How to get margin of safety with Commodities.

How to get margin of safety with Commodities.

According to Warren Buffet "Margin of Safety" are the three most important words in investment. This concept is also the corner stone of the philosophy that Benjamin Graham taught.

To get an answer of what margin of safety would mean in terms of investing in commodities , we need to be able to value a commodity relative to it's price. The lower the price in relation to the value, the higher the margin of safety. Commodities are also non-income producing assets, in fact there is a cost to carry the commodity. This cost is made up by the cost of money as well as the storage cost of the relevant commodity. The prudent commodity investor should thus factor in this cost when calculating value and should be more conservative in valuation to increase the safety margin.

How do we value a commodity? A whole book can be written about the valuation methods for commodities but we will try to capture a few key concepts.

- Production cost
This is the cost of producing the commodity. In the case of grains that will be the cost to produce per bushel. Unfortunately this is a difficult calculation at the best of times.. Sources to get this information would government agencies such as the US Department of Agriculture or the US Department of Energy.

-Producer break-even
This is the price under which some producers will start losing money. If this situation continue for too long, producers will have to stop producing or go insolvent. This method is handy when looking at metals or other commodities that are mined. Sources for information are the corporate reports of mining companies.

Supply/ Demand Ratios
- This method is widely used to determine a relative value number. This method should be used conservatively though, especially when a commodity is priced above production cost. The price might already factor in low supply/demand ratio.


So, this is a mine-field and the best approach is to be as conservative as possible in valuation. As a rule of thumb: If we are close or under production cost, producers are not making money or going out of business and prices have been depressed for a long time, the case for a value investment could be made..

Trade Ideas likes

Trading Ideas

Create your Like Badge