Natural resources funds were on a tear last year, thanks to surging commodity prices and strong demand from fast-growing economies in Asia. And, although markets briefly corrected in the spring, fund managers maintain that resources stocks will resume their upward trend.

“There were a lot of skittish investors. They were sector rotating, unsure where they wanted to be,” says Robert Cohen, a portfolio manager at Toronto Goodman & Co. Investment Counsel who oversees Dynamic Global Resource Fund. “But a lot of stocks are becoming extremely undervalued,” he says. This could be a good time to take advantage of the pullback.

The market overreacted to news that growth in China’s GDP is slowing, Cohen says: “China may not see exponential growth, but it is still expanding at a steady rate. We will get a linear growth pattern for a few years to come. What is interesting, however, is that commodity markets are still very tight.”

For instance, he says, copper inventories have declined to about 100,000 tonnes from one million tonnes in 2002. As a result, copper prices have risen to about US$1.50 a pound from US65¢. And prices could rise to US$2 a pound, he says, because of the time required to bring new mines onstream.

Likewise, he adds, nickel inventories have fallen to 7,200 tonnes from 60,000 tonnes in 1999, and nickel has moved to about US$8 a pound from US$3.50 a pound in that time frame. “The fundamentals for zinc, aluminum and iron ore are also strong,” he says.

As for gold, he argues that it is a substitute currency and is riding on the weakness of the U.S. dollar and the U.S.’s staggering US$700-billion current account deficit. Gold prices could also rise appreciably, he adds, should China boost its own gold reserves to levels seen in industrialized countries.

A value-oriented investor, Cohen runs a fund that is nominally a foreign one, but most of its 40 names are Canadian. “The projects are global, but the companies are domiciled here or listed on the Toronto Stock Exchange.” However, because of the fund’s relatively small size, he is also invested in highly liquid foreign stocks, such as Australia’s BHP Ltd.

On a sectoral basis, there is 20% in precious metals, 25% in oil and gas, 55% in metals and minerals (which includes 17% in uranium), and no exposure to paper and forest products because he is not at all bullish on that sector.

Leveraging off the growing global demand for uranium, the price of which has risen to US$31 a pound from US$18 four years ago, Cohen favours Cameco Corp., a leading producer. “It was trading at an appropriate valuation, given the spot price of uranium at the time,” he says. It was acquired in October 2003 at $17.89 a share. “But we felt the uranium market would go through the same tightness as the oil and gas industry.”
The stock recently traded at $48.45 a share.
His target is $60 in the next 18 months.

Another favourite is First Quantum Minerals Ltd. A copper producer in Zambia and the Democratic Republic of Congo, its production is expected to exceed 100,000 tonnes in 2005 and grow to 270,000 tonnes by 2007, thanks to new mines opening in the next two years. Acquired in 2001 at about $3.95 a share, it recently traded at $21. “It is discovering new ore bodies faster than it can put them into production,” says Cohen.
The stock is trading at nine times 2005 earnings; his 12-month target is $28.

There has been a seasonal pattern to the market slowdown, says Craig Porter, manager of Altamira Resource Fund and Toronto-based vice president at Natcan Investment Management Inc. “In 2003, we had the SARS scare, and base metals fell off 16%-17%. In 2004, there was a fear of China slowing and base metals fell again in a similar range,” he says. “This year, we had another correction of about 18% from the highs in early March.” Investors in base metals, he adds, tend to “binge” in the first quarter, then rotate out of their positions as spring shifts into summer.

But, Porter asserts, most of the correction is behind us. “If the U.S. and China both went into recession at the same time, the base metals sector would have a big sell-off,” he says. “I’m not of that view: the sector has been undersupplied for the past decade and not enough new mines have been built to meet demand.” In short, he maintains, fundamentals are still good and commodities — including uranium, nickel and zinc — are in tight supply: “It takes years before supply catches up with demand.”

@page_break@Porter, who is especially bullish on the base metals sector, expects to see industry consolidation. Cash-rich companies are on the prowl for acquisitions, he says:
“Intermediate-sized firms, such as LionOre Mining International or First Quantum, are trading at seven times 2006 earnings. They are fairly cheap. If you believe in the extended cycle, a lot of them may not be around in the next few years.”

