Looking beyond macro issues, and oil spill, resources companies show some strength

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Our assessment of the market in general, and resources in particular, reflects today’s conflicting headlines. There are several issues that present a challenge, but there are other indicators that are quite constructive. The positives suggest that the resource market consolidation of last year’s gains could be setting up for one of the better secondary buying junctures of the past two decades. The negatives make it feel like investors want to price in a global economic double dip, or at least wait it out long enough to see if equity prices could drift a bit before heading higher. While the Fund had a strong year in 2009, the quarter ended on June 30, 2010 was disappointing, as the broad weakness and some specific challenges like the Gulf Oil Spill caused the Fund to decline slightly more than its benchmark indexes. Looking forward, we believe it boils down to this: if the macro headlines turn out to be sufficiently overwhelming to cause a return into global recession, then stocks and commodities will drift; if not, then sufficient and improved long-term value exists for investors to maintain holdings and judiciously add to holdings during these pull-back events. Based on our models, especially with an eye for a potential year-end rally and to the intermediate term, we still remain committed to our base case, which is that the global economy will find a way to muddle through with sufficient growth this year, and over the next few years, to reward investors.

The moderation in global economic activity and the commensurate sell-off in equities have headlines scripting double-dip. We do not expect this, as they are rare historically, and typically only occur following early and aggressive policy tightening, with an inverted yield curve and declining leading indicators. These conditions are not present today. Ironically, in the middle of a quarter when the market was selling off on double dip fears, the Organization for Economic Cooperation and Development (OECD) raised its global growth forecasts to roughly 4.5% for both 2010 and 2011. We would argue that 3.5 to 4% is more likely, with Asia contributing twice as much growth as the U.S. and four times that of Europe. We recognize that the debt/deficit challenges of some governments are not trivial, and in our most recent commentary, we characterized this as a transition year with events that could “cause investors to cycle between risk on and risk off.” However, indicators are not lining up for a full repeat of 2008. We do feel it is a touch early for governments to be jumping on the aggressive fiscal discipline bandwagon and do not like that fiscal stimulus could turn into mild fiscal drag, however we do like that monetary policy will probably remain looser as a result and western central banks are unlikely to raise interest rates much if at all for the balance of 2010. Keeping interest rates low across the broad economy with a strongly positive yield curve is constructive. We believe that government debt will be a challenge, but corporate balance sheets are solid and better structured than just two years ago. Government deficits are not sustainable and will need to be reduced, but corporate free cash generation is strong. Greece is seeing credit rating downgrades and will eventually need to restructure, but the

U.S. corporate credit ratings ratio of upgrades to downgrades is a positive 1.2 (vs. a low reading of 0.2 in 2008). In 2008, corporate yields reflected increased economic stress by continuing to rise as the crisis spread, but this time corporate BAA yields have been well behaved and declined into quarter end. So while fixed income markets have been voting that the global economy will slow by driving down 10-year bond yields, they have also been voting that corporations are nonetheless in decent shape. Financial strength is also visible within the Fund, where many companies have little to no debt and very solid coverage ratios. We do not like that the pace of job creation has been mediocre, but we do like that corporations are remaining lean to defend profit margins. We do not like renewed currency volatility, particularly for resource sectors where a rising U.S. dollar has pressured commodity prices, but we think it is important to recognize that the latest dislocation is more about Euro weakness than dollar strength. The international diversification of the Fund and currency exposure, despite partial hedges of foreign currencies, had just under a 1% detraction for the Fund during the quarter. In short, resource investors are being tested by the latest round of short-term financial shocks and increased intervention by governments, but we remain confident in the wealth creation prospects of companies given our expectation of a successful but slow market upturn and OECD forecasts of continued economic growth.

Negative short-term sentiment is creating an attractive valuation opportunity, though not as cheap as at the lows in 2008-2009. With the S&P 500 hovering just over 1000 and earnings projections of $90-95 for 2011, equities are offering almost double digit earnings yields, compared with approximately 0.2% for U.S. 3-month Treasury bills, 1% for 3-year bonds, 3% for 10-year bonds, and roughly 5-6% for corporate bonds. The earnings yield premium over corporate bonds is larger now than in November 2008. At quarter end, the forward p/e (Ameasure of the price-to-earningsratio,(P/E),usingforecasted earnings for the P/E calculation) of the Fund in aggregate was approaching 10 times. For instance, even if we shave off 10% from analysts’ estimates for next year for Exxon and Chevron, they are still trading at under 10 times forward estimates. Rio Tinto, a global mining leader is under 8 times consensus estimates, as are coal and copper producer Xstrata and coking and thermal coal producer Alpha. As part of our individual valuation and price target reward/risk assessment, we review past share price trading and valuation ranges. Prior to the second quarter sell-off, stocks were trading with roughly 1.5-2.5 reward/risk ratios. By quarter end, the numbers were getting closer to 2.5-4 times reward/risk, i.e. 10% downside risk but up to 40% upside potential. Stated another way, we believe there are a number of companies currently in the Fund with valuations that could support 30+% higher share prices than today should the macro backdrop stabilize. Further compression during the third quarter would render a valuation buying juncture that we believe could be among the better opportunities over the past two decades. If macro concerns subside and the intense correlation subsides with it, the tone of third quarter earnings reports could help us better understand which companies have already consolidated enough and which companies are somewhat vulnerable. Companies will be cautious in giving guidance that is too positive, but in ongoing discussions with managements in basic materials we here language like “If there is a renewed slowdown in activity, we are not seeing it.”

