Port­fo­lio man­agers face a nar­row man­date, but they can di­ver­sify across in­dus­tries such as pre­cious me­tals and for­est prod­ucts

Investment Executive - - FRONT PAGE - BY JADE HEMEON

Surge in oil price is a short-term boon for nat­u­ral re­sources stocks.

fund port­fo­lio man­agers in Morn­ingstar Canada’s nat­u­ral re­sources cat­e­gory face the chal­lenge of find­ing in­vest­ments in in­dus­tries that are linked to com­mod­ity prices. Al­though these funds’ man­dates are rel­a­tively nar­row, the port­fo­lio man­agers are able to di­ver­sify across a hand­ful of in­dus­tries, in­clud­ing pre­cious me­tals, en­ergy, for­est prod­ucts and base me­tals, as well as re­lated busi­nesses, such as chem­i­cals, pack­ag­ing and re­sources equip­ment.

Mu­tual funds in the nat­u­ral re­sources cat­e­gory have been helped re­cently by a surge in the price of crude oil, which rose into the US$71 a bar­rel range in May from US$60 in early March be­fore fall­ing back slightly, as mea­sured by the bench­mark price for West Texas in­ter­me­di­ate crude (WTI).

That rise helped the Morn­ingstar nat­u­ral re­sources eq­uity fund in­dex achieve a 6% gain in April alone, thanks to the funds’ stakes in en­ergy stocks. The price of oil has been as high as above US$100 a bar­rel in 2014 and as low as $42 in June 2017, in­di­cat­ing how volatile com­mod­ity prices can be.

Few port­fo­lio man­agers of re­sources funds at­tempt to pre­dict com­mod­ity prices in se­lect­ing stocks for their port­fo­lios. Al­though the re­cent gain in oil has been a boost, higher prices ul­ti­mately lead to ris­ing global out­put and lower de­mand, which damp­ens prices.

Saudi Ara­bia and Rus­sia have sig­nalled that they’ll in­crease out­put, and the OPEC coun­tries also have sug­gested they may in­crease pro­duc­tion in the sec­ond half of this year. U.S. crude pro­duc­tion climbed to 10.47 mil­lion bar­rels a day in March — a monthly record, ac­cord­ing to data from the U.S. En­ergy In­for­ma­tion Ad­min­is­tra­tion. On the other hand, re­duc­tions in sup­ply from Venezuela and Iran, due to re­cent U.S. sanc­tions, are an­tic­i­pated.

Cana­dian oil pro­duc­ers have been con­strained by a l ack of pipeline ca­pac­ity to the west coast and the U.S., as well as a short­age of rail­way tanker cars. These short­falls have cre­ated a neg­a­tive price dif­fer­en­tial that has hurt Cana­dian com­pa­nies. The dis­count on heavy oil re­ceived for Cana­dian crude rel­a­tive to the WTI price has been as great as US$30 this year, which has been painful for pro­duc­ers with prop­er­ties in Canada.

How quickly these bot­tle­necks will be eased by the fed­eral gov­ern­ment’s re­cent $4.5-bil­lion pur­chase of the Tran­sMoun­tain Pipeline from Kinder Mor­gan Canada Ltd. re­mains to be seen. Canada’s proven oil re­serves are the third-largest in the world, and could be a huge source of wealth if their pro­duc­tion isn’t l and­locked any­more.

Canada’s in­abil­ity to get a pipeline built to the coast be­cause of po­lit­i­cal squab­bles, court chal­lenges, en­vi­ron­men­tal protests and other de­lays has tar­nished the per­cep­tion of Cana­dian en­ergy com­pa­nies among in­ter­na­tional in­vestors, and de­pressed stock prices. New obstacles may arise dur­ing the con­struc­tion phase with the na­tion­al­iza­tion of the pipeline. Al­though the fed­eral gov­ern­ment has stated it doesn’t in­tend to be a long-term owner, any deal to re­sell the pipeline has yet to be ne­go­ti­ated.

Mean­while, in an­other im­por­tant re­sources cat­e­gory, sag­ging prices for gold bul­lion in re­cent years have cur­tailed ex­plo­ration projects, and there have been few new dis­cov­er­ies. Ac­cord­ing to the World Gold Coun­cil, pro­duc­tion of 3,298 tonnes of gold i n 2017 was barely higher than the 3,277 tonnes pro­duced in 2016. Rather than wait­ing for higher bul­lion prices, port­fo­lio man­agers of re­sources funds are fo­cus­ing on com­pa­nies with promis­ing de­posits and ef­fi­cient mines that keep these firms’ costs down.

“The re­sources sec­tor does well at the mid- to end of the eco­nomic cycle,” says Benoît Ger­vais, se­nior vice pres­i­dent, in­vest­ment man­age­ment, leader of Macken­zie’s re­sources port­fo­lio team and port­fo­lio man­ager with Macken­zie Fi­nan­cial Corp. “When we have syn­chro­nized eco­nomic growth around the globe, that cre­ates the kind of sus­tained de­mand needed to de­plete i nven­to­ries and boost prices.”

The op­por­tu­ni­ties to beat bench­mark in­dices in the re­sources sec­tor lie in un­earthing op­por­tu­ni­ties in mid-cap stocks, Ger­vais says, as the more sta­ble, large-cap­i­tal­iza­tion gi­ants tend to dom­i­nate in­dices. Cur­rently, Macken­zie Global Re­source Fund’s weight­ing is 55% in en­ergy, in­clud­ing pipe­lines, distrib­u­tors and re­fin­ers; and 45% in ma­te­ri­als, in­clud­ing me­tals and min­ing.

