One of basic tenets of portfolio construction is following the principles of asset allocation. This is much more applicable and valid for do-it-yourself individual investors. In this context, at a minimum, I need to look at and at least consider evaluating all possible asset classes. While doing this, I also have to keep in mind that my portfolio is based on dividend growth philosophy. Among others, a commodity is also one asset class which I believe I should be investing. The next question is what should be my investing vehicle?

In recent years, commodity has been in news due to continuous increase in market price. This price increase was not restricted to any one particular commodity, but just manifested itself to all types of commodities. Commodities include agriculture products (grains, oil seeds, fertilizers, pesticides), bullion (gold, silver, platinum), Oil and related products (crude oil, natural gas), chemicals and petrochemicals (additives, fibers, yarns, paints, polymers), Metals (iron, steel, aluminum, zinc, etc). So you see it is indeed a very large domain. Now what does it really mean to trade or invest in commodities? It does not mean we buy or sell or invest in real physical commodity.

Similar to other markets in the world, in India also, the trading of commodity is under the umbrella of futures or options trading. In very basic terms, any commodity trading takes place using financial derivate instruments (a.k.a. futures or options). What it means is “contracts are prepared for commodities”. These contracts are then bought and sold, i.e. traded on the exchange. In our country, there are three national three national commodity exchanges viz., Multi Commodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX) and National Multi-Commodity Exchange (NMCE). All of these three commodity exchanges are regulated by a Forward Markets Commission (FMC).

My viewpoint is, these futures-based trading or options-based contract trading are just designed for speculation. Think about for a moment. The actual physical product is not being traded. There are less than 20% of the contracts that get converted into physical exchange of real commodity. If that’s the case, only the paper value is being traded. Speculators just raise the market level and cash out. The speculative boom of late 2007 and early 2008 was very good example. Crude oil touched $140 per barrel, why? The largest consumer US economy was slowing down, there was no shortage! Similarly, was there any real shortage of agricultural grains in India. I am of the view that India did not have any shortage. In both of these cases, the speculators created a virtual shortage and bumped up the prices. Demand in either of these commodities just does cannot vanish in thin air within few months. I haven’t seen people driving less or eating less! Do you see it?

As an individual investor I need to understand how these different forms of investment vehicles (i.e. futures or options) fit into my portfolio, what my expectation is, and what is my objective for investment in them. These derivates are not similar to equities. And as with any other investment vehicle, what is the price I am willing to pay?

In general, I do not find these derivatives as worthy investment vehicle. In their current format of trading in futures contracts and options, these do not meet my objectives and hence have no role to play in my portfolio. Perhaps they will never be unless there is any change in format (which I do not expect).

However, I do want to own commodity as an asset class. So I like to invest in business corporations that do business in commodity extraction, processing, marketing, etc. These are very good proxy for investing in commodity asset class. There are quite a few corporations that have profitable business models in almost all types of commodity business. One of the characteristics of almost all commodity businesses is that it is a very cyclical in nature. I believe that’s where the opportunity lies for dividend investor. Knowing that business is cyclic, we need to look for corporations that manage it around this constraint. Consistency and/or growth in dividends is a perfect measure for this aspect.

For example, following are some profitable business corporations that do business in commodities. I am studying quite a few of these for potential future investments:

• Chemicals (RIL, Atul, Bombay Dyeing, Finolex, Castrol India, Pidilite);

• Agriculture/Fertilizers (Tata Tea, GNFC, Deepak Fertilizers, GNFC);
  

• Oil (ONGC, RNRL, RPL, BPCL, Essar Oil, Cairn India Ltd);

• Steel/Iron/Aluminum (SAIL, NMDC, Sterlite, Tata Steel, Hindalco, Nalco, Jindal Steel, Ispat, Hindustan Zinc, Gujarat NRE Coke, NMDC, Sesa Goa);

• Gold (Titan)

While it is true that not all pay consistently growing dividends, but that’s the case in all sectors. As a dividend growth investor, I need to pick those that I think best suits my portfolio objective.

What this shows is there are so many corporations in commodity business, that any individual investors can easily avoid these commodity derivates. Investing in good quality individual corporations are very good proxy for commodity asset class.

What investment vehicles do you use for commodity asset class? Leave your comments as I would like to understand your viewpoints and perspective about investing in commodity asset class.

Full Disclore: Long on ONGC and Pidilite

Atul, Bombay Dyeing, BPCL, Cairn, Castrol, Deepak Fertilizers, Essar, Finolex, GNFC, Hindalco, Ispat, Jindal, Pidilite, RIL, RNRL, RPL, SAIL, Sesa, Sterlite, Tata, Titan