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What’s the dirt on natural resources equities?

JASON LIND, CFA 17-Jun-2019

Patience may be a virtue, and investors in public natural resources equities certainly have been testing the limits of this axiom. Whether driven by sentiment, a strong U.S. dollar, or emerging markets uncertainty, we must remember that over shorter-term time periods, individual company stock returns can vary meaningfully from their underlying commodity price trends. That’s inherent to investing in these public equities.

Today, we appear to be witnessing dynamics within the natural resources sector that are not dissimilar from the Global Financial Crisis, when select resource companies were commanding stock prices that ascribed little to no value for undrilled or undeveloped inventory. Therefore, investors should ask: Is a negligible valuation to natural resources in the ground warranted at this time, or does this spell opportunity?

Answering this question may require some historical context. As we step back and look at the current situation, we are reminded of the set up going in to the period often referred to as the commodity super cycle, from the late 1990s/early 2000s until the end of that decade. During that time there were some interesting phenomena that occurred.

For starters, the trade weighted dollar index—a broad measure of value for the U.S. dollar relative to other currencies—began to increase rapidly, and that coincided with strong outperformance from the U.S. equity market versus most other global markets. The strength of the economy started to impact commodity prices late in that cycle. But as commodity prices started to pick up marginally, the natural resource stocks were getting cheaper and cheaper. Eventually, the tide turned and there was a realization that these natural resources companies—many with years of untapped inventory, fairly clean balance sheets, and healthy free cash flows—were a relatively attractive place to deploy investment capital.

Although we all know that history doesn’t necessarily repeat, one could argue that the current set up today looks eerily similar. The U.S. equity market has consistently outperformed broad global equity markets in recent years. Commodity prices have begun to improve (putting aside some of the volatility of the most recent fourth quarter), yet many natural resource stocks are getting cheaper and cheaper regardless of company-specific fundamentals. Thus, it seems that a significant disconnect has emerged between stock prices of many natural resources companies and their underlying asset values. It is most pronounced on the small- and mid-cap companies, a little less so on large caps, and then even less so on the integrated oil companies.

So to answer our own question, we harken back to our belief that stock prices should reflect the present value of future cash flow streams (including some future cash flow from resources in the ground). And given that dislocations between asset and stock prices have become particularly wide for select natural resources companies, we are now staring at an intriguing opportunity (in our opinion) to own companies with what appear to be tier one copper, natural gas, oil and other commodities at a discount. It’s not always easy investing in natural resources, but understanding and acknowledging the difference between stock and asset prices can help.

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.