“We look for mid-cap com­pa­nies that can gen­er­ate sus­tain­able growth and free cash flow over time,” Ger­vais says.

The Macken­zie fund’s global man­date al­lows Ger­vais to look be­yond Canada for in­vest­ment op­por­tu­ni­ties. Al­though 30% of the fund’s as­sets are held in Canada, 42% is held in the U.S. and there are hold­ings in Europe and Africa.

“There are trans­porta­tion bot­tle­necks i n Canada,” Ger­vais says, “and al­though the prob­lems are fix­able, that may take sev­eral years.”

In the U.S., the cycle still is on the up­swing in the hous­ing s e c t o r, which au­gurs well for build­ing ma­te­ri­als such as lum­ber, Ger­vais says. As eco­nomic growth con­tin­ues at a healthy pace, he adds, im­prov­ing em­ploy­ment and wages will lead to more de­mand for hous­ing.

One of the Macken­zie fund’s top hold­ings is cop­per pro­ducer First Quan­tum Min­er­als Ltd., which has a mas­sive mine project com­ing into pro­duc­tion in Panama later this year. Few other com­pa­nies are build­ing mines be­cause of low cop­per prices, but Ger­vais fore­sees grow­ing cop­per de­mand, par­tic­u­larly as elec­tric cars be­come more pop­u­lar. There can be as much as 100 pounds of cop­per in an elec­tric car, he says.

“I’m a be­liever i n the elec­tri­fi­ca­tion of so­ci­ety, and that means more bat­ter­ies, wires and charg­ing sta­tions,” Ger­vais says. “We’re mov­ing to­ward clean en­ergy sources with lower car­bon emis­sions, such as nat­u­ral gas and elec­tric­ity.”

In line with the clean en­ergy theme, an­other top hold­ing in the Macken­zie fund is Wil­liams Cos. Inc., a nat­u­ral gas gath­er­ing, pro­cess­ing and trans­mis­sion firm. One of the firm’s key projects is a nat­u­ral gas pipeline in the U.S. that con­nects the north­east to the Gulf coast, where coal plants are be­ing re­placed. The fund also holds Tour­ma­line Oil Corp., which has ex­ten­sive land po­si­tion and con­trol of nat­u­ral gas pro­cess­ing and trans­porta­tion in­fras­truc­ture in promis­ing re­gions in British Columbia and Al­berta.

An­other top hold­ing i n the fund is No­ble En­ergy Inc., a Texas-based oil and gas pro­ducer with a large gas find in the eastern Mediter­ranean Sea close to mar­kets in Is­rael, Jor­dan and Egypt.

“There are many years of grow­ing nat­u­ral gas con­sump­tion ahead,” Ger­vais says. ja­son mayer, se­nior port­fo­lio man­ager with Sprott As­set Man­age­ment LP in Toronto and sub­ad­vi­sor to the Nine­point Re­source Class fund, says he uses a bot­tom-up style. That ap­proach, he says, leads him to small-cap to mid-cap com­pa­nies and of­fers a bet­ter chance of find­ing at­trac­tive val­u­a­tions.

“We look for world-class as­sets,” Mayer says. “We can find more hid­den gems in the small-to mid­cap space, as the com­pa­nies are not as well cov­ered by an­a­lysts.”

For ex­am­ple, the Nine­point fund in­vests in NexGen En­ergy Ltd., which has ura­nium prop­er­ties in the Athabasca Basin in Saskatchewan, near the pro­duc­ing de­posits of gi­ant Cameco Corp.

The Nine­point fund’s big­gest weight­ing is in gold com­pa­nies, which ac­counts for 45% of the fund’s as­sets. En­ergy is next, at 26%, fol­lowed by base me­tals, at 12%. Al­though there has been a lack­lus­tre mar­ket for gold bul­lion in the past sev­eral years, Mayer says, some com­pa­nies have man­aged to con­trol costs and in­crease free cash flow.

“A lot of gold com­pa­nies have been fi­nan­cial disas­ters with cap­i­tal over­runs — burn­ing through cash,” he says. “But there also are those that have bat­tened down the hatches, righted the ship and got­ten in line, and free cash-flow yields are im­pres­sive.”

Pa­tience is called for, Mayer notes, as there is “com­plete dis­in­ter­est” i n gold stocks i n the stock mar­ket and spec­u­la­tors are find­ing more ex­cite­ment in mar­i­juana or cryp­tocur­rency plays.

Look­ing l onger term, Mayer re­mains op­ti­mistic. He re­gards gold as the world’s old­est cur­rency, with a his­tory of main­tain­ing its pur­chas­ing power.

Mayer ex­pects widespread cur­rency de­val­u­a­tion will be “a sup­port­ive tail­wind” for gold some­day. In the mean­time, he l ooks for com­pa­nies with strong op­er­at­ing mines, l ow costs and high cash flow. Among the Nine­point fund’s top gold-min­ing hold­ings are Con­ti­nen­tal Gold Inc., Rox­gold Inc. and Kirk­land Lake Gold Ltd.

On the en­ergy side, a key hold­ing of the Nine­point f und is Yan­garra Re­sources Ltd., a ju­nior oil pro­ducer in Al­berta with high rates of growth and a high rate of suc­cess in its drilling pro­gram. The fund also holds Parex Re­sources Inc., a Cal­gary-based com­pany with Colom­bian oil prop­er­ties that are un­af­fected by the trans­porta­tion con­straints of Canada.

In base me­tals, Mayer favours Ari­zona Min­ing Inc., which is de­vel­op­ing a promis­ing zinc as­set. Zinc is used pri­mar­ily for gal­va­niz­ing steel.

Few man­agers of re­sources funds at­tempt to pre­dict com­mod­ity prices

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