When Commodities Attack!

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You know about stocks and bonds, but there are a few other investment classes out there that most individuals don't think much about, especially as they relate to individual companies. One is foreign exchange, which I've already talked about. Another is commodities, probably the world's oldest investments. Almost every type of business relies on commodities in some way, making it important for every investor to think about the broad implications of how their companies operate.

In a nutshell, commodities are raw materials like steel, cotton, sugar, or coffee beans. They are "fungible," which means they are the same no matter who produces them. Thus, extrinsic things like brand don't factor into the price of a commodity, only supply and demand. Unfortunately, supply and demand have their own problems.

For many important commodities like cotton or coffee beans, production is done mostly in a few areas of the world, so supply can be affected by currency risk, or even weather. Political risk is also a factor when a commodity is concentrated in one region, as we've seen with Middle East oil. Recent Chinese actions involving rare earths exports are also causing some worry about limited geographic scope of commodities production.

All the beans are in one basket
Take coffee, for example. Java companies like Starbucks (Nasdaq: SBUX  ) , or even Maxwell House and Yuban owner Kraft (NYSE: KFT  ) , have had to raise prices this year because of a double whammy of (1) poor weather in Brazil hurting coffee crops and lowering supply, and (2) the Brazilian real rising against the dollar. Brazil is by far the world's largest producer of coffee beans, so any large purchaser of beans has few other options if Brazilian coffee is too expensive, and one year of bad Brazilian weather could wreak havoc on a coffee company's margins.

Meanwhile, bad weather in China already damaged cotton crops, which, coupled with the flooding in Pakistan this summer, has caused cotton prices to nearly double in the past six months, putting a damper on third-quarter margins at clothing manufacturers like Hanesbrands (NYSE: HBI  ) and Abercrombie & Fitch (NYSE: ANF  ) .

Hedge maze
Fortunately for producers and buyers alike, the futures market exists. A large amount of commodities are bought and sold at the "spot" price, which is the current market price. But futures allow a buyer or a seller to lock in a certain price for a certain date in the future, hedging the risk. It's similar to filling up a tank of gas at today's price (the spot price), versus filling up a bunch of spare gas canisters when gas is cheap, anticipating that it will go up soon.

Southwest Airlines (NYSE: LUV  ) is known for employing just such a strategy, hiring full-time oil specialists to watch the market and buy oil futures when the price is right, allowing Southwest to keep ticket prices low even when fuel prices are skyrocketing. When gas was soaring in 2008, oil hedging allowed the company to get more than 70% of its oil needs at less than half the going market price, giving it a huge advantage over competitors that were forced to raise ticket prices or impose new fees.

One company's pain is another company's gain
Aside from looking for companies with intelligent hedging, an investor could also profit by investing in commodities scarcity itself. Fertilizer companies like PotashCorp (NYSE: POT  ) and seed companies like Monsanto (NYSE: MON  ) are in the business of making things grow against the odds. As long as bad weather hurts crops, farmers will be looking for ways to make their crops more weather-resistant. And as the world's population keeps growing, demand for staples like wheat and cotton will increase, driving demand for things like pesticides and more productive seeds. The growing needs of China, for example, are also part of what has been pushing cotton prices higher, as China's growing middle class begins to shop more.

The cost of doing business
Just about every company that produces something has some cost component that relies on commodities, whether it's auto companies with steel, food manufacturers with wheat, or even toy makers with oil for plastic. It's important to understand how commodities affect companies you invest in, whether the rising price of goods will hurt margins, give the companies a competitive advantage, or even increase the need for certain products.

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Fool contributor Jacob Roche would like to thank Santa for that Wii he asked for, and hopes everyone had a great holiday and will have an excellent new year. He owns call diagonals on Starbucks but holds no position in any of the other stocks mentioned.

Southwest Airlines and Starbucks are Motley Fool Stock Advisor recommendations. Motley Fool Options has recommended a synthetic long position on Monsanto. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (6)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 03, 2011, at 2:23 AM, lowmaple wrote:

    What % of beans does Starbucks buy from Brazil?

  • Report this Comment On January 03, 2011, at 2:58 PM, shaileshnita wrote:

    It is a very good article : educative too. I always wondered about the issues discussed in this article - namely, investor's perception of the future of the company based on the price of raw materials that the company uses. In fact, this issue is very relevant when you see a stock with a very "impressive" valuation.

  • Report this Comment On January 03, 2011, at 4:27 PM, TMFTheDoctor wrote:

    Lowmaple - I'm not sure, they don't give exact numbers, but it has to be a pretty decent figure. Starbucks gets its coffee from all around the world (some of the blends are regional so they have to come from Africa, Asia, the Middle East, etc), but since Brazil is the largest exporter of beans they're bound to get a large amount from there.

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