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Don't hang up

JASON LIND, CFA 09-Dec-2018

It has been a challenging and frustrating time for investors in natural resources. A simmering trade war between the U.S. and China is having an impact on near-term demand and, importantly, investor sentiment. Factor in a strong U.S. dollar and it’s easy to see why investors are harboring a healthy degree of skepticism toward this space.

Still, it may be too early to hang up on the natural resources sector. Some institutional investors typically maintain an allocation to natural resources for their inflation-hedging potential and return streams that are not necessarily correlated to stocks and bonds. Individual investors may wish to take a similar long view when it comes to constructing a diverse portfolio. In fact, the current dynamic has created a growing disconnect between commodity fundamentals, select individual company fundamentals, and stock prices. This disconnection offers a potentially intriguing opportunity.

SailingStone Capital, a subadvisor that works with Victory Capital and specializes in natural resources investing, reports that for the past 18 months, the public equity markets have priced companies in a manner that is inconsistent with what’s happening on the ground. SailingStone capital believe that fundamentals may actually be improving, evidenced by:

  • Declining spare capacity in most commodity markets
  • Falling above ground inventories
  • Lower levels of capital investment
  • Greater capital discipline
  • Improving balance sheets and corporate governance

According to SailingStone Capital, it sees companies that own what are believed to be some of the most attractive assets across the natural resource sector, but with stock prices that discount to $50 oil, $2.45 natural gas and $2.25 copper into perpetuity. This illustrates a severe disconnection given the current commodity price environment of $55-$80 oil, $2.75-$3.00 gas, and $2.65-$3.30 copper.

It’s important that we acknowledge that risks remain for natural resources investors and that the public equity markets aren’t always instantaneously efficient. In fact, SailingStone Capital believes that the equity markets may be inefficient for longer than they have been previously due to the growing influence of trend-following strategies. For evidence, we’re seeing much higher prices being paid for lower quality assets in the private markets versus their public market peers. While we also recognize the potential demand risks associated with emerging markets instability, the natural resource space appears to be one of the few areas that is already reflecting recessionary levels of demand destruction.

Ultimately, however, we believe that stock prices should reflect the present value of future cash flow streams, and therefore stock prices will move to eventually reflect the true value of a company.

Concentrating investments in the natural resources sector increases the risk of loss because the stocks of many or all of the companies in the sector may decline in value due to developments adversely affecting the sector. In addition, investors may buy or sell substantial amounts of the portfolio in response to factors affecting or expected to affect the natural resources sector, resulting in extreme inflows and outflows of cash into and out of the portfolio. Such inflows or outflows might affect management of the portfolio adversely to the extent they were to cause the portfolio's cash position or cash requirements to exceed normal levels.

International investing involves special risks, which include changes in currency rates, foreign taxation and differences in auditing standards and securities regulations, political uncertainty, and greater volatility. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.