 

In many cases in the resources sector, we feel that the direction of the underlying commodity price can trump company valuation. High p/e stocks with low but rising commodity prices will still rise, whereas low p/e stocks compliments of strong but falling commodity prices tend to struggle. So we still attempt to base much of the investment decision and rotation between industry subsectors on relative commodity price strength. Gold has been strong, and we continue to believe in a continued rising trend so we advocate holding some. We perhaps should have held more during the first half of the year because, other than Asian coal stocks, gold is the only resource sector that had positive results. This is also reflected in better recent relative results in competitive funds that tend to be more precious metals centric. We do not consider the rise in gold prices over the past 10 years to have entered bubble territory, especially not in comparison to the 1970s advance, on an inflation adjusted basis, or compared to other commodity prices. However, prices are somewhat elevated short-term and we recognize that buying gold ETFs has become popular in response to financial stress, leaving gold prices vulnerable to a short-term sell-off. We are more inclined to buy dips than chase the rally.

The Macondo well disaster was the headline grabber this past quarter, knocking off $100 billion of value from BP alone, and unfortunately, this unforeseen event, which also impacted other oil related entities, was the single biggest detractor of relative performance for the Fund during the quarter. The oil price also traded sharply lower from a recovery high of $87 down $20 in four weeks as speculators holding energy liquidated their positions more aggressively than in 2008. Post liquidation, the long positions look roughly in line with the average of the past few years and if the past is any guide, we think there is room for re-buying into the end of year. Our 12-month range outlook for oil prices is $80 +/-$15. The U.S. Gulf produces over 20% of U.S. oil production and over 10% of U.S. natural gas, using round numbers. Globally, the world needs to keep going after more difficult to find and harder to produce oil because there just isn’t enough that remains easily attainable. This is why we favored the franchise value of offshore service companies. At the end of the first quarter, the Fund held three world class services companies involved with the ill-fated well, namely Halliburton, Cameron, and Transocean. Some offshore drillers not involved, like Noble, were held in the Fund, and also were impacted. We held neither BP, the operator, nor junior partner Anadarko. We suspect that Halliburton and Cameron may come through this challenge with less impact than the market first factored in, and the steadying of the shares seems to support this. However, the pace of offshore drilling worldwide will be slowed. Previous to the accident, we had transferred some drilling holdings to Seadrill for more international exposure. We subsequently did more of this and early in the process progressively sold down and ultimately out of Transocean and Noble at prices that were more of a give back from prior gains than meaningful losses. These shares, along with BP, are quickly approaching deep value, but they may be value traps for a while. In addition, favoring oil, the Fund had smaller holdings in companies that plan to develop offshore oil fields. Through no fault of their own, these plans will be slowed, impacting share progress. Again we partially sold down positions to augment holdings in companies that we feel may be earlier participants in the next round of advances. In aggregate, an unfortunate accident was big enough in scope to impact several only moderately related companies. We estimate this has cost the Fund several points of absolute, and a couple of points of relative, performance. Will anything positive come of this? Modern equipment provided by premium companies should command superior margins, and the hurdle for new companies considering entering the offshore services industry has probably now become insurmountable. This should be good for franchise value and is one of the reasons we have chosen to maintain holdings in Cameron. One potential less obvious implication is that onshore production will be valued more over time, and this would benefit companies like Occidental, which recently increased its growth and return projections over the next several years. This is another good example of one of our holdings valued attractively and performing very well at the operational level, but trading lower short-term due to macro issues. Tar sands in Canada, with Canadian Natural as an example, could also be assessed higher over time.

Within the energy sector, we remain fascinated by electricity. Global electricity demand is growing at twice the rate of total global energy demand. The emerging world not only needs modern air conditioned factories, but it also wants microwaves and computers and hair dryers. The OECD’s International Energy Agency projects a moderate 1.5% annual growth in total energy to 2030 but a 2.5% growth in electricity for 75% total growth over 20 years. Our travels to Saudi Arabia suggest they will need 75% more electricity within the next decade as their society and economy transform. The Anglo-Saxon developed world consumes roughly 10 megawatt hours per capita. China consumes 2, India, less than 1. Multiply the potential for higher personal consumption by 2.5 billion people and it is clear that there remains huge demand growth potential. Oil is harder to find, harder to get, and increased government barriers will make extraction more costly too. Oil should therefore be more susceptible to scarcity price jumps between now and 2015, while the growth likely will be better in electricity. For the emerging world this mostly means coal. China has already become an important importer, after having been a major exporter in prior decades. Vietnam was once China’s largest external coal supplier. By 2015 it is forecast to require imports. Now India is set to join the league of major import demand growth with requirements ballooning from 100 million tonnes in 2009 to a potential 250 million tonnes in 2014. The coal stocks have been very volatile and are compressing valuations again, but if coal prices are sustained at higher levels than investors are valuing, coal stocks have plenty of upside. We prefer Asian based coal producers, but have also increased holdings in U.S. based companies that have export capacity and used this pull-back to increase exposure to thermal and met coal producers to roughly 15% of the portfolio.

