Natural resources stocks have been one of the few positive sectors in a market bedeviled by worries of a North American economic slowdown. Indeed, after a nine-year run, fund managers continue to be upbeat on commodities, thanks to the growth story in China and other emerging economies.

“We’re bullish on all [commodities],” says Andrew Cook, lead manager of Marquest Resource Fund and a partner with Toronto-based Marquest Asset Management Inc. “There is strong growth in emerging economies and a lack of supply in some commodities.”

He notes, for instance, that global copper supplies are down to about 2.5 days of production: “There are critically low levels of inventories. Any kind of hiccup will lead to price spikes. It could be a political event, labour disruption or an infrastructure issue such as power shortages, as we’ve seen in Chile and South Africa.”

In addition, there have been few significant discoveries even though resources companies have been spending billions on exploration. “New supply coming on is minimal,” says Cook, adding that weak commodity prices during the 1980s and 1990s led to under-investment in new supplies. “The timeline to bring a resource into production has gone from five to seven years to 10 to 12 years because of equipment and labour shortages and a lot more political permitting and environmental constraints than we had 25 years ago. Critically low levels of supply may exist for some time.”

Emerging economies, led by China, are driving demand, argues Cook, adding that copper consumption in the U.S. has been flat over the past six years but is growing in China at a compound annual rate of about 14%. Although Cook admits it is very difficult to predict the top, as far as commodity prices are concerned, he is confident that we are in a period of sustained higher prices: “Companies can earn a significant return on capital, and therefore should be awarded higher valuations. Right now, the values are very compelling, and we’re comfortable that equities will go significantly higher.”

A growth investor who works with Marquest founding partner Gerry Brockelsby, Cook had taken profits in early May and raised cash to about 20% of assets under management. Since then, cash has dropped to around 10% of AUM. Currently, about 50% of the fund is in energy stocks, 35% in base metals and 5% in gold. Significantly, most of the energy stocks are domestic, as opposed to an earlier bias toward Canadian firms with international operations. “Margins have improved, and valuations have come down, too,” says Cook. “Our view that commodity prices will remain strong led us to this focus.”

One favourite stock in the 35-name Marquest fund is Storm Exploration Inc. Primarily a natural gas producer active in Alberta and northeast British Columbia, it is expected to produce 8,500 barrels of oil equivalent in 2008 and about 11,500 BOEs in 2009. “It has a very strong management that can execute on the plan,” says Cook, adding that Storm’s shares trade at a multiple of 7.5 times enterprise value to cash flow. Acquired in early 2008, the stock is $15.85 a share. “As long as it sustains its growth, the stock should continue to move north,” says Cook, adding that he has no stated price target.

Another favourite name is Grande Cache Coal Corp., a mining firm active in Alberta. Cook bought its shares at the initial public offering three years ago, and later sold at a profit. But he returned to the stock late last year, when it was $1 a share, the firm had resolved some labour issues and metallurgical coal prices had escalated to US$150 a tonne from US$95. The stock is now $7.30 a share. Based on a forward price-to-earnings multiple of 3.5, Cook believes the stock could have 25%-30% upside in the next 12 months.

The outlook continues to be bullish for four fundamental reasons, says Fred Sturm, co-manager of Mackenzie Universal Canadian Resource Fund and senior vice president with Toronto-based Mackenzie Financial Corp.

“The primary demand coming out of emerging markets [remains strong],” says Sturm. “If it were enough just to meet the West’s needs, we can come up with solutions. The problem is three billion people want to do the same. There’s no evidence that those expectations are being muted.”

@page_break@Pointing to the rapid urbanization of Japan and South Korea, he notes that within several decades, the same trend will spread through China.

The second driver concerns limited supply. “We have no evidence that Mother Nature is willing and able to provide a lot more [supply] quickly,” says Sturm, adding that labour shortages are exacerbating the issue. “But we have evidence that the governments of the world are working in a counterproductive fashion and hindering development of new supplies. In almost every country, the resources success is being seen as a windfall tax grab opportunity. Instead of creating tax incentives to encourage production, they are taxing higher and causing the cost of production to rise over time.”

