I'll show you how to choose...
When it comes to resources, we can put our trading "tools" into seven broad categories.
Below, I'll give you a "thumbnail" overview of each category and rate it on a scale from 1 to 10, from relatively conservative to relatively risky. (Only experienced traders who can handle volatility should even consider putting money in anything with a risk rating of 10.)
One more note before we begin: These ratings are specific to the resource market... I'm not considering how risky any of these categories are relative to bonds, real estate, or blue-chip stocks, for example.
Let's get started on the "low risk" end...
If you're bullish on a given commodity and you have the means, just buy the stuff! That's the advice you'll hear from investors who don't want to trade in and out of stocks.
The problem is, most commodities don't lend themselves to low-cost, efficient storage. Sure, you can buy 10 ounces of gold bullion and store it in a vault. But most folks don't have the means to store corn, crude oil, natural gas, uranium, or cotton.
Generally, buying the physical commodity itself only works with precious metals like gold, silver, and platinum. They have tremendous "value density" – just a handful of one-ounce coins can add up to $10,000.
So owning a stash of gold, silver, and platinum coins is a great idea, in my opinion. It's real, tangible wealth to keep on hand in case of a dollar crisis... or if you need to discreetly transfer a large amount of wealth.
Risk rating: 1
In any given commodity sector, there are usually a handful of giant producers that dominate the industry. They have the money to hire most of the best people... They manage the biggest projects... They buy the most equipment... And their capital spending "sets the tone" for the rest of the industry.
In the gold sector, for example, a handful of large producers mine most of the world's gold. These include Barrick Gold (ABX), Goldcorp (GG), Newmont Mining (NEM), and AngloGold Ashanti (AU).
In the oil sector, you have ExxonMobil (XOM), Royal Dutch Shell (RDS), and Chevron (CVX), in addition to large, state-owned companies that aren't publicly traded.
The "biggies" typically have been around a long time and have fairly stable businesses. They have a mix of assets around the world. Their market caps are anywhere from $10 billion to $300 billion (depending on the industry), and many pay dividends.
This means they are less volatile than smaller companies... and are appropriate for conservative investors.
They are not without risk, however. A big fall in the price of the commodity they produce can send their shares lower. Likewise, shares might stall if increases in their production costs outpace increases in the price of the commodity they produce.
Risk rating: 2
EXCHANGE-TRADED FUNDS, PART I
When it comes to resource investing, exchange-traded funds (ETFs) come in two different "flavors"...
One flavor owns a diversified basket of exploration and production firms. For example, the iShares U.S. Energy Fund (IYE) owns a broad swath of oil producers, explorers, and various other energy firms. Today, the fund owns nearly 80 different energy stocks.
When it comes to gold, a popular fund is the VanEck Vectors Gold Miners Fund (GDX). This fund owns 50 different gold stocks – some large, some small.
When you own a diversified basket of stocks, you give up much of your upside. You'll also end up owning lots of so-so companies. But these ETFs can give you exposure to a sector without subjecting you to the risk of owning just one or two companies. These are appropriate for risk-averse investors.
Risk rating: 3
This is one of my favorite categories. Royalty companies are a unique and efficient way to invest in a given resource trend.
Most royalty companies are in the gold and silver sector. But they mine no metals of their own. Instead, they finance a lot of early stage exploration or production projects. When a mine they finance starts producing, the royalty company gets a cut of the cash flow.
Royalty companies are high-profit-margin, diversified, and leveraged ways to speculate on higher commodity prices. The large royalty firm Royal Gold (RGLD), for example, climbed 23-fold from mid-2001 to 2011. The large silver royalty firm, Silver Wheaton (SLW), climbed 14-fold from its credit-crisis low in 2008 to its 2011 high.
If you buy quality royalty firms when their underlying commodities are out of favor, you can set yourself up for huge gains. But always keep in mind that their share prices can fall if their underlying commodity enters a bear market.
Risk rating: 4
"PICKS AND SHOVELS"
Another one of my favorite ways to invest in a resource boom is with "picks and shovels." These companies provide vital equipment and services needed to explore for and extract resources.
The classic "picks and shovels" success story is set in the 1850s. Back then, a German immigrant moved from New York to San Francisco to participate in the California Gold Rush. Rather than the "all or nothing" route of looking for a big gold strike, this guy sold basic goods to the miners. He eventually started producing a new type of durable pants. They became a huge hit... and he got rich.
His name was Levi Strauss. Levi didn't risk it all on trying to find the big strike... He just sold the stuff everyone else needed to try to find the next big strike themselves.
The idea of owning "picks and shovels" has become an investment cliché for good reason. It can be an incredibly profitable, diversified way to profit from rising commodity prices.
When it comes to modern-day "picks and shovels," we have a wide variety of ideas to consider...
You have companies like Schlumberger (SLB) and Halliburton (HAL). These two companies are giant "oil services" providers. They sell equipment and services to large oil companies...
There is Joy Global (JOY), which sells mining equipment... and Core Laboratories (CLB), which performs advanced seismic research so oil companies know where to drill...
You have companies like Trican Well Service (TCW.TO) and Calfrac Well Services (CFW.TO), which perform the latest type of "hydraulic fracturing" services that have revolutionized North American energy production...
There is Kennametal (KMT), which sells extremely durable cutting teeth and blades to explorers. And there is Fairmount Santrol (FMSA) and Hi-Crush Partners (HCLP), which provide frack sand to oil and gas producers.
