Can Raw Materials Continue Their Run?

Bill Miller, who knows a thing or two about investing, sees today’s red-hot commodity market as a fool’s paradise.

Miller, one of Wall Street’s winningest stock pickers of the last 20 years, wrote a blistering essay last week on the risks of jumping aboard the wild bull market in commodities such as oil, gold and copper.

“The time to own commodities is, or at least has been, when they are down, when everybody has lost money in them, and when they trade below the cost of production,” Miller wrote. “That time is not now.”

There is a tinge of purple -- as in sour grapes -- in Miller’s tone. Commodities, and the stocks of the companies that produce them, have never been his style.

Miller’s Legg Mason Value Trust mutual fund, with $20 billion in assets, currently has substantial stakes in Internet companies, including EBay Inc. and Amazon.com Inc., and in blue chips such as Citigroup Inc. and Home Depot Inc.

The Baltimore-based fund is down 1.3% year to date. By contrast, a Morgan Stanley index of 20 major commodity-related stocks is up nearly 19%.

On Wall Street, as in Hollywood, it doesn’t feel good to miss a big party.

Since 1989, however, Miller’s fund has risen 13.7% a year, on average, compared with a 10.6% average annual gain for the Standard & Poor’s 500 index. He has beaten the S&P; index every year for the last 15. So when he talks, people pay attention.

His message on commodities is simple enough: It’s probably too late to get in. Better to buy something that has been out of favor, like Citigroup stock, than a commodity or shares of a commodity producer, he says.

“The excitement and enthusiasm surrounding commodities, and the belief that they will continue to rise, is not surprising,” Miller says. “People want to buy today what they should have bought five or six years ago.”

No doubt the 56-year-old investor is reflecting the frustration of many who have sat out the bull run in raw materials and other hard assets since 2002. And it’s hard to fault him for warning against buying into a panicked run-up, which describes metal prices, in particular, in recent weeks.

But Miller could be way too early in calling the game over in commodities, says Bob Howard, who writes the Positive Patterns investment newsletter from Springfield, Mo. He’s been pounding the table for many raw-material stocks since 2004 or earlier.

Prices in any free market ultimately are a function of supply and demand, Howard says. Look around the world at demand for oil and other commodities, he says. Then look at supplies.

“Yes, at some point production will become such that it meets and exceeds demand, but for many commodities this may be years away,” Howard says.

The commodity bull market that began in 2002 has confounded plenty of veteran investors on Wall Street. It’s fair to say that, over the last 25 years, most fund managers haven’t been interested in commodities or the companies that produce them. These are dirty businesses, literally -- pulling things out of the ground. They also have been prone to boom-and-bust cycles, with a couple of good years, then a crash.

In the 1980s and 1990s, commodity investing was mostly a loser’s game. An agile trader might have made money, but not a long-term investor. Buying and holding stocks, on the other hand, was spectacularly lucrative in that era.

But for the last few years, the commodity market has been the buy-and-hold investor’s dream. Oil is up 130% since the end of 2002. Copper is up 375%, sugar 129%, gold 87% and coffee 82%.

Among stocks of commodity producers, Occidental Petroleum Corp. is up 261% since 2002. Copper miner Phelps Dodge Corp. is up 444% since then. Gold miner Goldcorp Inc. is up 176%.

The S&P; 500 index’s return since 2002, including dividends: 58%.

The thumbnail explanation for the new commodity boom is well known. After mostly falling for 20 years, raw-material prices began to rebound in 2002 as demand soared in China, India and other emerging economies. Because there was little incentive for producers to hunt for new sources of those raw materials in the ‘80s and ‘90s, they weren’t prepared to meet the sudden increase in demand.

Now, even with prices up sharply, supply remains a problem, commodity bulls say. It is much more difficult worldwide to find and produce many raw materials than it was 20 years ago, they say. You don’t snap your fingers and open a new copper mine overnight.

But to be optimistic about commodities, you can’t just assume that supplies will remain restricted. You also have to believe that demand will stay strong. And on that issue, in particular, Miller is skeptical.

“It is undeniable that the demand picture is different this time,” he says. “But the prices are different, too. What the commodity bulls implicitly assume is that higher prices will not curtail demand.”

China’s government may be signaling unwillingness to enable further commodity inflation. The nation’s central bank sent a shudder through commodity markets on Thursday, when policymakers raised their benchmark interest rates in an attempt to slow the economy’s breakneck pace.

Any deceleration in China’s growth rate could send raw-material prices tumbling, if only because short-term speculators who have been riding the commodity bull market might decide they’ve had enough fun for now. In any hot market, it’s impossible to know how many players are standing near the exit rather than settling in for the long haul.

But the China scare lasted all of one day. By Friday, many commodity markets were rallying again. Near-term oil futures in New York rose 91 cents to $71.88 a barrel, although that was down from the all-time high of $75.17 set one week earlier. Copper futures rose 7.5 cents to $3.33 a pound. Gold surged $18.50 to a 25-year high of $651.80 an ounce.

At these prices for raw materials, the earnings of many commodity-producing companies should be stellar, and they generally are. Witness the public outcry over the energy industry’s record results.

Those earnings don’t attract Miller. If the laws of economics still work, he says, commodity prices can’t continue at these levels. They’re just too rich relative to the cost of production, he says.

To put it another way, with the price of copper at $3.33 a pound, and the average mine production cost at 90 cents a pound, the reward for producing copper is just too great for a free market to sustain it, Miller says.

Even so, he allows that when any bull market gets a head of steam up, it’s hard to know where it will stop. In markets, he notes, “lots of things happen that never happened before.”

Investors worldwide have all sorts of reasons to bet on commodities now. Some see raw materials as the best way to play the economic ascent of the developing world. Some like the prospect of earning higher dividends from cash-flush commodity companies. Still others simply want something in their portfolio besides stocks, bonds and real estate.

Some commodity bulls say one of the best arguments for keeping the faith is that many Wall Street pros -- and small investors -- are in Miller’s camp, disbelieving that the raw-material rally has legs.

Peter Schiff, president of money management firm Euro Pacific Capital Inc. in Darien, Conn., is a big fan of gold, even with the price at a 25-year high. He scoffs at the idea that the gold market is a bubble about to burst.

That can’t be true, Schiff contends, because popular culture has yet to embrace gold’s bull market.

“As has been the case for all real manias, if metals investing were a speculative bubble, it would have migrated from the financial and commodities spheres to make an impact on the broader culture,” Schiff says. “In other words, taxi drivers would be offering tips on mining companies.”

Miller, however, believes that investors’ fascination with the commodity story is far more intense than Schiff suggests. In any case, it’s too intense for Miller, who has made his living as a fund manager finding undervalued investments and avoiding overvalued ones.

“I can’t help but be skeptical of the advice to start or increase a position in commodities after the biggest bull move in 50 years,” he says.

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, visit latimes.com/petruno.