Why Commodity Investors Should Focus on Dividend-Paying Equities

(Bloomberg View) -- Over the last year, many bullish commodity traders and investors have chosen to take positions in equities of commodity producers rather than seeking commodity exposure through the traditional route of futures and options. This strategy, which allowed them to reap the double benefits of rising commodity prices and robust equity markets, was particularly successful in the second half of this year: Commodity prices did not have any solid gains until July, whereas world equity markets have performed spectacularly over the entire period.

But now with concern about equity markets that are breaking all-time highs, and a prevailing belief that a major correction is in store, investors are faced with a dilemma of what to do with those long equity holdings. Rather than sell or pare positions, market participants should consider focusing on dividend-paying commodity equities. There’s a value proposition in dividend investing because such stocks historically have had higher returns than the market average, according to many studies. In addition, cash-flow growth, which enables payment of dividends, positively correlates with excess returns.

Studies also show that dividend stocks typically outperform bonds in low interest-rate environments and help prevent wealth deterioration, that is, low-yield income reduced by inflation over time. While inflation is not an issue now, it could become one. And compared to the fixed payments offered by bonds, equity dividends may increase over time. A return of cash in a portfolio should not be overlooked as it represents the risk of losing one’s investment. Dividend stocks can serve to grow cash flow over time and compound returns.

Commodity producer stocks, classified under the basic materials and energy sectors, tend to be high-dividend payers relative to other sectors. Macro factors affecting these businesses are the state of the economy, interest rates and the U.S. dollar, all of which are currently favorable. Commodity producers tend to perform well in a strong economy and are able to expand in a low interest-rate environment.  They also favor a weak greenback as most global commodities are priced in dollars, making them more affordable throughout the world. Geopolitics and mother nature, both which have been and will likely continue to be turbulent, are also supportive of commodities as they produce a supply-side fear and help to maintain upward-sloping forward curves known as contangos. Contentious relations with North Korea and Russia, terrorist groups and global warming and its effects on hurricanes, fires and droughts are not going away soon.

Investors can participate in commodity-dividend stock investing in many ways, including mutual funds, indexes and exchange traded products, but the best pure play approach is through individual shares. 

Nonetheless, there are risks. Dividend characteristics are based on historical payouts, so they don’t use current information and ignore other underlying financial metrics. Settling for low-yield and low-growth dividend-paying stocks will minimize the effect of compounding. Because dividends can only be paid with cash, it is worthwhile to look at a ratio that expresses dividends as a proportion of cash flow, which determines a company’s ability to pay, rather than earnings. On some occasions, a dividend may come in the form of additional shares rather than a cash payout, typically fractions paid per existing share, known as a "scrip dividend."  They can be a warning sign that the company's availability of liquid cash is in short supply.

It is important to distinguish between recurring and one-time cash flow payments. Using operating cash flow without adjusting for non-recurring cash flow may overstate the ability of the company to pay dividends. Applying adjusted earnings and adjusted cash flow can alter the cash flow quality to the extent that what looks like a buy, becomes a sell.

Commodity prices are likely to stand their ground. The Western world is in holiday season, the Chinese New Year is approaching, and travelers are supporting gasoline and jet fuel demand. As the northern hemisphere’s temperature drops, there is heightened demand for heating fuel and natural gas, along with growing food and grain stockpiles. U.S. and Asian infrastructure demand is healthy for metals and mining, and there is enough geopolitical risk to keep supply-side investors on edge. But while equity markets are still on a tear it does not pay to be complacent. Commodity dividend stocks still face the risk of an equity market correction, but they can still provide cash flow during uncertain times.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Shelley Goldberg is an investment adviser and environmental sustainability consultant. She has worked as a commodities strategist for Brevan Howard Asset Management and Roubini Global Economics.

For more columns from Bloomberg View, visit http://www.bloomberg.com/view.

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