Porter Stansberry: Two critical lessons every commodities investor must know now
From Porter Stansberry in The S&A Digest:
In today’s Digest, I would like to share with you part of a larger research project I’ve been working on for the last six months or so. Caution… this Friday Digest is almost completely an exercise in teaching. Thus, it is almost surely a waste of time…
As you know, I completely disclaim the ability to teach anyone anything. Or as I prefer to explain: There is no teaching; there is only learning. So if you feel like learning something important about how to invest in commodities, please continue reading.
One of the best educations that you can give yourself in investing is simply reading the annual letters Warren Buffett writes to the shareholders of his holding company, Berkshire Hathaway. You can read them for free at www.berkshirehathaway.com. Also, a new book compiles all of his letters and can be read on devices like Amazon’s Kindle. It’s well-worth the price, as it makes his writing searchable.
To better understand Buffett’s methods, I’ve been studying his mistakes. You always learn more by studying when something doesn’t work. That’s the main reason I spend so much time every year thinking about and personally writing our company’s Report Cards (available for free to all paid subscribers).
It’s like Buffett’s business partner, Berkshire Hathaway vice chairman Charlie Munger, says: Just tell me where I’m going to die, so that I won’t go there. What he’s really saying is, tell me how and why an investment approach fails, and I will learn how to improve upon it.
Improving upon Buffett? You might think that sounds like hubris or idiocy. But the truth is… since the late 1990s, Buffett’s performance (as a stock picker) hasn’t been special. After averaging annual gains in the mid-20% range for most of his career, Buffett’s portfolio of publicly traded equities has only averaged about 6% a year since 2000.
And for the first time in his entire career, Buffett will announce sometime later this year that Berkshire’s book value did not increase faster than the S&P 500 over the last five years. Buffett has beaten the S&P 500 over every other five-year period since the mid-1950s. The reason Buffett did not beat the S&P 500 over the last five years was because of poor stock picking. Berkshire’s wholly owned businesses have performed well.
Buffett (and many others) will likely attribute this declining performance in stocks to Berkshire’s portfolio size. Don’t believe it. The two other managers who work with Buffett on Berkshire’s portfolio both beat the market easily. But Buffett still manages the lion’s share of capital. And he made one big, uncharacteristic mistake in the last five years… He chased a commodity boom.
During 2007 and 2008 – as oil prices soared to $150 per barrel on talk of “Peak Oil” – Buffett invested $7 billion in major oil firm ConocoPhillips. It was the single largest investment Buffett had ever made at the time. Within 12 months, he would sell most of the stock at a huge loss to free up capital for other investments. By then, the damage was done: ConocoPhillips cost Buffett several billion dollars. It was, by far, the worst investment he has ever made and probably his only genuine “blow up.”
Buffett, who has always been completely honest with his shareholders about his mistakes, explained what happened in his 2009 letter:
Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year… I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.
Buffett started buying ConocoPhillips in 2007. He bought a little more than $1 billion worth of the stock and paid an average of $59.34 per share. It was a peculiar investment for Buffett to make.
First… the stock wasn’t cheap. Over the previous five years, ConocoPhillips’ share price had risen from a split-adjusted $13 to $60. Even more uncharacteristically, Buffett kept buying even as the stock went much, much higher. By the end of 2008, Berkshire documents show the company held a little less than 85 million shares of ConocoPhillips, purchased at an average price of $85.35. As I mentioned earlier, the size of Buffett’s investment made ConocoPhillips the largest publicly traded investment of Buffett’s entire career at that time. The stock represented almost 19% of the total cost of Berkshire’s existing portfolio and almost 15% of the portfolio’s total value.
The same year that Buffett began buying ConocoPhillips shares, he described his overall strategy as an investor this way:
Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great… A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer or possessing a powerful world-wide brand is essential for sustained success.
You don’t have to be a cynic or a Buffett critic (and we’re neither) to wonder about how a massive investment in ConocoPhillips could qualify as an investment for him. ConocoPhillips is a vertically integrated energy company, meaning it controls every step in the process from exploring and producing oil to selling refined gasoline. It produces and refines gasoline and other commoditized fuels and competes in global markets with virtually no barriers to competition.
And why, we wondered, would Buffett make such a business his largest-ever commitment to a publicly traded stock? And why… why… would he ignore the inevitable commodity price cycle and continue to buy an oil company even as petroleum prices soared?
I think I know… I believe that for the first and only time in his career, Buffett got caught up in an investment mania – the “Peak Oil” bubble.
