In all investing circles, the question of whether to invest in commodities and commodity-related stocks is a hotly debated one. Fundamental analysts argue that commodity stocks reflect the underlying prices of their commodity, making it pointless to invest in them. Others argue that commodity stocks can continue benefiting from a bull run in commodities, where periods of stable high prices continue lifting commodity stocks but may not offer great trading opportunities for commodity traders. Therefore, to settle the issue once and for all, we decided to compare the pros and cons of investing in commodities and commodity related stocks in this article. Firstly, we shall begin with pros and cons of investing and trading in commodities:
Pros of investing in commodities
High Profit opportunity
Commodity prices are known to be quite volatile, and hence can rise and fall very quickly according to the current scenario in the market. This provides great opportunities for commodity traders to utilize their expert know-how about the commodity’s future supply and demand to earn profit.
Investing in commodities can help you diversify and reduce the risk in your portfolio. This is because when commodity prices rise, stock prices can fall due to higher input costs; hence having commodities in your portfolio can help balance the impact caused by commodity prices on other assets.
Hedge against inflation
Commodities greatly benefit from inflation, as when general prices rise throughout the economy, commodity prices rise as well, which can lead to good profits for a commodity investor. Assets such as fixed deposits or bonds lose value due to inflation, unlike commodities which gain more from this macroeconomic trend.
Cons of investing in commodities
Commodities are generally more volatile than equity markets, which is good for traders but not necessarily in the best interest of investors. Commodities can gain and lose a major chunk of their value in a short period of time, which makes it unsuitable for risk-averse investors. It also lacks a fixed interest or dividend income, which affects the liquidity of commodity investments.
Requires extensive market know-how
Just like equities, commodity investing also requires thorough research for achieving profitability. One must know about the major supply and demand factors that impact the chosen particular commodity, and keep a close watch on news of changes in those factors.
Difficult to calculate intrinsic value
Unlike stocks, which have a certain book value based on the company’s assets, it can be very difficult to quantify the intrinsic value of a commodity. For example, during the lockdown last year, oil prices dropped to near $0 due to oversupply of oil, while this year they have crossed $70 per barrel. The value of commodities is strongly affected by market supply and demand, and it is difficult to determine the ‘right’ value of any commodity because of the ever-shifting nature of supply and demand in the global economy.
Hence, investing in commodities entails high volatility and requires thorough knowledge of the commodity’s market, but also provides high profit opportunities, diversification and a shield against inflation. However, should investing in commodity-based stocks be any different? Yes, it is! Here are the pros and cons of investing in commodity-related stocks:
Pros of investing in commodity-based stocks
Lags behind commodity prices
A commodity-based company’s profits are almost entirely dependent on the price of the commodity it sells, and hence its share price follows the price of the commodity. If a commodity such as oil or gold shoots up rapidly, investors can take advantage of the lag in stock prices to invest in commodity-based stocks and earn a reasonable, predictable profit.
Performs great during stable & high commodity prices
While commodity traders may find a lack of opportunity during periods of stable high prices, commodity stocks continue earning abnormal profits overtime, which can push their stock price higher and higher. However, one must keep in mind that commodity-stocks can severely underperform during periods of stable low prices as well.
A great advantage of investing in a commodity-based stock instead of a commodity is that companies often pay out dividends, which is not applicable when investing in commodities themselves. Dividends can provide some annual income for investors, although most commodity stocks may not have a stable dividend payout policy, and would prefer to keep cash with themselves when commodity prices are low.
Cons of investing in commodity-based stocks
Follows commodity prices
Since the majority of the commodity-based company’s profits come from commodity prices, their share price also follows the price of the commodity. Analysts often question whether one should invest in a commodity-based stock, when one can directly invest in commodities themselves and achieve similar returns.
Requires double research
A major problem with commodity-based stocks is that an investor must not only have knowledge of the commodity’s market, but also of the companies selling the commodity. A company with good management and efficient capital management can generate higher returns than a poorly-run company, even during periods of high commodity prices. Therefore, investing in commodity-based stocks requires extensive research of both the commodity’s market and the companies selling that commodity.
Like commodities, commodity-based stocks are also more volatile than other equities, which make them riskier for investors. People who prefer more stability in their investments may not find commodity-based stocks to be an appropriate investment for them, due to its highly volatile nature.
To summarize, investing in commodity-based stocks requires doubly extensive research, have high volatility and follow commodity prices, but also provide dividend payouts and generate great returns in periods of stable and high prices. Both investing in commodities and commodity-based stocks provide great diversification and act as a hedge against inflation in your portfolio, though one must conduct thorough research about the chosen commodity’s market before investing. We hope you found this article helpful. If you liked this article, please share and comment below.