The variety of "picks and shovels" choices is extraordinary. And one well-timed buy when these companies are out of favor can make for hundreds-of-percent gains. But always keep in mind that these companies boom when times are good and bust when times are not so good.
Many of the above companies saw their stock prices bottom earlier this year when times were bad. Today, they're less bad. For example, the sand producers have all jumped at least 100% since the beginning of the year. And Japanese equipment maker Komatsu announced in July that it would acquire Joy Global.
Risk rating: 4
THE MID-TIER PRODUCERS
You can consider mid-tier producers "biggies in training." Mid-tier producers are still relatively large companies, with market caps ranging from $1 billion to $50 billion (again, depending on the industry). But mid-tier producers typically have a narrower asset base. For example, a gold mining "biggie" might operate 10 large mines around the world, while a mid-tier producer might operate just two or three large mines.
Because mid-tier producers have less asset diversification, they are riskier than larger, more diversified companies. If a mid-tier producer has a major problem with one of its mines or oil fields, it will cause a huge swing in its profitability and a huge swing in its share price.
Still, these companies can be great investments if they have smart managers. There's more potential for growth with mid-tiers than there is with the "biggies."
Risk rating: 5
EXCHANGE-TRADED FUNDS, PART II
The second "flavor" of resource ETFs are "pure play" funds. There are funds that rise and fall in lockstep with gold and silver prices, for example. There are funds that attempt to rise and fall with oil, natural gas, and copper prices, too.
The SPDR S&P Oil & Gas Exploration & Production Fund (XOP) and VanEck Vectors Oil Services Fund (OIH) are examples of pure play funds.
I'm generally not a fan of these kinds of funds. Most of them "bleed" value because they have to trade in the futures market... and they charge substantial fees.
Also, when it comes to owning "real money" assets like gold and silver, why own "digital" when you can own the real stuff?
Risk rating: 8
NONPRODUCERS WITH GOOD ASSETS
"Nonproducers with good assets" is an odd class of resource stock. These are companies that own one or two large assets that could be turned into mines or oil fields... but, for some reason or another, have not been put into production.
Seabridge Gold (SA) is one of the highest-profile companies in this class. It owns the KSM Project in British Columbia, Canada. KSM is one of the world's largest undeveloped gold and copper deposits. It's an absolute monster, with 38 million ounces of gold, 10 billion pounds of copper, and 191 million ounces of silver in proven and probable reserves.
The problem with KSM is that it's in an inaccessible area of Canada. Huge investments in roads and electrical infrastructure are required to mine KSM. We're talking billions of dollars. Still, if gold prices were to keep soaring, it would be worth it.
You can make good money in these types of plays if you buy them when their underlying commodity is in the pits... and on the cusp of a big rally. From 2005 to 2008, for example, Seabridge Gold rallied more than 1,000%.
But investors have to be very careful buying these companies. Often, these big deposits have big factors working against them... like environmental concerns, political concerns, or, in Seabridge's case, a remote location. They are among the riskiest plays in the resource market.
Risk rating: 9
Junior explorers are the "bloodhounds" of the resource industry. Their market caps are typically in the $5 million-$100 million range, miniscule next to a "biggie." (ExxonMobil is 1,000 times larger than a $36 million "junior.")
The business model here is to find a prospective area that could be rich in metals or oil, raise money from investors, hire geologists and buy some drilling equipment, and look for a big strike. If it finds that big strike, the junior will sell it to a larger company.
Early investors can make 1,000%... 5,000%... even 10,000% here. But this is the "Wild West" of the resource stock world. Junior explorers are the riskiest area of the market. They are inappropriate for 99.9% of investors. They have little in the way of tangible assets. They are essentially a group of corporate managers and geologists with a dream and a story.
The vast majority burn up their cash and find nothing.
In any given industry, however, there are some folks who are habitually successful when it comes to finding big resource deposits. If you stick to investing with proven, honest managers, you can make great money in "juniors." Just keep in mind that out of a random selection of 1,000 junior explorers, just five or 10 are worth considering as a speculation.
Again, most investors should steer clear of this market, which has less trading liquidity and lots of worthless companies masquerading as "investments."
Risk rating: 10
When it comes to "playing" a resource trend, you have lots of tools. You have to decide for yourself how much risk and volatility you can tolerate.
"Biggies," mid-tier producers, royalty firms, the physical assets, selected funds, and picks and shovels can all work well.
I recommend avoiding most "pure play" funds. I only recommend "juniors" to folks who are comfortable with handling risk and volatility.
You might note that I've left the futures and options markets off this list. I know many folks who are successful in these areas of the market, but they're totally inappropriate for most individual investors... and these ideas are outside the scope of what I do. Please only swim in these waters if you are an advanced trader.
You now have the tools to succeed. Tomorrow, I'll cover the best strategy to "ring the cash register" with resource stocks. You can follow this plan to safe, triple-digit gains.
Editor's note: Matt is presenting next month at the 2016 Stansberry Conference in Las Vegas. The event is nearly sold out... But if you didn't have a chance to buy tickets, you're in luck. We've arranged a way for you to watch the event from the comfort of your own home. You'll hear from many of Stansberry Research's top analysts, as well as resource expert Rick Rule... a $15 billion hedge-fund manager... a former White House economic director... and many, many others. Learn more here.