Resources funds hit by slowdown in China

Although China should continue to be a dominant global buyer of commodities, Lekkerkerker has been cautious on that country’s prospects for more than a year. He notes that China’s policy-makers – in an effort to bring down inflation in food and housing, especially in the crowded coastal cities – have steered that country toward a slower-growth path.

“Is there going to be a hard landing, or will growth stabilize? We’re of the view that growth will stabilize around the 7.5% target,” says Lekkerkerker, who shares portfolio-management duties with portfolio manager Joe Overdevest. “China has debts; but, directionally, its debt-to-gross domestic product [ratio] is a lot lower than [for] the Western nations. And China’s banks’ reserve ratios are the highest in the world, which will allow them to deal with their non-performing loans.”

As China’s political leadership is expected to change in the autumn, Lekkerkerker says, “We’re in a transition period.” But, he adds, growth will stabilize: “Longer term, China will continue to be an engine of demand for commodities. But the focus is gradually changing.”

That is, demand for some commodities will lessen as China’s economy shifts from infrastructure-building and demand falls for coking coal for steel, for example, to more demand for oil to fuel-transportation systems. Says Lekkerkerker: “The magnitude of price increases for some commodities is over.”

Bottom-up stock-pickers, Lekkerkerker and Overdevest are focusing on energy and energy services stocks, which account for about 60% of the Fidelity fund’s assets under management (AUM). The fund also holds about 32% of AUM in materials and chemicals stocks and about 6% in cash.

A top holding in the 54-name Fidelity fund is Methanex Corp., a leading producer of methanol (a byproduct of natural gas) that is benefiting from cheap natural gas and strong methanol prices. “[Methanex] has added capacity by opening up older facilities in Alberta and New Zealand [and] also is benefiting from long-term contracts,” says Lekkerkerker, noting that methanol is a key fuel additive in markets such as China. Methanex shares are trading at about $28.12 each, or 7.1 times forward earnings, and pay a 2.7% dividend. There is no stated target.

the market decline is largely about revised downward expectations concerning China, agrees Benoît Gervais, vice president, investments, with Toronto-based Mackenzie Financial Corp. and co-manager of Mackenzie Universal Canadian Resource Fund.

“China has been working off speculation in the housing market, particularly in the coastal areas,” says Gervais, who shares portfolio-management duties with Fred Sturm, executive vice president and chief investment strategist with Mackenzie. “Inflation reached a low last December. But we still haven’t had the fiscal and money-supply response. That could have helped the materials sector – but it hasn’t happened yet.” (On June 7, the Chinese central bank cut interest rates for the first time since 2008, a move that pushed up Asian stocks immediately.)

There is split in the energy sector, says Gervais: crude oil producers have benefited from relatively strong oil prices while natural gas producers have been hurt by a huge oversupply resulting from technological advances. “Horizontal drilling also has helped oil production, and it’s been a big win on the cost side. But the gas supply increase has been disastrous for [that] price,” says Gervais, noting that the natural gas price has fallen to $2 per thousand cubic feet. “The market has not been kind to gas companies that were not fast enough to make the transition into the new world.”

Meanwhile, on the materials side, Gervais notes that companies are being hit by rising costs that have reduced margins and returns on capital: “Most of the market decline is due to multiple compression. Investors are on strike; people want to hear companies say, ‘It’s expensive, so we will build less – until we can assure we can get a very good return on capital.’ Going forward, we think that executives will be more receptive to what investors want.”

Bottom-up investors, Gervais and Sturm look for firms that benefit from either production growth or technological innovation. Currently, about 57% of the Mackenzie fund’s AUM is in the oil and gas sector, 24% is in metals and mining, and 10% is in industrial products, as well as small weightings in areas such as paper and forest products.

One top holding in the 160-name Mackenzie fund is Dow Chemical Co., a maker of polyethylene, a building block in the plastics industry. Dow has benefited from cheap natural gas, which has pushed down the price of ethane, from which polyethylene is derived, so Dow has experienced higher returns on capital.

“Instead of closing its U.S. plants,” says Gervais, “[Dow is] bringing back capacity and plans to add more. [Dow has] gone from one of the higher-cost producers to one of the lowest.” Dow stock is trading at about US$30.10 ($30.60) a share and pays a 4.2% dividend yield. There is no stated target.

some critics suggest the secular bull market is at an end, but Chris Beer, vice president with Toronto-based RBC Global Asset Management (RBCGAM) and co-manager of RBC Global Resources Fund, argues that the cycle has a way to go, due to China’s appetite for resources.

“Demand is not as high as in 2008, or 2010, but inventories and housing prices in China have come down. It’s happened in the past, [and] China starts to re-stock inventories,” says Beer, who works alongside Brahm Spilfogel, vice president with RBCGAM. “The new five-year plan is more focused on consumption and a ‘China first’ policy, and some say that’s not a powerful move for commodities. I’m not sure that is the case. China has to build the equivalent of a city the size of Toronto for the next few years.”

On the demand side, Beer admits that austerity in Europe is having a negative impact and there is uncertainty about the U.S. economy beyond the presidential election.

“The demand picture is certainly cloudy. But the biggest issue is the supply side,” says Beer, adding that the rising cost to build new mines is cutting into returns on capital. “Investors are saying, ‘We’re not sure we want you to spend $10 billion to build a plant based on copper at US$3 a pound – all for a 10% return. Who knows what prices will be like in five years time?'”

What is certain, however, is that valuations have been slashed. Beer notes that a blue-chip name such as Suncor Energy Inc. has seen its multiple cut to five times earnings before interest, taxes, depreciation and amortization from 10 times in 2008: “This would imply that the returns on invested capital are cut in half. But this downward move has been excessive.”

Running a fund that has about 57% of its AUM in energy stocks and 39% in materials, Beer also has split the RBC fund’s portfolio between small-/mid-cap names and large-caps: “Our focus is best-in-class in both areas.”

One top holding in the 102-name RBC fund is Trilogy Energy Group Inc., a mid-cap oil and gas producer active in Alberta’s Duvernay region. Trilogy is aiming to boost production from 20,000 barrels of oil equivalent to 40,000 over the next two years. Says Beer: “If oil is US$100 a barrel, and [it doubles] production in that time, that return should get rewarded.”

Although Beer sold the RBC fund’s position in Trilogy when the stock peaked at $32 a share early this year, he bought in again at around $26 a share. His target is $40 within 12 to 18 months.

© 2012 Investment Executive. All rights reserved.