"If they're just processors, forget them... Shoot them, in fact."
Jeremy Grantham is a legend on Wall Street. He called the top of the Japanese economy in 1989, the top of the tech bubble in 2000, and the bottom of the stock market in 2009.
When he talks, investors listen. And now he's talking about shooting people. Let me explain...
The prices for most commodities – things like copper, corn, and cotton – are up at least 30% since July. Rising prices are good for some companies ("the producers") and bad for others ("the processors"). Investors who don't recognize the difference between these two are going to get burned.
Producers are companies that have "stuff in the ground." Obvious examples include miners and farmers. Processors are companies that have to buy a lot of raw materials to produce the goods they sell to consumers.
My colleague Matt Badiali has covered how to make money in commodity producers (like gold miners and uranium miners). But to protect those gains, investors must avoid companies that fall into the processor category.
One of the obvious victims of a long-term rise in commodity prices is the apparel sector. These companies buy cotton and other materials, then turn them into a t-shirt or pair of jeans. It's a simple business that fits perfectly into the "processor" category.
Here's the thing: Cotton prices DOUBLED between July and November. And the long-term trend is up. That's going to destroy profits in the apparel sector.
Take a look at the simplified table below. It shows how rising cotton costs squeeze the profit apparel companies earn from a piece of clothing...
As you can see, profits quickly evaporate if input prices double. As cotton prices rise, a clothing company goes from highly profitable (with gross margins at a healthy 25%) to a losing proposition. The only choice in that scenario is to raise prices for the consumer.
Cotton-based goods make up around 75% of sales for companies like Gap (NYSE: GPS). For the past six quarters, Gap's gross margins have drifted between 39.5% and 42.5%. That won't hold steady when the company's paying 50% higher cotton prices in 2011.
The only thing Gap can do is increase prices and hope people are willing to pay up for a pair of jeans or t-shirt. Gap's peers, including Abercrombie & Fitch (NYSE: ANF) and American Eagle (NYSE: AEO), are facing the same problem...
This is the problem facing almost all processor companies right now.
Take a look at your portfolio... Hopefully, you've added a few commodity producers and are already profiting. You should also make sure you don't have a lot of processors. With commodities in a huge long-term trend, these stocks will drag down your returns. It's time to take them out... and shoot them.
Disclosure: The author does not own positions in any of the stocks mentioned