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Does the commodity bull market have legs? Is it too late to buy gold ? And should small investors really be messing around with oil and corn and base metals?

Commodities are all the rage, or at least that's what we've been told. Here at Investor Clinic we prefer to get our commodity exposure the conservative way, through oil and gas pipelines that pay us a rising dividend. That way, we don't have to lose any sleep worrying about what direction commodity prices are heading.

We also get commodity exposure through the iShares S&P/TSX 60 index exchange-trade fund, which has about a 47-per-cent weighting toward energy and materials producers.

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But we recognize that some investors may want more direct exposure to the wonderful world of commodities. So we invited John Stephenson, author of The Little Book of Commodity Investing and a portfolio manager with First Asset Investment Management in Toronto, to tell us why commodities are booming and what investors should do about it.

Many commodities have had huge gains already. Isn't it too late to jump in?

The average length of a commodity cycle is 20 years and, even accounting for the rise in commodities at the start of 2000, we are at most four innings into the rally. The average mine takes the better part of a decade and more than $1-billion to bring into service, which is why the cycle is so long. What's more, when commodity prices are high, manufacturers have difficulty passing on these raw material increases in their finished products, so their margins and stock prices tend to suffer. Since rising raw material prices are inflationary and higher interest rates tend to follow higher inflation, bonds suffer when commodities zoom. Commodities zig when bonds and stocks zag, so if you're not considering commodities, why not?

What's the biggest factor driving prices higher?

In the long term, all that matters for commodity prices is supply and demand. To understand demand is to understand China, which is the engine of demand growth. After more than two decades of underinvestment in commodity production and [then]the global financial crisis, supply is nowhere to be found. Copper inventories on the London Metal Exchange represent just eight days of global consumption - a very tight market.

During the 1960s and 1970s, around 75 million people entered the global middle class in Europe, Japan and North America. This time around, hundreds of millions of people in Asia are entering the global middle class while the supply situation is way worse. Prices will go higher and stay higher for longer than anyone suspects. Eventually, supply will adjust and demand will be satisfied and the bull market in commodities will be over - it just won't be any time soon.

What's your favourite commodity?

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Oil. It's a miracle fuel that powers your car, buses, airplanes and is used to make perfumes, plastics and other everyday items and it's cheaper than orange juice on a volumetric basis.

Least favourite?

Natural gas. We have way too much of it in North America and U.S. producers are drilling not because it makes economic sense, but to retain their land base. With no producer discipline, prices are likely to remain in the basement for the foreseeable future.

What's an appropriate portfolio weighting in commodities?

During the 1980s and 1990s, the average investor would have held a zero weight toward commodities. Today, an appropriate weight would be much higher, closer to 40 per cent or more. Of course, your age, risk tolerance and level of investment sophistication will figure prominently in this decision and may cause this weighting to fall.

What's the cheapest way to get exposure to commodities?

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The cheapest way is through exchange-traded funds that are backed by physical commodities. That way, investors get low fees, and the price tracks the price in the here and now as investors would expect.

What sort of allocation do you recommend between the various commodity classes?

Of your total portfolio, including the non-commodities portion, gold should represent 10 to 15 per cent. Of the commodities portion, energy should be 30 to 35 per cent, base metals 25 per cent, agricultural should be 25 per cent and bulk commodities, such as coal and iron ore, around 20 per cent.

So you think gold still has room to run. What about all those poor folks who bought gold back in 1980 at $850 (U.S.) an ounce, only to watch the price collapse?

The U.S. has in the past used the printing press to flood the money supply with more dollars and, in essence, debase the dollar. They did it after the Second World War and they did it after the Vietnam War, and those were both times that gold started to soar. That's why with QE2 [a second round of quantitative easing]being floated there's a lot of concern that's what the U.S. intends to do - inflate away their problems. You want to hold gold if that scenario unfolds. If there's any time to buy gold, it would be now.

What's in your personal portfolio?

All of the things I say. I have about a 15 per cent weighting in gold, mainly gold producers but I also have the SPDR Gold ETF [GLD-N] which is probably the most common. And I have well over half my portfolio in commodity-oriented stocks. I also have some dividend stocks, too, a few bond funds and some cash for buying opportunities down the road.

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About the Author
Investment Reporter and Columnist

John Heinzl has been writing about business and investing since 1990. A native of Hamilton, he earned a master's degree from the University of Western Ontario's Graduate School of Journalism and completed the Canadian Securities Course with honours. More

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