Despite robust commodity prices, natural resources stocks have been in a funk for some months, plagued by investor concerns that global growth is slowing. Yet fund managers maintain that the longer-term economic fundamentals are generally positive and stocks will resume their upward trend later this year.
“We are still in a long-term secular uptrend for natural resources, with the main driver being the growing demand side from China, India and other emerging markets,” says Bob Lyon, senior vice president at Toronto-based AGF Management Inc. and lead manager of AGF Global Resources Class Fund. “And on the supply side, because we’re dealing with difficult geology and tighter environmental standards, it’s more difficult to bring supplies to the market at the pace the world demands. That secular story is still intact.
“What we’re going through is investors are reassessing just how strong the global economy is,” he adds. “We’re seeing concerns from the U.S.: the housing market has not rebounded, the consumer is still highly indebted and growth has been subpar.”
Meanwhile, China’s economy also has been slowing, thanks to its central bank raising interest rates to curtail inflationary trends. “China is destocking now. By this fall, though, we expect to see China back in the market, having to buy [commodities] relative to normal levels of consumption.”
Running a 90-name fund, Lyon has about 53% of the AGF fund’s assets under management in energy companies, 22% in basic materials, 21% in precious metals and smaller weightings in areas such as fertilizers. From a geographical standpoint, about 65% of the AGF fund’s AUM is in Canada, 15% in U.S. and 8% in Europe, with smaller exposures in Africa and Latin America.
“Natural gas prices are bottoming and poised to bounce back,” says Lyon, adding that he expects gas prices will edge up because there is less drilling activity. “We had a minimal weighting, but are now increasing our exposure.”
One favourite name is Painted Pony Petroleum Ltd., a small-cap oil and gas firm active in Saskatchewan’s Bakken region. “[The site is] highly economic, even if oil prices fall much lower than today,” says Lyon, noting that the Bakken play produces 2,000 barrels of oil equivalent a day. Painted Pony also has a natural gas play in British Columbia’s Montney region that is producing 2,000 BOE a day. Painted Pony stock is trading at about $12.35 a share; Lyon’s target is $17 a share in 12 to 18 months.
Another top holding is Osisko Mining Corp., a mid-cap gold miner that has just started production at its Canadian Malartic mine in Quebec’s Abitibi region. Says Lyon: “With a 10 million ounce resource, a US$1,500 gold price environment [and] US$400 an ounce production cost, it’s a cash machine.” Osisko stock is trading at about $14.25 a share, but Lyon believes it could be $18 a share within 12 to 18 months.
Although There Are Concerns about China and the ongoing crisis in Europe over Greece’s fiscal tensions, the long-term story is still strong, argues Darren Lekkerkerker, a portfolio manager with Toronto-based Fidelity Investments Canada ULC and co-manager of Fidelity Global Natural Resources Fund.
“Yes, there is a temporary slowdown. People are concerned about the risks, and there are several,” says Lekkerkerker, who shares portfolio-management duties with Joe Overdevest. “First, people are asking, ‘Will Greece restructure? How does it impact Portugal or Ireland?’ China, I believe, is more impactful. It’s had very strong economic growth, and one of the factors that accompany growth is inflation, particularly in housing and food prices. The government is very sensitive to this. So, they had to tighten, which has caused the economy to slow a bit. People are saying, ‘Is this the end? Or are we going to have a soft landing?’ That will mean a steady level of growth, around 7%-9%.”
Another worry is the end of the second part of quantitative easing, known as QE2. The move by the U.S. Federal Reserve Board to stimulate the U.S. economy ends on June 30, and investors are apprehensive that this will affect energy and mining stocks that have been boosted by the weak U.S. dollar. Says Lekkerkerker: “People are asking, ‘Is this going to revert [the trend]? Will the dollar go up, and commodity stocks go down?’”@page_break@Some of these so-called “tail risks” have a small probability of happening, he believes.
Although resources stock prices have been weak and multiples have declined year-to-date, Lekkerkerker notes that underlying commodity prices have been strong: “Copper inventories in China are getting tighter. We expect that imports will really pick up toward the end of the year, and that should strengthen metal prices. It all points to a tighter demand/supply balance. You could say this applies to a lot of other commodities. While people worry about the macro, the micro fundamentals have been improving.”
Secular bulls on the sector, Lekkerkerker and Overdevest have long favoured energy, which accounts for 58% of the Fidelity fund’s AUM; 30% of AUM is in materials, and 9% is in chemicals (dominated by fertilizer names).
Among the top holdings in the 66-name Fidelity fund is Potash Corp. of Saskatchewan Inc. The world’s largest potash producer has an annual output of 12.5 million tonnes and expects to produce 17.5 million tonnes by 2014. “The management team is top-notch,” says Lekkerkerker. “If any company can increase their capacity, Potash Corp. can.”
Lekkerkerker adds that the increased output is feasible because the firm’s infrastructure is in place. A long-term holding, Potash Corp. shares are trading at about $54 a share. There is no stated target.
The Resources Sector Has been struggling with several headwinds, admits Chris Beer, vice president at Toronto-based RBC Global Asset Management and lead manager of RBC Global Resources Fund. “We had the Mideast/North African uprisings causing oil prices to rise,” says Beer, “which can cause lower [global] growth because there is less money for other consumption. We also had the Japanese tsunami disaster, which created a lot of issues for Japan and worldwide, with supply-chain events that may have caused some of the weakness in the U.S. job numbers.”
China is another major worry, says Beer, who shares duties with Brahm Spilfogel. “The issue in emerging markets,” adds Beer, “is that a large part of their inflation is [attributed to] food. But raising interest rates is like a toddler trying to put a round cylinder into a square hole — it’s not that effective. And with QE2 coming off soon, that’s another headwind to global growth. But, given this quadruple whammy, stocks haven’t been doing badly. If I’d told you six months ago that we would have these serious headwinds, you would expect things to be much worse than what we have had.”
Like others, Beer and Spilfogel are secular bulls on the resources sector. “Unless demand is back at global financial crisis levels [in 2008],” says Beer, “the only way to kill the commodity price is massive supply increases. We haven’t really seen that yet.”
Running a 95-name RBC fund, of which about 54% of AUM is in energy companies and 42% in materials, Beer and Spilfogel favour small- and mid-cap stocks. One favourite name is African Minerals Ltd., a London-listed company developing one of the world’s largest iron ore deposits in Sierra Leone. The stock is trading at 540 pence ($8.50) a share, but Beer and Spilfogel foresee the share price doubling in 12 to 18 months as its cash-flow multiple rises in line with other iron ore producers.
Arcan Resources Ltd. is another top pick. Active in Alberta’s Beaver Hill Lake region, the small-cap oil and gas firm encountered some production problems last year, which hurt its stock price. But management has addressed those issues and production is back up to 3,500 BOE a day. Says Beer: “You’re looking at production growing by about 20% a year for the next couple of years. It’s very high-quality oil. Even if the company does not become an M&A candidate, it should be trading closer to $8-$10 a share on a cash-flow basis.” Arcan shares are trading at about $5 a share. IE
Emerging markets fuel resources funds
Demand from India and China for commodities should be positive for natural resources funds over the long term
- By: Michael Ryval
- June 24, 2011 October 30, 2019
- 10:45