Within America, we believe natural gas will be the electricity growth fuel. We remain selective by focusing on companies with concentrated, low cost shale plays. Natural gas continues to linger at cheap prices that are only half the heating value equivalent of oil, so our instincts are to keep looking for conditions that may offset the known negative of continued lower cost shale production growth. For gas in general, the short term upside is likely to be minimized by inventories and switching back to coal. However, in the intermediate term, we expect gas will displace coal and we likely will reflect that in the Fund. Hot weather and disrupted production from hurricanes could be near-term positives for natural gas. Longer term, the gas/ oil spread should narrow as electricity is deployed more aggressively in transportation for both plug-in and fully electric vehicles. The successful IPO of Tesla Motors is a sign of exciting developments to come over the next decade. We encourage investors to review their web site to see how far the technology has already progressed. While we did not participate in the IPO, we do have exposure to lithium cell makers in Korea and these stocks advanced to record highs this past quarter, with LG Chemical one of the few positive contributors for the Fund during this difficult quarter. We suspect that copper will also remain relatively tight as the global electricity grid is built out and enhanced. The Fund has copper exposure through Teck, Antofofogasta, Xstrata, and First Quantum. Copper prices may still briefly decline and drag these shares lower, but the multi-year outlook for tight supply-demand conditions is why copper remains our preferred base metal.

Renewable energy, which 2.5 years ago was over 12% of the portfolio, is now roughly 1% wind and 3% solar. China High Speed, the wind manufacturer of GE turbines has performed well enough for the Fund, but the solar stocks have cost the portfolio an incremental 1% relative to benchmarks. Even though the Fund did well to focus on leading low cost Chinese producers TSL and Yingli, and these companies continue to deliver on their growth plans, the shares are down a nasty 35% in the first half compared to their more than 100% average gain last year. The volatility is wild. The primary reason for the decline is that Europe has been the primary solar market and the sharp decline in the Euro is squeezing margins for the producers that have dollar-linked costs. We expect more global policy announcements in favor of solar and we intend to maintain some exposure.

 

Agriculture and fertilizer was close to 15% of the portfolio 1.5 years ago, but we have been holding a much lower 5% exposure over the past quarter. The companies are profitable and fertilizer prices have bottomed, but the shares have sold down with the rest of the market. Valuations are looking attractive to us again.

One of the more interesting developments during the quarter was the Australian government flip-flop on punitive taxation of the mining sector. Highly profitable companies around the world stand out as potential targets by governments seeking to raise revenue to balance the books, or support increased social programs. Prime Minister John Howard of Australia was ousted by his own party as voters sent a clear message that they did not want to harm an industry that has been a critical part of wealth creation in the country. Government policy risk has increased, but this could also force additional discipline on companies to slow supply growth.

 

An issue that is harder to assess is the likely policy choices China will make. Especially with such uneven global recovery, policy decisions in China will have significant impact. Their efforts to moderate growth to more sustainable levels, and in particular arrest the rapid rise in house prices, have been in force for half a year, and have put pressure on resources. We believe they will have mostly achieved their target within the next several months. This concern is already reflected in share valuations, which are lower, but more sustainable growth is not a bad outcome for resource sectors, and commitments to develop Tier 2 and Tier 3 cities will support resources demand longer term. Suppliers of iron ore, coal, copper, and potash will need to remain disciplined to defend their markets as demand growth from China moderates naturally or should China attempt other methods to manipulate prices lower. This issue is much more important than the Greek debt. Further tightening has risks for resources, whereas a sense that they have achieved their targets could ignite a rebound in resource stocks.

 

To conclude, it was a disappointing quarter for the sector and the Fund as exaggerated European macro risk and an unforeseen oil spill piled concern onto a consolidation process that was expected after last year’s strong rebound. The portfolio remains balanced with what we feel are financially strong companies, a tilt toward energy, and a positioning for an expectation of continued moderate growth. As markets price in a potential double dip, valuations are becoming more compelling. Share prices could slip further awaiting more constructive headlines. We would clearly see this as a reason to rebalance into resources and, where there is room, to increase exposure. We allow for a summer rally, and are preparing to become more aggressive on subsequent retests. We are also hopeful that a more positive phase for resources before year end will provide a window to recover some of the moderate underperformance from the aforementioned challenges. From our vantage point, deciding on whether to stay patiently invested or observe from the sidelines can perhaps be guided by the underlying cash generation of the companies. Most resources sectors are earning their cost of capital and then some. Commodity prices could rally into next year and we still expect them to strengthen over the next 2-5 years. This, and not short-term day trading, is the basis of wealth creation over time.

 

 

 

The opinions expressed are those of the Fund managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through July 12, 2010, and are subject to change due to market conditions or other factors.