Sector Watch: Mixed feelings on natural resources

The overall bearish mood is attributable to the fact that margins for the mining sector peaked last year, says Benoît Gervais, vice president, investments, with Toronto-based Mackenzie Financial Corp. and portfolio co-manager of Mackenzie Universal Canadian Resource Fund.

“The margin expansion trade that we’d seen in the previous decade is now over,” says Gervais. “Over the past year, we’ve had many reports by various investment houses that said, in effect, ‘From here, the sun is setting.’ As active managers, we’ve been saying that [mining companies] have to offer something other than margin expansion. And that’s volume growth, human ingenuity, discoveries and, basically, producing more for less [cost].”

Gervais argues that if resources investing can be divided into seasonal periods, then this should be the season in which the economy gathers momentum because of growing confidence and the producers benefit from pricing power. “That’s when resources tend to do best, and the market pays more attention,” says Gervais, who shares portfolio-management duties with Fred Sturm, executive vice president and chief global investment strategist with Mackenzie.

Gervais believes the resources sector is at a critical juncture, uncertain where to move: “I am still divided. I would not have expected copper, for instance, to come down this much,” says Gervais, noting that copper prices are US$3.25 a pound, compared with US$3.75 in January. “If the economy is getting stronger, you would think that copper would have held up better. Commodities prices are suggesting that things are a little softer than usual – and so are the economic numbers, which point to slower growth than expected.”

A bottom-up investor, Gervais focuses on companies that benefit from either production growth or technological innovation. From a sectoral standpoint, about 68% of the Mackenzie fund’s assets under management (AUM) is in a mix of energy producers and energy services, 17% is in precious metals, 15% is in base metals, with smaller holdings in chemicals. There is also 20% in index short positions used to reduce market volatility.

Noting that many bellwether resources stocks already reflect the comparable drop in commodities prices, Gervais is prepared for one of two outcomes – investors will get either a fair price or some upside.

Running a portfolio with about 90 names, Gervais likes Rio Tinto PLC, a leading metals producer. “It’s a premier iron ore producer in an oligopoly,” he says. Rio Tinto, under a new CEO, Sam Walsh, is cancelling projects and preserving capital. Adds Gervais: “When times are tougher, it’s time to introduce the accountant. But cutting costs will be the tougher part.”

Rio Tinto stock is trading at about US$44.35 ($45) a share and is listed as an American depositary receipt on the New York Stock Exchange. Based on anticipated improvement in commodities prices and cash-flow projections, Gervais has a target of US$65-US$75 a share within two years.

The cause of the down- turn is increased supply, says Darren Lekkerkerker, a fund portfolio manager with Toronto-based Fidelity Investments ULC and co-manager of Fidelity Global Natural Resources Fund.

“In the 2000s,” he says, “you had the perfect confluence of factors: a soft U.S. dollar, strong demand from emerging markets and supply growth was anemic and hard to come by. There was a lack of investment in capital, people and technology. What’s changed is supply. If you look at natural gas, for instance, you had new technology in shale drilling, which has increased supply. That’s also happening in the oil sector. And look at nickel, where we had technological developments that also effectively lowered the price.”

Meanwhile, he maintains, demand still is generally strong. And although China’s annual gross domestic product growth has slipped to around 7.5%, he adds, “China’s economy is growing off a larger base, so the percentage growth looks smaller.”

Lekkerkerker, who shares portfolio-management duties with Joe Overdevest, another Fidelity portfolio manager, agrees that the resources sector did peak in 2011 and it is hard to predict when the sector will come back into favour – even though commodities tend to move in definite cycles. “Right now,” says the bullish Lekkerkerker, “it looks like we’re in a later cycle. But, still, we are finding several interesting opportunities.”

Overdevest, a bottom-up stock-picker, says many businesses don’t get the fanfare “but have the attributes of a very strong business and benefit from higher commodities prices. Their stocks don’t decline as much when commodities prices go flat or down. They have tighter supply/demand within their subsectors.”

The Fidelity fund is fully invested, with about 60% of its AUM in energy producers and services firms, and 40% in materials (including 11% in chemicals, 7% in lumber and 3% in gold).

Running a 49-name portfolio, Lekkerkerker and Overdevest favour Methanex Corp., a producer of methanol that is benefiting from abundant natural gas. “It’s still a great company,” says Lekkerkerker, “that is very well managed. And we believe in the growth story on production and cash flow.”

Methanex stock is trading at about $46 a share and pays a 1.8% dividend. There is no stated target.

Robert Taylor, vice president with Toronto-based BMO Asset Management Inc. (BMOAM) and lead manager of BMO Resource Fund, says he has been cautious on the resources sector for the past couple of years, particularly those areas that are tied to global growth.

“With respect to China, it’s in transition,” says Taylor, who shares portfolio-management duties with Mark Serdan, vice president of BMOAM. “It can no longer rely on export markets and has been losing its competitive advantage: cheap land, labour and raw materials.”

Moreover, Taylor notes, inflation is dormant globally, in spite of massive global central bank stimuli: “Coming out of 2009, stocks started to price in inflationary pressures. But that hasn’t materialized. Stocks have performed much worse than the underlying commodities.”

Although Taylor is cautious in the short term, he’s bullish over the longer term: “As emerging markets continue to grow, so will demand for commodities. Sourcing new supply will become increasingly expensive, which should be supportive for commodities prices over the longer term.”

When it comes to energy, Taylor is more bullish on natural gas prices but less so on oil. “We’ve seen increasing U.S. oil supply, growing OPEC spare capacity, little demand growth from the developed world and slowing growth from emerging markets. But gas is a different story,” says Taylor, noting that more North American industries and power plants are switching to natural gas. “The other dynamic is that you will see supply levels correct from here. There’s a high decline rate in the [Western Sedimentary] basin. Given the lack of drilling, you will see an adjustment to supply levels. That should be bullish for natural gas prices. We are halfway through the cycle. There’s much more room to the upside.”

Taylor, a “growth at a reasonable price” investor who favours companies with proven managements and track records, is bullish on the energy sector; it accounts for about 67% of the BMO fund’s AUM, followed by 23% in materials and 10% in cash.

Running a 60-name fund, Taylor likes Tourmaline Oil Corp., which produces mainly natural gas in Western Canada: “Under CEO Mike Rose, [Tourmaline has] done an excellent job in amassing a very attractive land position and building the appropriate infrastructure to grow the company. It has consistently exceeded what we consider to be high growth expectations.”

Tourmaline stock is trading at $41.90 a share. Taylor’s target is about $50 within 12 months.

© 2013 Investment Executive. All rights reserved.