How to profit from falling commodity prices

The merciless arithmetic of investing in commodity producers is imposing itself on many a portfolio: Copper down a few percentage points; copper stocks cut in half. It's nice when the swing works in your favour; when it's conspiring against your wealth, it's an agony not even the Marquis de Sade could dream up.

The bad news is that there's good reason to think that commodity prices are ready to wither even more. Europe is a disaster, the U.S. is too, and China's economy is cooling fast. Since resources are priced at the margin – that is, the last unit of demand sets the price – it doesn't take much of a slowdown to trigger drastic price cuts.

Commodity prices, as more than a few high-profile market watchers have pointed out, are way higher than their long-term trend lines suggest they should be. And while it's true that there are more people clamouring for them today, economies always crest and trough. So commodity prices could be at risk of a steep correction even if the longer-term outlook is favourable.

Depressed yet? Don't be. There are always opportunities, even in a market where 70 per cent of everything is somehow related to resources prices. Keep in mind, for instance, that some companies spend money on commodities rather than earning revenues from them. These producers will benefit – in some cases, a lot – from falling prices.

The trick to spotting these fortunate firms is to dig around and sharpen your pencil, because you'll have to do some calculating. Most companies will disclose somewhere in their filings – the annual report is a good place to start – how much of their input costs are related to resources. Some will even give shareholders a sensitivity table that shows how much a percentage move in certain key input costs affects earnings.

They'll also often reveal sensitivities to currency changes. This is just as important because as commodities fall, so will the Canadian dollar tend to lose value (there are admittedly other factors in the currency markets – political ones notably – but resources inevitably do have an influence). Companies that report in U.S. dollars are especially worth looking at.

Once you have a handle on this, you have to try to guess how much, if at all, a slowing economy will choke off demand for a company's products, and work that in. At that point, you can gauge how much a drop in resource prices and the dollar might offset lower demand.

The accompanying table (based loosely on a packaging manufacturer) illustrates the point. About two-thirds of the company's cost of manufacturing are related to commodity prices. If you run the numbers, a 10-per-cent drop in demand accompanied by lower prices would normally destroy almost a third of the profit. But assuming two-thirds of the input costs are resources, and using the assumptions listed in the table, the company's profits only drop a little.

This is pretty simplistic, of course – commodity prices might fall but rest assured that the suppliers will drag their feet passing the savings on to the company, just as gas stations do with gasoline when oil prices fall. If there are only a couple of suppliers, they can drag their feet for a long time. And there are so many moving parts it's hard to capture them all (where, for example, does the company make its stuff – here or south of the border?) But the point is to demonstrate what might happen.

The company's stock would, of course, get crushed in the meantime. But if you're on the ball, and able to spot the possibly mitigating factors, you might be able to get the shares cheaply.

You have to believe that the relevant resources will fall in price and stay down, and that the loonie will follow suit, naturally. But if you do, you might make the case that the market is overreacting in certain cases. And if you're really lucky you might also benefit from rising prices. Some companies have, over the past year or so, started passing on higher commodity prices to customers. If those prices increases stick in our scenario, the rewards get juicier.

Special to The Globe and Mail

A safety net (of sorts)

Falling commodity prices and a weaker dollar can soften the blows of recession for a manufacturer of products that's exposed to commodity inputs. While revenues fall sharply, profits fare much better in Canadian dollar terms.

Fabrice Taylor publishes The President's Club investment newsletter, focusing on off-the-radar small to mid-cap companies trading at a discount to net asset value. His letter and The Globe and Mail have a distribution agreement. He can be reached at fabrice.taylor@gmail.com.