The commodities gusher
Fund manager Frank Holmes argues it's not too late to find opportunities in natural resources.
(FORTUNE Magazine) – The prices of natural resources have been soaring lately, and everyone has been feeling the impact--from consumers socked at the gas pump to big manufacturers forced to absorb sharply higher costs for steel, copper, and aluminum. But if you've been investing in natural resources, you're probably ecstatic. While the S&P 500 has barely been moving--the stocks in the index have gained a negligible 1.5% in the past 12 months--the average commodities mutual fund has gushed a 38% return. U.S. Global Investors fund manager Frank Holmes has pumped out even better results. His Global Resources fund (PSPFX) has posted a 47% annualized return over the past three years, walloping every fund in the category. (Over the past ten years, his fund has gained an average of 13.5% a year.) Holmes remains bullish on commodity prices, though he thinks they may soften in the near term. He argues that continued growth in China and India--plus a tepid dollar--is creating a long-term opportunity for investors to keep profiting from natural resources.
Is it too late to invest in commodities?
No. Commodity prices have softened in anticipation of a U.S. slowdown caused by rising interest rates. Some commodities have gone through a modest correction: Zinc, steel, copper, and oil have all come off their highs. But there have been no major discoveries of copper, gold, oil, or gas, so supply is limited and I'm not worried about commodity prices falling much further.
How long will the current boom last?
I believe the commodities boom will last until about 2010 or 2012. In the short term I expect commodity prices to be choppy, but in the second half of 2005 I expect all commodity prices to move back up. China and India will continue to drive global demand. Although we've just passed the peak in growth of Chinese demand--commodities consumption was rising at 20% per year--it's still growing at 12% and will continue to increase at double-digit rates until the end of the decade. In China you have a government that is building infrastructure, which uses commodities. And you have an emerging middle class, which wants to buy products that are made from commodities.
How do swings in the dollar affect commodity prices?
Commodities are priced in U.S. dollars, so when the dollar falls, it makes commodities cheaper for countries whose currency isn't tied to the dollar. The result, of course, is that demand increases in those places, and that makes commodity prices go up. So in the end a cheaper dollar benefits the commodities market, and that fuels the exploration and development of more commodities. I think the U.S. dollar is going to be strong until June, when it'll decline modestly and then be flat for the following six to nine months.
What do you look for in the stocks you invest in?
First, I look for growth in a company's reserves. Oil wells and coal mines all have a limited life. The companies continually have to find more reserves or deposits to replace what they've supplied. I also look for growing production--how fast the company is actually producing the commodity. And then I look for growth in cash flow. I seek companies that are building cash and are able to pay dividends. If you have those factors, you'll see a rising stock even if the commodity price is falling. And then, if a commodity price is rising, you can get 200% and 300% returns. I also look at management. A lot of natural resources companies are run by geologists, who don't tend to be financially disciplined. I look for executives with financial expertise. I don't like debt, especially in mining companies, because that makes it harder to survive periods when commodity prices are low.
Given those factors, what stocks do you recommend?
I have 3.3% of my fund in Fording Coal (FDG, $92), which is a royalty trust, meaning it pays out most of its earnings in dividends. Fording is the second-largest worldwide producer of hard-coking coal, the type you use for making steel. Steel prices have corrected a bit, but I think they will continue to go up. The price of hard- coking coal has doubled from $55 per ton to $120 per ton in the past year because of the demand for steel in Asia. Demand for coal has also been pushed up by oil prices; oil is so expensive that people want a cheaper alternative. We like the fact that it's a pure commodity play, and we love the dividends. Fording paid a big fat dividend of 4.5% in 2004, and the company has announced that the dividend will be 10% in 2005. In 2006 we see a 240% increase in cash flow.
We also like Canadian oil and gas company Penn West (PWT.TO, $70--1.8% of his portfolio) because they want to become a royalty trust, which means they'll start paying out big dividends. The stock is now $75 per share, and if they start paying monthly dividends, as we expect them to, then it's worth $90. The monthly dividends will make the stock less volatile in the event of a fall in energy prices.
What mining companies do you like?
My top mining pick is Northern Orion (NTO, $3--3% of his portfolio), a copper and gold producer from Argentina that is trading on the American Stock Exchange at eight times its cash flow. It has a mining deposit that's worth about $10 per share--and the stock is just $3. Once it begins mining the deposit, the stock is likely to rise. We love that the company mines both copper and gold. You get better cash flow and less volatility when you have a mix.
I also like Goldcorp (GG, $14--2%). With its recent acquisition of Wheaton River, it has become the lowest-cost gold producer in the world. It produces 1.2 million ounces of gold a year at less than $80 an ounce, when the average cost of producing gold is $300 an ounce, and gold is selling at $420 an ounce. Plus, they've got a half-billion dollars of liquid assets and are debt-free.