Commodity stocks again in vogue as global economy heats up

Your Money

March 13, 2005|By Tom Petruno

Wall Street has been developing a better appreciation for classic smokestack businesses for the past two years, as the U.S. economy has revived and as China and other emerging economies have stoked demand for raw materials and all sorts of industrial goods.

Lately, however, appreciation of commodity-related stocks has given way to near-panic buying. Some investors who paid no attention to these issues for a decade or longer - if ever - now seem willing to pay any price to get into them.

But the final peak in any market cycle is evident only well after the fact. Some people who are buying mining, energy, steel and other smokestack stocks today believe that many of the companies are in the early phase of a long-term growth cycle, perhaps where the tech sector was at the start of 1997, with two solid years under its belt and three more to go.

"Mining is the tech sector of the new century," says Christopher Ecclestone, an analyst at Hallgarten & Co., a small investment research business in New York.

That kind of talk can get an analyst (and his clients) in trouble, and it's a real stretch to compare an innovation-driven industry such as tech with another that extracts valuable elements out of the dirt.

Nonetheless, Ecclestone makes a good case that strong fundamentals underpin mining companies such as Freeport-McMoRan Copper & Gold Inc., Noranda Inc. and Phelps Dodge Corp.

Mining is a business that has been largely consolidating for two decades, as prices of raw materials fell through the 1980s and 1990s, Ecclestone says. There was no incentive to add production capacity in those decades.

Now, as the global economy revs up - powered by heady growth not just in China, but also in India, the Pacific Rim and Eastern Europe - demand for commodities including copper, zinc and nickel is soaring, and prices have jumped.

The U.S. dollar's sharp decline since 2002 has fed the global hunger for commodities, because raw materials typically are priced in dollars. That means they are relatively less expensive for countries whose currencies have strengthened against the dollar.

And even though many commodity prices are back to their levels of the early 1980s - generating bad memories for fans who remember the peak of the last commodity cycle and the crash that followed - it's important to note that adjusted for inflation, prices of oil, metals and other raw materials are far below their 1980s heights.

Expectations of much more to come have helped fuel the performance of the few mutual funds that focus on commodities. The Pimco Commodity RealReturn fund and the Oppenheimer Real Asset fund, for example, invest in commodity-linked derivative securities. Both funds have been red-hot this year.

If mining companies were to quickly bring on a lot of new production capacity, their boom could fizzle in a hurry.

If they don't add major capacity and global demand remains strong, there's great potential for miners to reap healthy earnings for years to come, Ecclestone and other mining bulls say.

"Users did not pay enough to miners over 30 years to adequately reward the risk that miners take," Ecclestone said. Now "miners can finally write their own checks. No one is rushing to break ranks and add vast new production, even if they could."

He's also betting that a significant chunk of miners' earnings will be returned directly to shareholders via dividends at a time when dividend income again is fashionable on Wall Street.

None of this is news to big investors. They've been hearing it for two years. But that doesn't make it any less true. And in an environment in which many investors are struggling to find stocks that might produce something better than low-single-digit annual returns for the rest of this decade, the smokestack story continues to resonate.

At some point, however, soaring stock prices will factor in virtually all the good news that might be ahead, and then some.

Are we there yet with commodity and other industrial stocks?

Bob Howard, who writes the Positive Patterns market newsletter from Springfield, Mo., has been bullish on energy stocks for some time. But he said he has become wary of the sector as more investors have jumped in this year, driving most big-name oil and gas shares to record highs.

"Now, all of a sudden, the oil doubters are believers," Howard recently told his subscribers. "Now we see people on the tube saying oil will go to $100 a barrel, and everyone nods their head. ... It sounds like all the energy bears are finally throwing in the towel. What does that tell us?"

He's advising clients to consider taking some profits in stocks such as Exxon Mobil Corp.

At the same time, Howard sees opportunities in commodities such as timber and gold.

"I do believe the bull market for these commodities is just beginning," he said, pointing to companies such as timber company Rayonier Inc. and gold miner Placer Dome Inc.

The risks in the commodity story are many: Rising interest rates could dampen world growth; the dollar could strengthen; raw-materials production capacity could expand at a much faster rate than investors are expecting; or the stocks could get too far ahead of the companies' fundamentals.

The good news is many investors automatically shun these stocks, Ecclestone said. "It's just anathema to them that anything so old and crusty could be sexy," he said.

But that also means there is a big crowd of potential converts if the commodity story keeps improving.

Tom Petruno is a columnist for the Los Angeles Times, a Tribune Publishing newspaper.

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