The precious commodity of rising prices

With stock markets flat, investors are going into physical assets like gold, says Simon Hildrey

The film Trading Places was released 20 years ago but in investment terms it seems like a lifetime. The put-upon heroes, played by Dan Aykroyd and Eddie Murphy, gained their revenge on their scheming masters by trading frozen orange juice. If the film was set today, they would be dealing in equities and derivatives.

In 1983, a 20-year rise of 180 per cent in commodity prices had just ended and this was followed by a 20-year bull market in equities.

The Reuters CRB (Commodity Research Bureau) index peaked at 335 in November 1980, but over the next 20 years, excess mining production, the end of Japan's industrialisation and global disinflationary policies led to a fall in the index to a low of 183 in October 2001.

However, the commodities index has subsequently risen to 240 because of the prolonged decline in equity markets until March 2003 and the uncertain geopolitical environment. Gold, for example, recently reached a seven-year high at just under $390 (£235) per troy ounce.

Despite the recovery in stock markets and substantial increases in prices for some commodities such as gold and platinum, there are demand and supply reasons why they could still represent a good medium-term investment. This has led to a number of investment banks issuing positive notes, and First State and Martin Currie launching funds in this sector.

The economic growth of Asia, particularly the 8 per cent a year generated by China, is increasing demand for commodities. With the exception of zinc, China is a large importer of other commodities. It imports three times as much iron ore and steel as the US, comprises 18 per cent of the demand for copper, compared to 16 per cent by the US, and buys 34 per cent of the world's crude steel.

Commodity prices have been boosted by the lack of supply to meet this increased demand. It can take 10 to 15 years to discover and exploit copper and zinc mines, while oil production is being disrupted in Venezuela and Nigeria, as well as in Iraq.

Hugh Hendry, manager of the Odey European fund, is a believer in the commodities story. "They have been the antithesis of the sexy investment over the past 25 years. But that means mines have not been exploited, demand has been rising and supply is inelastic. This leads to higher prices."

Mr Hendry also believes commodities will benefit from a flat stock market, a weaker dollar and high budget deficits in the US that will push investors into physical assets such as gold.

There are three ways in which people can get into commodities. First, they can buy a fund such as Merrill Lynch World Mining, which has produced returns of 236.52 per cent over the past five years, compared to 4.45 per cent by the FTSE All Share. The Merrill Lynch Gold and General fund has, meanwhile, returned 330.85 per cent against 12.57 per cent by the MSCI World index.

Investors can also take a punt on movements - both up and down - in the price of gold and oil through covered warrants from Goldman Sachs that have futures as their underlying investments. The warrants give investors the right to buy (call) or sell (put) gold or oil at a specific price within a certain period for only £12 a trade.

The third way to invest is via the shares of companies in the commodities business. Not all of these necessarily benefit from a rising commodity price: stocks such as BP and Shell will have higher transport costs if the oil price goes up and may suffer a fall in sales at their forecourts. Share prices can also anticipate rises in commodity prices. Investors who wait for the increases to happen run the risk of missing out on the gains in equity values.

Fund managers, however, argue that the importance of commodity prices can be overstated. David Whitten, head of global resources at First State Investments, which is to launch a UK version of its Australian fund, says the price movements are too hard to predict to be the main basis of investment decisions.

"We look for companies around the world with low costs and high margins, which will be profitable even if commodity prices fall," he says. "Research pays because costs of production vary substantially. Gold mining costs range from $50 an ounce at Meridian to up to $280 at Emperor Mines. If you invest in Meridian, gold can fall 75 per cent from its current price of more than $380 and the company is still profitable."

First State's global resources team carries out an average 76 mine visits a year to check equipment and infrastructure, as well as the morale of employees. The fund has delivered an annual return of 27.5 per cent over the past five years. Mr Whitten says the advantage of investing in a fund is the diversification across 25 to 35 shares in 39 countries.

John Dodd, manager of Artemis UK Smaller Companies, has Premier Oil as the biggest holding in his fund. "The demand and supply factors look favourable and there appears more discipline in Opec to keep the oil price high," he says.

"But when investors buy mining stocks, they need to look at the economic fundamentals of the company. Premier Oil has low debt below its asset value."

If the global economy is in the early stages of recovery, both the demand for and the prices of commodities and raw materials will continue to rise. There are risks, however. Commodity prices are vola-tile, while company profits can be hit by movements in currencies, and many mines are located in politically unstable parts of the world. Nevertheless, there is money to be made in them there hills.