Investment Outlook - The Risks Ahead December 17, 2009, 5:00PM EST

The Case for Commodities

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I think it will be worth 200 by the time the oil rally is over."

Jordan also thinks grains will experience a sharp upswing in 2010. "Outside the U.S. the rest of the world is having a terrible time producing enough grains," he says. "Farmers haven't put down enough fertilizer because the cost of fertilizer has become expensive. But you can only go so long without putting nutrients in the ground before grain yields are less. At the same time there is a rising demand for meat in emerging markets, and the amount of arable land and water resources is declining."

Rather than buy agricultural stocks, Jordan owns a 5% position in the PowerShares DB Agriculture (DBA) exchange-traded fund (ETF), which holds futures contracts that track the price of wheat, corn, soy, sugar, cattle, and hogs directly. "If you want to play agriculture, there are few ways to play it in a stock-specific way," he says. Such futures-oriented ETFs are increasingly popular with investors.

Many ETFs that track individual commodities such as oil or natural gas can be volatile. Because of this, Wilmington's Fraundorf prefers ETFs with diversified baskets of commodity futures. "We've looked at how baskets of commodities have performed over time and found them to be a much better hedge against inflation than any individual commodity," he says. Currently his fund has a 33% position in the PowerShares DB Commodity Index ETF (DBC), a broadly diversified fund.

GOING WITH GOLD

If the dollar declines sharply, the best investment may be gold. "Gold prices aren't based on supply and demand like other commodities," says commodities trader Sperandeo. "They're based on people's desire to run away from paper currency into hard assets." He thinks price moves in other commodities may be correlated with the stock market in the short term, until inflation hits. Right now he's bearish on stocks. So Sperandeo prefers the SPDR Gold Shares ETF (GLD), which owns gold bullion directly, to investments in other commodities.

Gold stocks may not be as safe as bullion, since mining companies face special geopolitical and financial risks. But it is precisely the fear of such risks that often makes them attractively valued. "South African stocks such as Gold Fields (GFI), Harmony Gold Mining (HMY), and AngloGold Ashanti (AU) continue to be somewhat overlooked because of their perceived geopolitical risk," says portfolio manager Rachel Benepe of First Eagle Gold Fund (SGGDX). "But South Africa has a 25% unemployment rate, and the mining companies are its largest employer. The country can't afford to take the risk of hurting that business."

Other, less popular commodities may also present opportunities. Cotton declined for many years only to begin to recover recently along with the price of oil. "Cotton's primary competition is polyester," says Jim Llewellyn, manager of the WorldCommodity Fund (WCOMX). "Since polyester is made from oil, as oil prices rise it becomes less compelling compared with cotton." Llewellyn's favorite in the sector is J.G. Boswell, "the largest cotton grower and one of the best-run farming operations in the world," he says. The company has a not-so-well-hidden asset in the vast quantities of water on its property in California's San Joaquin Valley. Its stock, however, is not very liquid, since the company is closely held by the Boswell family, which doesn't trade its shares much.

Llewellyn is also a fan of natural gas. He likes it as an energy play but also because it is a primary ingredient in fertilizer. "I have a strong view that there will be a shortage of fertilizer in the next 36 months," he says. He favors Canadian gas players such as Birchcliff Energy. As for investors playing these volatile commodities directly via futures, Llewellyn agrees that is best left to the pros.

Braham is a freelance writer in Brooklyn, N.Y.

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