TCS Daily


Brains vs. Things

By James K. Glassman - March 26, 2004 12:00 AM

One of my heroes is the late Julian Simon, the University of Maryland economist who challenged the conventional wisdom that the world was getting overpopulated and would soon run out of food and other critical resources.

The best evidence of increasing demand and diminishing supply is, of course, higher prices, so to prove his point Simon in 1980 made a famous bet with Paul Ehrlich, who had been predicting catastrophic shortages.

Ehrlich, a Stanford biologist, could pick any five metals he liked. If the 1990 price of the metals after inflation rose, then Ehrlich would win. In the event, each of the metals -- copper, chrome, nickel, tin and tungsten -- fell in price, by an average of about 40 percent. Simon won.

"Simon's central point," wrote my colleague Ben Wattenberg in 1998, "was that natural resources are not finite in any serious way; they are created by the intellect of man, an always renewable resource." In other words, human intelligence, with the right economic incentives, can find ways to get more oil out of the ground or substitute plastic for metal or use less copper (or none at all) to transmit signals by telecom.

Partly because of Simon's influence, I have always been reluctant to buy stocks in the natural-resource, precious-metals or materials sectors. In fact, my 2002 book, "The Secret Code of the Superior Investor," includes a chapter titled "Don't Invest in Things. Invest in Brains."

And yet. . . .

There is one reason to invest in things that I can recommend without reservation. Things -- let's call them "commodities" -- have very little correlation with stocks or bonds.

Just last week, I received one of those rare items: a promotional brochure from an investment firm that focused on a truly compelling idea. The brochure, from Morgan Stanley, was mainly a large, color-coded chart that showed graphically how six asset classes had performed in the 23 calendar years from 1980 to 2002.

None of the six classes -- Nasdaq stocks, European stocks, large-cap U.S. stocks, corporate bonds, Treasury bills and managed futures -- "has consistently outperformed all other types of investments," wrote Morgan Stanley. "By prudently distributing funds among several asset classes, an investor can potentially reduce overall portfolio risk and increase the chances of achieving greater returns."

I am not sure about the "greater returns" part, but I am convinced that, by spreading your assets across several categories that don't move up and down together, you'll modulate the severity of the ups and downs of your portfolio's value. In other words, you'll get a smoother ride.

Things, or commodities, are represented on the Morgan Stanley chart as the Barclay's CTA Index, the benchmark that tracks the performance of more than 300 "commodities trading advisors" -- that is, specialists who run programs that invest in contracts to buy food, metals and other things.

Over the 23-year period, managed futures finished in first or second place eight times -- exactly as many times as the Standard & Poor's 500, the index for large-caps. But, typically, when the S&P did poorly, futures did well -- and vice versa. For example, in 2002, futures rose 12 percent while the S&P dropped 22 percent; in 1998, the S&P rose 29 percent while futures rose only 7 percent. According to my calculations, the annual average increase for managed futures between 1980 and 2002 was 15.5 percent, for the S&P 14.5 percent. Very close, but very uncorrelated.

Morgan Stanley points out that during each of the eight quarters over this period when the Citigroup Bond Index experienced negative returns, the Barclay's CTA Index averaged a gain of 6 percent while the S&P fell an average of 4 percent and corporate bonds fell an average of 3 percent. In other words, futures were a great hedge against declines in both bonds and stocks.

The fact that managed futures performed so well overall is not a refutation of Julian Simon's thesis. Managers of futures programs play both sides, sometimes shorting commodities because they expect prices to fall, sometimes going long (or buying) because they expect prices to rise. And, of course, managers don't buy all commodities; they pick and choose among vast choices, including gold, natural gas, soybeans, coffee, pork bellies, corn oil, cotton, cattle and dozens more.

Taken as a whole, commodities had a rough time in the 1990s. Between 1991 and 1998, for example, the Goldman Sachs Commodity Index (GSCI) -- which reflects the prices of energy, metals and agricultural futures -- was flat. During this same period, however, managed futures programs rose an average of 7 percent annually, after accounting for commissions.

While managed futures look like mutual funds, they are typically limited partnerships with restrictions on who can invest and when you can take your money out. Managed futures are sold through brokerage firms, and the commissions are high -- 4 percent a year is not unusual. Initial investments can be lofty and, since trading is often frenetic, you can run up big tax liabilities in a good year. Be sure you understand what you are getting into.

