Commodity Stocks: High Yields and a Hedge Against Inflation

For years now I've been pounding the table on two big themes...

The first is that income investing is a great way to boost not only your returns but your cash flow. And second, that every investor should have a substantial chunk of their portfolio invested in commodity stocks.

Here's the good news: it is perfectly possible to combine the two strategies, earning the benefits of both worlds.

In fact, in a moment I'll tell you about a few of my favorite high-yielding commodity stocks. Two of them pay safe, hefty yields over 7%!

Compare that to what you can earn with your local bank or with U.S. Treasuries. You'll quickly find there is nothing comparable.

In fact, by investing in income-producing commodity stocks, you get a steady stream of income along with the best possible protection against the ravages of inflation.

That combination is tough to beat. Let me explain...

The Best of Both Worlds: Income and Appreciation

The truth is, income investing is crucial for three reasons.

The first is obvious. No matter how well-off you become, the bills just keep getting worse and worse. I never met anyone that couldn't use more cash.

The next two aren't nearly as evident to most investors-- even though both are of the utmost importance to their portfolios.

Stocks that pay steady, consistent dividends add a measure of certainty to share prices. It's why top quality dividend stocks typically do well even in bear markets. Conversely, since earnings are so easily manipulated, companies with fancy bottom lines but no dividend usually turn out to be a scam and end up being priced accordingly when things turn south.

Finally, dividends themselves keep management honest (or fairly honest.) Cash that is paid out to shareholders cannot be used for grandiose expansion plans, or to pump up the stock price to help inflate top management's stock options.

As a result, companies that pay decent dividends are less likely to suffer value-destroying scams than those that don't and are likely to be around longer. For investors, that offers stability -- invaluable these days.

As for commodity stocks, I'll be the first to admit they are not a universal panacea. But two long-term factors currently favor them.

The first is in emerging markets which tend to consume more commodity-intensive goods as their national wealth grows. (One of them is in Singapore, which is one of the world's newest "sweet spots".)

The second trend is a bit less agreeable though one of the most powerful movers of commodity prices. It's the world's central bankers.

For the past five years, global monetary policy has been jammed into accelerator mode, with interest rates far below the inflation rate. This tends to raise commodity prices, especially in gold and silver, since they are thought to be good protection against inflation.

But here's the payoff for investors: commodity stocks are actually cheap right now.

Commodity prices have come off their spring 2011 highs, indeed declining more than the stock market in general. Still, commodity prices have remained quite strong, so many commodity-related stocks are selling at very attractive valuations.
With global monetary policy becoming even more expansive and emerging market growth continuing strong, the stage is set for a sharp commodities-related rally.

In fact, even if the markets as a whole are weak in the second half of 2012, commodity stocks with moderate leverage and good dividends are likely to outperform.

Five Ways to Play the Commodities Rebound

The following are some dividend-paying commodity stocks you may want to look at, in different commodity sectors. All the companies involved have earnings that well cover dividends, and at most moderate levels of leverage.

In today's markets, all of these companies provide good value and upside potential if commodity prices remain strong.

They include:

Cliffs Natural Resources Inc. (NYSE: CLF): Cliffs is a major iron ore and coal producer, with U.S. and Australian operations and good relationships with Chinese buyers. The company has a trailing P/E ratio of 4.5 times and a dividend yield of 5.1%, which is covered 4.4 times. Its long-term debt is about 40% of total capital. Its huge dividend coverage and low P/E ratio makes it exceptionally attractive.

Alumina Ltd. (NYSE: AWC): AWC is a major Australian aluminum producer. The company's historic P/E is 15.8 times, but prospective P/E 6.7 times. Its debt is less than 10% of total capital. The yield is a nice 7.2% and is trading at only 67% of book value. Alumina is a good value play in often-overlooked sector.

Alliance Resource Partners LP (Nasdaq: ARLP): ARLP produces and markets coal for utilities and industrial users in the United States. Its historic P/E is 10.5 times while its forward P/E is just 7.6 times. The company pays a 7.3% yield but its debt is about 50% of total capital. As a Master Limited Partnership, it pays no corporate income tax, provided it pays out income to shareholders; it is one of the few coal MLPs.

Southern Copper Corp. (NYSE: SCCO): SCCO is a major copper producer in Peru, Mexico and Chile, all of which are reasonably investor-friendly. Its P/E is 10.7 times, yields 6.7% and has debt about 1/3 of total capital. Copper looks an especially good bet, as major new supplies won't reach the world market until 2015.

Freeport McMoran Copper and Gold (NYSE:FCX): A major gold and copper producer with worldwide operations, FCX has a P/E 8.5 times with a prospective P/E of 6.7 times. The company pays a dividend yield of 3.7%, but it's more than 3 times covered. Debt is about 20% of total capital. It's probably the best way to play gold prices among these selections since few gold mines offer high dividends these days.

Rock solid dividends, low debt, and a hedge against Ben Bernanke and friends make these commodity stocks hard to beat.

Of course, there's always that CD down at the bank.

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