Conform Or Be Cast Out
I like unloved assets. I can be a patient investor when I find an asset or an asset class that is unloved, but not truly loathed. When an asset class is loathed, it can take an enormous amount of time to realize value from it although if one’s horizon is long enough and one’s patience deep enough, this is where the best risk-adjusted returns are hiding. But for most of us, finding unloved assets where value is realized over a handful of years is the best we can hope for.
One of the reasons is that asset managers (ahem) tend to be a very impatient lot, and most of their clients even more so. I heard it said once that “the patience of the client is three point zero zero years,” meaning that assets whose value may take more than three years to unlock are potential poison to the asset manager’s business. This is, therefore, where investors with longer time horizons, such as family offices, foundations, and pension funds, ought to focus. The problem is that most of these institutional investors lack the expertise to analyze deep-value propositions in all of the different possible fields, so they tend to rely on sell-side analysts and buy-side firms that clearly have a vested interest in persuading them that, say, farmland is still undervalued after years of being hot, or high-tech stocks are still worth buying back in 1999 because new metrics apply.
I am continually surprised in this context by how few people “get” something as simple as commodity indices. Perhaps it’s because most people think they understand the basic idea: a commodity is something that you can feel, like corn or cattle or copper. Seems simple enough, and since these assets have no cash flows associated with them, our discounted-cash-flow-trained brains tend to view them suspiciously. “If I can’t value tech stocks, because they don’t pay a dividend,” the thought seems to run, “then how can I value commodities? If I rely on another buyer coming along to purchase it from me, isn’t this the same as holding Pets.com and hoping another buyer comes along?” Deceptive similarities like this make investors treat commodities as much riskier than at root they are. The difference, of course, is that there may be value ascribed to Pets.com solely because someone else will pay for it, whereas the commodity item itself has value-in-use. That is, you can grind the corn into meal, you can slaughter the cow to make hamburgers, or you can draw the copper into industrial cabling. If you’re the last buyer of Pets.com, you may have nothing at all; but you will never be the last buyer of corn because there will always be Orville Redenbacher standing behind you.
Pets.com is much more like a dollar bill, when you think about it – it’s only worth something because someone else accepts it as being worth something. You can’t use it, per se, if you don’t like the price.
But commodities – and even worse, commodity futures – seem more ephemeral than stocks. You feel like you own something concrete when you own MF Global stock, or Lehman, or Enron, or General Motors… well, you get the point. What you own is a small part of a business that may or may not be there tomorrow, as the result of management decisions, government action, or a global financial crisis.
Now, all of this doesn’t mean that commodities are automatically undervalued. Some commodities are actually well-liked, such as gold. You either have to look at an independent measure, such as the ones we have developed that relate commodities to currency in circulation, or compare returns to some other asset class that we think we understand better.
And it is here that it becomes really obvious that commodities are really disliked. As of today, the S&P in real terms is just about exactly where it was at the end of the month Bear Stearns collapsed. Yet the DJ-UBS commodity index is still down 34% in real terms. (See chart, source Bloomberg, with 3/31/2008=100).
Equity bulls will tell you this is because stocks got cheap in 2009, and earnings rebounded with the economy. But these same people will tell you that commodities are languishing because of the risk of weak global growth. And commodities, too, were beaten up in 2009 (in fact, the DJ-UBS fell further than stocks). Where is their bounce?
The chart below shows a slightly longer time-frame, dating from roughly the lows of the post-equity-bubble bear market. You can see in this picture that these two markets move together much better, especially in the days since early 2009. The brief (oil induced) commodity bubble shows up in early 2008, but then the current period can only be called a negative commodity bubble (or, perhaps, the beginning of an equity bubble).
So I like commodities, and I like people telling me why they’re dead money. Those people are wrong, or they’re too impatient and that’s the same as wrong. By our measures, commodity indices are between 15% and 25% cheap to fair value while stocks are somewhat rich.