Lemon Cake Investing

Expected return sits at the heart of capitalism (and this blog) – but not every asset or investment strategy inherently has one.  Investors need to consider how they will earn a return for putting their capital at risk. Just because the price of something can change is not an adequate justification for holding it in a portfolio.

Those with capital take the risk of not getting adequately reimbursed so that those without it can finance productive projects. Debt securities, such as loans and bonds, are priced to give an explicit nominal return to the lender over a known period of time. Shares in the equity of companies are priced by the synthesis of a multitude of estimates of the required return – the nominal return is not explicitly known but it is the job of money managers and security analysts, in aggregate, to estimate it and adjust it to reflect the riskiness. There is a price for debt and a price for equity, but not everything that has a price has a return.

Buying a selection of lemon cakes from a supermarket today and expecting to sell these for a higher price in five years is a sure-fire way to lose money. Cakes are perishable: newer is better. Also, there is a replenishing supply of them. Newer is not necessarily better for equities and bonds and creating more of existing ones actually tends to reduce appeal overall. Cakes are not investable assets; they are consumption goods and should not be used as stores of wealth or means of allocating capital.

This lemon cake logic is rejected by speculators who cite sustained rises in prices over certain periods of time as reasons to buy commodities. However, commodities are not priced in such a way as to compensate the buyer for the future volatility in returns.

The magnitude of any expected price increase has to counter the risk that it does not increase. But there are structural natural forces acting against this: as price goes up there is an incentive for producers to supply more and this puts downward pressure on the price. At which stage, users may buy more but there is nothing to suggest that this should offset the pressure on the price. Equities and bonds do not have this characteristic.

Equally, there isn’t the same concept of fair value that goes hand in hand with equity investing. A stock is at fair value if the expected return that it offers offsets the associated risk; fair value increases over time to give you a return. The value of a commodity is derived from how useful it is as an input in the production of other goods. There is a complex web of substitutes, final goods and variable production costs that makes predicting whether the price deviates from the value very difficult.

Some would argue that holding commodities offers protection against inflation in a way that equities and bonds do not. This is certainly true for bonds (except inflation-linked ones), but the picture for equities is decidedly less clear – it depends on the nature of the inflation and the pricing power of the company. It is similarly unclear for commodities. The impact is dependent on the market structure, the way in which inflation is generated and the extent to which suppliers can use advancing technology to reduce production costs (exhibit A). You should not rely on commodities to always preserve purchasing power.

Allocating capital to something that is not designed to give you a return but leaves you exposed to the risk of a substantial and permanent loss requires a much stronger justification than investing in debt or equity. A short history of increasing prices is not enough to ignore this fact. 


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