A growth investor, Porter begins with a top-down view of the commodities, then selects about 90 names for diversification purposes. Currently favoured base metals have a 30% weighting, which is larger on a proportionate basis than other resources subsectors. There is also 39% in oil and gas, 9% in oil service companies and 22% in gold and precious metals.

This past March, as crude oil peaked at US$57 a barrel, Porter began taking profit in oil and gas stocks and reduced some positions. But that move was a bit too early, he admits. After a momentary drop, stocks began climbing again. Among his favourite energy names are Penn West Petroleum Ltd., Niko Resources Ltd., Talisman Energy Inc. and EnCana Corp. Primarily a gas producer in Western Canada, Penn West converted to a royalty trust at the end of May and yields about 11%.

On the base metals side, Porter favours Western Canadian Coal Corp. A British Columbia-based producer of metallurgical coal, it has benefited from strong commodity prices as coal has climbed to US$125 a tonne from US$70 a year ago. Bought two years ago at about $1.50 a share, it recently traded at $3.60. In a similar vein, he likes Australia’s Macarthur Coal Ltd., which trades around AUS$7.20, or about five times 2006 earnings. Porter took the position at AUS$2 two years ago.

He also like intermediate-sized gold stocks, including IAMGOLD Corp. “It has a couple of good operating mines in Mali and Ghana, and owns the Quimsacocha site in Ecuador, which could be quite promising,” he says, referring to the 13,000-hectare site that is being explored. IAMGOLD is an acquisition target, adds Porter, and could figure in a merger with South Africa’s Gold Fields Ltd.
and its recent partner, Russia’s MMC Norilsk Nickel. Acquired at $5 a share three years ago, IAMGOLD is now trading at $8.30 a share.

The current environment is to be expected, says Fred Sturm, lead manager of Mackenzie Universal Canadian Resource Fund and senior vice president at Toronto-based Mackenzie Financial Corp.
“We are in a period of rising interest rates, and money growth is slowing. In a period of monetary tightening, the economy generally slows, as does the broader market — and the resources sectors.” Rising rates support the US$ and, he notes, “Natural resources tend to be inversely correlated with the US$.”

But Sturm puts the present phase in the context of a long-term 12- to 14-year bull market. The first phase was the “recovery” period, when commodity prices rose from “stupid” levels (such as US$10 a barrel for crude oil). “We are now in the ‘big, fat middle.’ Commodity prices should stay in the top half of their historical ranges rather than the bottom-half doldrums,” he says.
“Companies can now generate returns on capital in excess of their cost of capital. At the operating level, they are enriching shareholders, even if the shares are not necessarily rising.”

Although the macroeconomic environment may not be ideal, it is still a good one, Sturm says. For instance, he argues, central banks are engineering a moderate economic deceleration, and demand for commodities is still strong.

“Is capacity utilization high?” he asks. “Yes.
Are there new technologies on the horizon that will injure the industries? No. Are there long-term supply constraints? Yes. Are shares significantly off their highs, such that there is a ‘buy low’ entry point? No, but it’s improving, as we had a pullback — especially in gold stocks.” Moreover, corporate balance sheets are relatively healthy, although paper and forest products are under pressure.

Strategically, Sturm was defensive until late March, when there was about 20% cash in the fund. But following the spring pullback, he has been investing again, mainly in precious metals and, to a lesser extent, energy service stocks. Overall, he has lowered the energy weighting to 40% from a high of 55% at the end of 2004. He also has 10% in paper and forest products (including Brazil’s Aracruz Celulose SA), 15% in base metals (Alcan Ltd. and Inco Ltd.), 25% in precious metals and the balance in cash.
Although 50 names account for the bulk of the fund, there are several small holdings at the margins.

Significantly, Sturm has doubled the precious metals weighting from about 12%.
He expects the US$ to come under increasing pressure because of mounting U.S. trade imbalances. As a result, he is also expecting gold bullion to rise to US$500 an ounce in the next 12 to 18 months. His top 10 positions include Placer Dome Inc., Barrick Gold Corp. and Cambior Inc.

Arguing that the last name has been excessively punished lately, he says: “We started to reach down into the mid-sized companies for which the share prices have traded off a lot.” IE