Week 115 - Capitalization-weighted Commodity Index (Updated)

Situation: Back in Week 49, we took a stab at creating a commodity index referencing stocks issued by key producers. It was intended to be a quick guide to the most volatile stocks in a favorable period, i.e., during rapid urbanization. To do that, the index needed to include companies that make the products most in demand and are marketed in all of the urbanizing regions. Our 8-company list came up short on both scores, so we’ve added 7 companies: duPont (DD), Occidental Petroleum (OXY), Potash (POT), Enbridge (ENB), Alcoa (AA), FMC (FMC), and BHP Billiton (BBL).

Mission: Create a capitalization-weighted index of 15 companies that have a primary focus on commodity extraction, production, packaging, or transportation. Demonstrate recent as well as long-term finance values, recent as well as long-term total returns, dividend information, debt, return on invested capital (ROIC), free cash flow per share (FCF/Sh), and multiple statistical presentations of recent and long-term volatility. In the Table showing these items, highlight any metric in red that fails to meet the standard of our recommended anchor investment: Vanguard Balanced Index Fund (VBINX). Include an appropriate benchmark, i.e., the lowest-cost no-load mutual fund that is most representative of natural resource stocks: T Rowe Price New Era Fund (PRNEX).

Execution: What does the Table tell us?
        A) Since the end of the “dot.com recession” over 11 yrs ago, total returns are 14.3% vs. 6.9% for VBINX (Col C). But this has been at the expense of greater risk. Losses of 34.3% were accumulated during the Lehman Panic vs. overall market losses of 28% (Col D). Risk-adjusted returns (Col E) show that only 9 of the 15 companies have “Finance Value” vs. VBINX, i.e., are worth committing your funds over the long-term. But overall, our 15 companies had risk-adjusted returns on a par with VBINX. 
        B) How have those 9 better-performing companies been doing recently? There we look to the Barron’s 500 table for guidance, since it tells us recent trends in sales and cash flow. Only two of the 9 showed improvement in 2012 vs. 2011: Monsanto (MON) and Canadian National Railroad (CNI).
        C) What about dividends (Columns I-K)? Dividend yield is 2.6% vs. 1.9% for VBINX, and dividend growth is 9.5% vs. 2.2%; 9 of the 15 companies have increased their dividends annually for at least the past 10 consecutive yrs.
        D) Capitalization-weighted returns were a full 1.2% higher (Col N) than average returns (Col C), indicating that larger companies have an advantage over smaller companies. (The opposite holds true for almost all of the 10 S&P industries.) The companies with the most impact are BHP Billiton (BBL), Monsanto (MON), Occidental Petroleum (OXY), and Chevron (CVX).
        E) Risk is a different story (Columns P-S): Only 4 companies lost less than the balanced index fund (VBINX): FMC, Enbridge (ENB), Chevron (CVX), and Exxon Mobil (XOM). Only one of those (XOM) had a tighter range of annual returns over the past 11 yrs and only two (XOM & ENB) had better 5-yr Beta values. However, Enbridge (ENB) is a pipeline company funded primarily with long-term debt (62.3% of capitalization). That presents a risk of default should the company have to rollover a large maturing loan during a credit crunch.
       F) How efficient are these companies (Col T)? Using a standard of 12% return on invested capital (ROIC) we see that 10 of the 15 have efficient operations: MON, FMC, POT, CVX, XOM, CNI, BBL, SLB, CAT and DD. Exxon Mobil (XOM), as always, is the standout in this regard.
      G) How does our Index stack up compared to a large natural resources mutual fund with ~100 companies (PRNEX)? On average, Index returns are greater and losses are less.

Bottom Line: Let’s start by recalling that on a risk-adjusted basis you can’t beat the S&P 500 Index. Yes, I know, two guys have done that. Peter Lynch ran the Magellan Fund in the 70s and 80s and beat the S&P 500 Index for 22 consecutive years but he did that by including ~1000 companies and doing superhuman research on those companies (helped by a large staff). Warren Buffett couldn’t do it consistently by stock-picking so he turned to company-picking and now owns over 100. Though he hasn’t beat the S&P 500 Index every year, he has beat it for every rolling 5-yr period over the past 40+ yrs while taking less risk (current 5 yr Beta =0.25). Your only chance of beating the S&P 500 Index is to take more risk or buy stock using insider knowledge (which is illegal in the US).

The world is urbanizing at a rapid rate, so this is the time to bet on infrastructure. That means betting on commodity producers, and here’s a terrific article about commodity cycles to help you decide if that’s something you’re willing to tackle. Five of our 15 companies are in the 30-stock Dow-Jones Industrial Average (DJIA): CVX, XOM, CAT, DD and AA. You might want to start your research there, since the DJIA outperforms the S&P 500 Index most years (DIA in the Table).

Risk Rating: 9

Full Disclosure: I have significant holdings (over 100 shares) in XOM, CVX, and OXY.

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