GMO’s Jeremy Grantham and Lucas White came out with a report entitled An Investment Only a Mother Could Love this past week laying out the prospects for natural resource equities. Here’s the executive summary of their findings and thoughts:

• We believe the prices of many commodities will rise in the decades to come due to growing demand and the finite supply of cheap resources.
• Public equities are a great way to invest in commodities and allow investors to:
  • Gain commodity exposure in a cheap, liquid manner
  • Harvest the equity risk premium
  • Avoid negative yields associated with rolling some futures contracts
• Resource equities provide diversification relative to the broad equity market, and the diversification benefits increase over longer time horizons.
• Resource equities have not only protected against inflation historically, but have actually significantly increased purchasing power in most inflationary periods.
• Due to the uncertainty surrounding, and the volatility of, commodity prices, many investors avoid resource equities. Hence, commodity producers tend to trade at a discount, and they have outperformed the broad market historically.

The team from GMO makes some good points here. If you’re looking to gain long-term exposure to commodities, it rarely makes sense to invest directly in the commodities themselves. You’ll get cash-like returns with stock-like volatility.

I wanted to look back at the performance history of these stocks to check out their other claims. The longest running fund I could find is the Vanguard Precious Metals & Mining Fund (VGPMX). It may not be a perfect match with what GMO is doing but it has a performance history going back to 1985.

David Fuller's view

I have long held Jeremy Grantham in high regard and I maintain that we have only seen this year’s initial recovery for industrial commodities and precious metals.  However, I question this opening bullet point:

We believe the prices of many commodities will rise in the decades to come due to growing demand and the finite supply of cheap resources.

1) Supply is the key variable for commodities.  In boom years it increases steadily, eventually reducing demand and sometimes even encouraging substitution.  Following sharp falls, production eventually declines and demand increases, leading to higher prices. 

2) This causes commodities to be an extremely volatile sector, so prices seldom rise over decades.  Instead, they are more likely to see sharp bull and bear market trends of only a few years’ duration. 

3) Demand for commodities does not grow exponentially, although it can increase in line with global GDP growth over decades.  However, while the supply of industrial commodities is finite, technology ensures that it can be found and retrieved much more easily than in earlier decades.  The world has certainly not run out of crude oil, as alarmists repeatedly told us would occur in the second half of the previous century.  Moreover, technology is proving very effective in creating manmade substitutes for industrial commodities.    

Commodities will remain highly cyclical, so the best strategy remains: buy low, sell high.