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The Hidden Dangers of Rising Commodity Prices

By Larsen Kusick, analyst, Phase 1 Investor
Monday, November 22, 2010

"If they're just processors, forget them... Shoot them, in fact."
Jeremy Grantham is a legend on Wall Street. He called the top of the Japanese economy in 1989, the top of the tech bubble in 2000, and the bottom of the stock market in 2009.
When he talks, investors listen. And now he's talking about shooting people. Let me explain...
The prices for most commodities – things like copper, corn, and cotton – are up at least 30% since July. Rising prices are good for some companies ("the producers") and bad for others ("the processors"). Investors who don't recognize the difference between these two are going to get burned.
Producers are companies that have "stuff in the ground." Obvious examples include miners and farmers. Processors are companies that have to buy a lot of raw materials to produce the goods they sell to consumers.
My colleague Matt Badiali has covered how to make money in commodity producers (like gold miners and uranium miners). But to protect those gains, investors must avoid companies that fall into the processor category.
One of the obvious victims of a long-term rise in commodity prices is the apparel sector. These companies buy cotton and other materials, then turn them into a t-shirt or pair of jeans. It's a simple business that fits perfectly into the "processor" category.
Here's the thing: Cotton prices DOUBLED between July and November. And the long-term trend is up. That's going to destroy profits in the apparel sector.
Take a look at the simplified table below. It shows how rising cotton costs squeeze the profit apparel companies earn from a piece of clothing...
Profitability of a T-shirt as Cotton Prices Rise
Rise in Cotton Prices
Cost of Cotton
Other Costs
Sales Price
Gross Profit
Gross Margin
As you can see, profits quickly evaporate if input prices double. As cotton prices rise, a clothing company goes from highly profitable (with gross margins at a healthy 25%) to a losing proposition. The only choice in that scenario is to raise prices for the consumer.
Cotton-based goods make up around 75% of sales for companies like Gap (GPS). For the past six quarters, Gap's gross margins have drifted between 39.5% and 42.5%. That won't hold steady when the company's paying 50% higher cotton prices in 2011.
The only thing Gap can do is increase prices and hope people are willing to pay up for a pair of jeans or t-shirt. Gap's peers, including Abercrombie & Fitch (ANF) and American Eagle (AEO), are facing the same problem...
This is the problem facing almost all processor companies right now.
Take a look at your portfolio... Hopefully, you've added a few commodity producers and are already profiting. You should also make sure you don't have a lot of processors. With commodities in a huge long-term trend, these stocks will drag down your returns. It's time to take them out... and shoot them.
Good investing,

Further Reading:

The two most heavily populated countries in the world are growing rapidly, leaving plenty of upside in several commodities. "It's a major driver of a bull market that will last for a long time," Matt explains. Read more here: The Hidden Driver Behind This Commodity Rally.
Commodities are up across the board. But while coffee, silver, and cotton are seeing double-digit gains, Matt Badiali has one commodity that is still super cheap... and three companies in the sector worth checking out. "These companies are beaten down," Matt writes, "and have the potential to rise a quick 25%." Learn more here: How to Buy the Cheapest Commodity in the World.

In The Daily Crux
Market Notes
Natural gas prices jump 9% in a week... oil prices drop 5%.
Oil and gas fund DIG up 50% in three months.
Carbo Ceramics rockets to all-time high... America's biggest energy trend takes off.
Earnings today... Hewlett-Packard, Tyson Foods, Valspar (paint).
Market Watch
Symbol Price
S&P 500 1197.84 -0.2% +9.8%
Oil 35.05 -0.5% -11.1%
Gold 133.48 +1.0% +18.2%
Silver 27.17 +1.6% +49.1%
US-Dollar 78.42 -0.2% +3.8%
Euro 1.36 -0.5% -8.4%
Volatility 18.37 +1.8% -17.2%
Gold Stocks 554.00 +1.5% +17.2%
10-Year Yield 2.81 -2.4% -16.4%

World ETFs
Symbol Price
USA 120.19 -0.1% +9.8%
Canada 29.55 +0.0% +14.7%
Russia 20.87 +1.1% +8.4%
India 36.76 +0.2% +20.5%
Israel 16.59 +0.1% +13.4%
Japan 10.46 -0.3% +12.4%
Singapore 13.80 -0.2% +21.4%
Taiwan 14.18 +0.7% +14.6%
S. Korea 56.57 +0.1% +22.8%
S. Africa 70.08 -0.8% +27.6%
China 44.48 -0.4% -0.3%
Lat.America 52.41 -0.6% +11.6%

Sector ETFs
Symbol Price
Oil Service 130.38 -0.5% +11.3%
Big Pharma 64.14 -0.2% -1.3%
Internet 71.63 +1.9% +26.8%
Semis 15.27 +1.1% +30.1%
Utilities 31.22 +0.3% +6.7%
Defense 17.85 -0.2% +8.3%
Nanotech 9.89 -0.1% +1.8%
Alt. Energy 9.86 +0.2% -2.6%
Water 17.92 +0.1% +10.5%
Insurance 15.77 -0.8% +17.2%
Biotech 20.33 -0.3% +27.0%
Retail 19.10 +1.3% +26.5%
Software 24.13 +0.6% +22.7%
Big Tech 52.91 +0.8% +21.8%
Construction 12.42 -0.1% +8.2%
Media 13.19 +0.2% +21.0%
Consumer Svcs 65.92 +0.5% +22.2%
Financials 53.14 -1.2% +2.5%
Health Care 64.06 +0.1% +3.8%
Industrials 60.91 -0.1% +17.2%
Basic Mat 71.17 +0.2% +20.9%
Real Estate 53.84 +0.2% +25.1%
Transportation 87.93 -0.2% +24.2%
Telecom 22.25 -0.2% +21.4%

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