As the commodity cycle continues into its seventh year, Rory Ronan, manager of AIM Trimark Investment Ltd.’s $307.9-million Trimark Canadian Resources Fund in Toronto, is thoroughly aware of the key drivers — and the dangers that may lie ahead.

“Prices have come off very low levels when the cycle bottomed in 1998. And there’s been a lack of capital invested in this area. These factors explain why the cycle has lasted so long, and why it could continue,” says Ronan, 34. “The surprise is there hasn’t been a big response by companies in expanding supply, especially in oil and gas.”

Although crude oil is currently around US$49 a barrel, Ronan notes that some firms, such as those exploiting the Canadian oilsands, are starting to use US$30 a barrel and higher to justify spending to boost production. “There is a supply issue, which is difficult to analyse but you can forecast it. The tougher part is figuring out the demand equation.”

Ronan says China will become a major consumer of energy, but suggests its per capita oil consumption has a long way to go to reach the level of a developed country.

But making top-down calls is not Ronan’s style. “If I tried to do this, I would be right half the time, and wrong the other half. I would not add value for my clients. I try to add value in a bottom-up approach — by understanding the companies I invest in, and their assets,” he says. He admits that is unusual, as most managers focus on the commodity because it is a big driver of what a company does. Instead, he focuses on good long-term returns and a balanced risk approach. “With every investment, I don’t just think of the upside but of the downside, too.”

It is a method that has paid off. For the five years ended April 30, the fund averaged 21.5%, compared with 18.1% for the median natural resources fund. Over the past three years, it had an average annual compound return of 15.7%, compared with 19.1% for the median fund. For the past 12 months, the fund returned 14.9%, compared with 23.6% for the median fund. The
performance gap in the past year is largely a result of his cautious stance on high-flying energy stocks. The fund carries a four-star Morningstar rating.

Ronan’s balanced risk-return approach is characteristic of the AIM Trimark style. “But it is even more important when you are dealing in an area such as resources, which can be very volatile,” he says. There are many risks that can throw a wrench into the works. A fire can disrupt an oilsands mine, for instance, or a prolonged labour dispute at a mine can bring production to a standstill. “I am looking for strong companies that can manage business risk,” he says. “This helps me achieve a balance between risk and return.”

Ronan selects about 50 companies for the portfolio. Single positions are limited to about 6% of the fund, although core stocks are about 2.5%. Turnover tends to be moderate, at 42.2% in 2003 and 62.4% in 2002. Each name must meet three criteria:
the right business plan, strong management and attractive valuation. “In the resource game, I prefer the best asset with mediocre management to a mediocre asset with the best management.”

But management still must be adept at controlling costs, allocating capital and determining return on equity. “Quality is based on management and the asset base.
That is the differentiating factor. You’re dealing with a commodity business.”

Although he is a bottom-up investor, the sector weightings in the fund reflect his biases in terms of opportunities and attractive valuations. Currently, about 20% is in base metals, 20% in oil and gas, 16% in gold, 11% in paper and forest products, 10% in energy service providers, 10% in non-traditional resource stocks (which reduce some of the volatility and increase diversification), 7% in cash and small weightings in areas such as packaging.

Among his favourite names is West Fraser Timber Co. Ltd., which has been in the fund since mid-2001 and was acquired at about $30. “Management owns a big chunk of the company and is prudent in how it spends its money,” says Ronan, noting its debt-to-capital ratio is 0.25. “It’s the lowest-cost lumber producer in North America. It has been able to withstand a higher Canadian dollar and the softwood lumber dispute.”

@page_break@Over the past 18 months, the stock has moved to $44 from $35. More recently, its rise has been propelled by its late 2004 acquisition of Weldwood of Canada Ltd. The stock is trading at seven times earnings, based on Ronan’s earnings estimate of more than $4 a share this year.

“The risk is on the ‘macro’ side. If the Canadian dollar charged up to par, or the housing market crumbled, that would be very negative. But these factors are out of my control,” says Ronan. However, he believes the company’s low-cost structure would enable it to survive when conditions turned around. “The risk-return tradeoff is favourable.”

Another favourite is Barrick Gold Corp. The world’s second-largest gold producer has been in the fund for several years, but Ronan has gradually been adding to the position. In 2003, the stock bottomed at $22 a share, mainly because of its then-large hedge book and disappointing earnings.
After some extensive turmoil, the company appointed a new CEO, Greg Wilkins, and gradually turned around. “It hit all its operating targets, while the overall industry had a poor year,” he says, adding that the hedge book has dropped to about 10% of reserves, compared with 25% at its peak several years ago.

This year, the stock has climbed to around $28 from $27. Ronan attributes that to the market’s favourable view of Barrick’s growth potential, which should see production rise to seven million ounces of gold by 2007 from five million ounces as four new mines come on stream.

On a valuation basis, Barrick is not cheap and trades at about twice net asset value, or about 10 times 2006 cash flow. “But it has a better growth profile than its peers. I would not be surprised if the multiple expands,” says Ronan, who declines to offer his upside target. “It also has limited downside risk, versus its peers. It has a large production base, multiple mines, a strong balance sheet and a long track record.”

Ronan has been lead manager since September 2001 and part of the investment team since March 1999. Ronan joined Trimark Investment Management in 1993 after graduating from University of Toronto with a bachelor of arts in economics. He began working in customer service and, in late 1996, moved into sales. During this period, he identified with the hallmark Trimark approach. “I had a philosophical “buy-in” that this was a prudent way to manage long-term money.”

With his CFA in hand, Ronan was given the resources file, which coincided with the recovery in the resources cycle. “It was a time when everyone hated these funds. But you had a better chance of creating a good 10-year record. That’s our goal,” he says, noting the fund has had no losing years.

If the market does turn down, he believes his stocks would ride out the turmoil.
“Things can happen, when you aren’t expecting them,” he says. “That’s what I’m shooting for.”

Fund analyst Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc., thinks highly of Ronan’s caution in a sector prone to volatility. He recommends the fund, but suggests clients limit exposure to 5% of a portfolio, as the cycle is getting long in the tooth.

James Gauthier, senior fund analyst at Toronto-based Dundee Securities Inc., is also a fan. “Ronan emphasizes management, and quality and longevity of the asset base,” he says. “For investors who want a conservative approach to a volatile sector, this is a good solution.” IE