Besides the totally out-of-character moves Buffett made buying ConocoPhillips (chasing the price way higher), Buffett made a number of public statements that indicated he believed in the theory of Peak Oil – which argued that petroleum production had entered an inevitable and irreversible decline.
For example, on CNBC in early 2008, Buffett was specifically asked about why oil prices were soaring. Here’s what he said on live television:
We have been sticking straws in the ground now since Titusville in 1850 or something… We have found a lot of the oil that’s going to be found… And if we’re going to use 85 million barrels per day now… and the rest of the world is going to increase its demand… we’re going to have a tough time maintaining production that satisfies that demand at this price…
Oil is finite… If you look at our production versus 30 years ago, it’s way down. Most fields are depleting at a pretty good rate… Who knows what the equilibrium price will be?
Another clue: During the 2009 annual meeting of Wesco (the small holding company that was run by Munger and is now fully integrated into Berkshire), Munger spoke at length about Peak Oil. “Whether the peak is five years from now or last year I don’t know, but we are somewhere near peak oil production,” he said. “Oil, I think, will get more and more expensive.”
These comments were similar to ones Munger made before. For example, during a mid-2000s conference with Chinese business leaders, he said:
Oil is absolutely certain to become incredibly short in supply and very high-priced. The imported oil is not your enemy, it’s your friend. Every barrel that you use up that comes from somebody else is a barrel of your precious oil, which you’re going to need to feed your people and maintain your civilization… It’s going to get way worse later.
Looking at these comments and what happened with the stock, Buffett and Munger clearly believed in Peak Oil. They thought the world was literally running out of oil. That’s the only explanation for Buffett’s ConocoPhillips investment. The losses he took on this investment are the real reason Buffett isn’t going to beat the S&P 500 over the most recent five-year period – his self-imposed key management goal.
There’s a huge lesson here for investors. Rick Rule, who has spent his entire career investment in commodities, is fond of saying that in commodities, “You’re either a contrarian or a victim.” As a long-term investor, you almost never make money chasing commodity prices higher. Instead, to buy commodities (and commodity stocks) safely, you should always wait until their prices have collapsed.
Another of Rule’s key laws to success in commodities is to remember that markets work. Sooner or later, higher prices will create new supplies. Extremely high prices – record-high prices – will create record new supplies.
And to the surprise of the disciples of 19th-century economist Thomas Malthus… it turned out that we aren’t really out of oil at all. Nope. Instead, record cash flows from oilfields enabled huge investments in new technologies, like horizontal drilling. Those technologies unlocked new supplies of oil that dwarfed all previous discoveries combined.
Today, just five years later, the U.S. government is taking steps to allow our trading partners to tap our oilfields. These moves will strengthen the U.S. dollar and generate massive trading profits and hundreds of billions of dollars in new revenue in taxes and royalties for the government.
Two important takeaways from Buffett’s biggest-ever mistake: Never, ever get caught up in any kind of Malthusian, limited-supply investment story.
Don’t forget: Markets work. As prices move higher, new supplies are bound to be discovered and flood the market. It’s only a matter of time. And second, never chase commodity prices higher. Always wait until they’ve fallen 80% or more to make a major commitment.
If you’ve been reading our research lately, you know many of our analysts believe one sector of the commodity world offers a huge opportunity today… gold stocks.
The Gold Bugs Index (the “HUI”), a basket of gold-mining stocks, is down more than 65% from its 2011 peak. And that’s after the recent recovery we’ve experienced. As we mentioned in yesterday’s Digest, gold stocks would have to double from today’s levels just to get back to their average historical ratio versus the price of physical gold.
People are disgusted with gold stocks… The shares have gone straight down for years, to the point where several mining stocks are trading for less than the value of their gold in the ground. Lots of junior mining stocks are down 80%-90%. It has been brutal.
But we think the tide has turned… And the buyers are coming back to the market.
Here’s the thing… When bull markets in gold stocks get ripping, these stocks absolutely soar…
I’m not the only guy on our team who thinks the bull market in gold stocks is on the way… Steve Sjuggerud, Frank Curzio, and Jeff Clark all agree. Jeff just recommended a trade to his S&A Short Report readers that he thinks could return more than 300%.
The gold stock in question is down 50% from its highs… And Jeff says it’s on the verge of a breakout.
You can learn more about subscribing to the S&A Short Report and start trading along with Jeff by clicking here…
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