Programs sold by Merrill Lynch & Co. are run by Campbell & Co., which, according to Merrill's literature, "uses a computerized, technical, trend-following approach combined with quantitative portfolio management analysis." Don't worry too much about what that means. When you buy managed futures, you are buying a black box that, you hope, spews out returns that will, again in Merrill's words, "potentially reduce overall portfolio volatility by diversifying beyond traditional investments."

Right now there's a separate case for investing in things: They're going up in price. The GSCI has doubled since the end of 1999, and the Dow Jones-AIG Commodity Index has risen by about three-quarters since mid-2001.

There are three reasons for these increases: First, the dollar has fallen lately, which means that it requires more dollars to buy a commodity with constant value. Second, supplies have been tight because businesses cut back on expansion during a worldwide recession and are still reluctant to invest heavily in getting things out of the ground or turning them into products. And, finally, demand is rising as China, especially, booms and gathers raw materials from around the globe to feed its people and its industries.

China, as Charles Allmon writes in his Chevy Chase newsletter, Growth Stock Outlook, "consumes more copper than any other nation, and they're growing as a formidable oil guzzler. Long term, China's demands on raw material and commodities could change the price equation drastically."

Buying commodities futures contracts -- which are promises to buy or sell a certain amount of stuff on a specific date (say, 1,000 barrels of light, sweet crude oil in June 2005) -- is an extremely risky business. Investors typically use tremendous leverage, putting up small amounts of cash to "control" large positions.

If you are long and prices rise, you can make a lot of money in a short time, but if prices fall, you can get wiped out -- and then some. This is an investment where you can lose more than you put up. Your liability is unlimited, and nine out of 10 commodity speculators (let's not call them investors) lose money.

So stay away from futures contracts.

There are alternatives. You can buy mutual funds that specialize, not in things themselves, but in companies that profit from the extraction and production of things. One of the best known is T. Rowe Price New Era (PRNEX), which is the first mutual fund I ever purchased; that was more than 20 years ago, and I still own it.

For the 10 years ending Feb. 29, New Era has returned an annual average of 11 percent, or about four-tenths of a percentage point less than the S&P 500. More important, however, its correlation to the stock market has been very, very loose -- just what you want in a portfolio. For example, in 2000, when the S&P fell 9 percent, New Era rose 20 percent; in 1997, when the S&P rose 33 percent, New Era rose just 11 percent.

Overall, New Era's volatility has been pleasantly low, and the fund has earned a risk-adjusted rating of five stars (tops) from Morningstar, the Chicago-based research firm.

Charlie Ober, the fund's manager since 1997, keeps turnover to a minimum, holding the average stock for about five years (compared with just one year for the typical fund), but the mix of sectors does vary with time. Currently, 60 percent of his assets are in oil and gas stocks, including large holdings in Devon Energy (DVN), an Oklahoma-based exploration and production company, and Total S.A. (TOT), the integrated French giant, whose American Depositary Rights trade as shares on the New York Stock Exchange.

New Era's second-largest holding, after Devon, is Newmont Mining Corp. (NEM), which has reserves of gold totaling 87 million ounces. Newmont also produces silver, copper and zinc.

Such precious metals as gold and silver are considered good stand-ins for commodities as a whole, and investors see them as a store of value in dangerous times. While you can buy the real thing in bars and coins, the paper version is more convenient.

One of the best precious-metals mutual funds is First Eagle Gold (SGGDX), co-managed by the talented Jean-Marie Eveillard and rated five stars by Morningstar, has more than tripled over the past three years, but its long-term record is much more modest: an average annual increase of 7 percent since February 1994. It is also expensive, with a load (or up-front commission) of 5 percent and expenses last year of 1.5 percent.

Vanguard Precious Metals (VGPMX) may be a wiser choice, with no load and annual expenses of only 0.6 percent. Although it has lagged First Eagle lately, the fund has returned an annual average of 22 percent over the past five years and 5 percent over the past 10. Top holdings include Compania de Minas Buenaventura SA (BVN), a Peruvian firm with shares that trade on the NYSE, and Placer Dome Inc. (PDG), based in Canada.

In the end, I'm with Julian Simon: Bet on brains. Still, in an era of stock volatility, terrorism, a falling dollar and a rising China, it's not unreasonable to make at least a small bet on things as well.


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