Sturm argues that the third factor is a kind of insurance contract against currency devaluation and growing inflation. “On balance, this, too, is favourable for resources investors,” says Sturm, adding that rising commodity prices may start to level off if the U.S. dollar begins to rally.

Fourth, valuations have not kept pace with corporate prospects and earnings improvements. “We still see, broadly speaking, the resources sector as trading at a discount to the broader market,” Sturm says, noting that senior U.S. oil companies are trading at a large discount to the broader market.

From a macroeconomic perspective, Sturm maintains that the U.S. is not likely to slip into recession during an election year and that this year and 2009 should be good years for global growth: “One of the most constructive examples is the rapid rise in iron ore prices, which are up 70% year-to-date. If the world were imploding, that would not be happening.”

From a structural viewpoint, Sturm and co-manager Benoît Gervais, vice president of Mackenzie, have 55% of the fund’s AUM in energy stocks (vs 57% in the benchmark MSCI global resources index), which represents the midway point in the 25%-75% range that energy stocks can represent in the fund under its mandate. The benchmark for each of the four remaining subsectors — precious metals, base metals, forest products and industrials — is 10%-12%. Currently, the managers have a neutral 12% in precious metals, an overweighted 17% in base metals, an underweighted 4% in forest products, and an underweighted 5% in industrials, plus about 7% cash.

One of the biggest holdings in the 70-name Mackenzie fund (in which the top 25 holdings account for 60% of the portfolio) is Russia’s OAO Gazprom. The world’s largest producer of hydrocarbons, it supplies 33% of the natural gas consumed in Europe. Escalating gas prices in Europe and Russia will allow earnings to rise dramatically over the next three to four years. Acquired last fall, the London-listed American depository receipts are trading at US$60. Sturm has no stated price target.

Another large holding is Voto-rantim Celulose e Papel SA. The Brazilian firm, known as VCP, is one of the largest landowners in that country and has full control over its assets (unlike Canadian forestry companies, which pay royalties for access to land). VCP’s eucalyptus plantations are used to supply pulp for cartons and photo-copy paper. Acquired five years ago, the ADR-listed stock is US$30.50. “The company will likely double or triple its capacity to generate earnings over the next four years,” says Gervais, adding that the stock is trading at 17 times 2009 earnings. “If it does that, in four years it will look too cheap.”



Resources stocks have been driven recently by hot money chasing commodities, as well as the weak US$, cautions Peter O’Reilly, manager of Investors Global Natural Resources Class and vice president with Dublin-based I.G. Investment Management Ltd. “They could provide a bit of a speed bump in the next three to four months. There could be a correction.”

Still, despite some of the near-term risks, O’Reilly shares the long-term view of his peers that natural resources have some way to go: “If you believe that we will continue to see the convergence in emerging markets, along with the replenishment of the infrastructure in the West, it is very difficult to fight the argument that the outlook for commodities will remain very strong.” Moreover, while it may be advantageous to be a little contrarian, O’Reilly admits, “Why would you want to aggressively cut your resources exposure from here? I am struggling to come up with a compelling argument.”

Although the U.S. economy may be weak, O’Reilly maintains that the global economy is still growing at around 2.5%-3%. “No major economy is going through a massive recession. There is no major economic crisis at the moment,” says O’Reilly. “Bottom line, people will continue consuming materials. As they move into the cities, they will want to improve their lifestyle.”

Running a 50-name fund, O’Reilly has an underweighted 45% in energy stocks and an over-weighted 45% in materials (vs 42% in the benchmark). The energy underweighting is largely stock-specific, as O’Reilly is shunning the major integrated oil firms such as Royal Dutch Shell PLC that dominate the index. He favours smaller exploration firms such as Tullow Oil PLC, which is active in the North Sea, Gabon, Congo and Mauritania, and produces about 75,000 BOEs a day. Bought last year, the London-listed stock trades at UK925p a share. O’Reilly has no stated price target.

Another favourite is Arch Coal Inc. One of the largest coal producers in the U.S., the firm supplies low-sulphur coal to power generators. Although thermal coal is regarded as a dirty fuel, O’Reilly says, it is not likely to be replaced by bio-fuels: “The move to alternative fuels will take a lot longer than people expect. The outlook for coal will remain pretty robust.” IE