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Be ready to grab oil, gold, timber funds
But first wait for a big fall. If the United States successfully invades Iraq, prices of oil and other natural resources will tumble, creating an opportunity to buy and hold on for a bull run.
By Timothy Middleton
A looming war against Iraq has driven the price of oil above $30 a barrel and the price of gold above $360 an ounce. Stocks and mutual funds investing in these industries are thriving. So whatever you do, dont buy them.
Robert Shearer, manager of Merrill Lynch Natural Resources Fund (MAGRX), recalls that during the Gulf War of Bush the Elder, When the first bombs fell, and all seemed to be going well, we saw the price of oil plummet. Such reactions are so commonplace that Wall Street has an adage as old as itself: Buy the rumor, sell the news. And just as a bear market takes stocks down indiscriminately, a collapse in oil prices will devastate the entire natural-resources sector.
So envy the speculators' profits in resources, which have ignored the bear market in other stocks. And admire their satisfaction when they sell their positions to suckers as GIs set foot between the Tigris and Euphrates. Then, a few months after that, when natural-resources funds stink to high heaven, give thanks and buy them in bulk.
A secular bear market in commodities has ended, and a long-term bull phase appears to be born. The world cant get through the day without the companies that heat its homes, fuel its cars, fell trees for the morning paper and mine the metals that Coca-Cola (KO, news, msgs) turns into cans and Tiffany (TIF, news, msgs) into bracelets. But those companies are disappearing faster than Enrons auditors.
Diminishing competition
Resources have been such a lousy industry for 20 years that capital has not been injected into those areas, and competition has diminished, says Fred Sturm, manager of Ivy Global Natural Resources (IGNAX), which shot up an average of 10.5% for the three years ended Jan. 31. Any business can be a good business as long as you dont have too many competitors.
Take the oil business -- please. Twenty years ago, Dow Jones (DJ, news, msgs) created a special class of shares to make it impervious to a takeover by Mobil, which wanted to quash embarrassing oil-price stories in The Wall Street Journal. Today, Mobil is the rump of one of its bitterest rivals, Exxon.
Takeovers are rampant among the major oil companies, and they are no less ubiquitous among the rest of the oil patch, as well as mining, paper and chemicals companies. The net effect has been to weed out the weakest players throughout the global resources arena.
That arena is surprisingly large. Energy stocks account for 7.2% of the worlds total market capitalization, according to the Dow Jones Global indexes. Utilities add 3.8% and basic materials 4.4%. The total, 15.4%, is a third higher than health care, and only marginally smaller than technology and telecommunications combined.
Because energy so thoroughly dominates the group, the mutual funds with the most assets focus on it exclusively. Four of the five largest natural resources funds have energy in their name. The largest of about 30 resources funds, with assets of $1.27 billion, is Vanguard Energy (VGENX).
Low but fast-rising prices
But the best-performing energy fund over the last five years, Icon Energy (ICENX), has less than $100 million in assets. Run entirely on a quantitative methodology that characterizes all Icon funds, Icon Energy looks for stocks displaying the best combination of low but fast-rising prices.
According to Standard & Poors, the energy sector comprises five industries: exploration and production; refining and marketing; equipment and services; drilling, and integrated oil and natural gas giants like Exxon Mobil (XOM, news, msgs).
Of these industries, Icons current favorite by a wide margin is exploration and production, which accounts for about one-third of the portfolio. But that group has led the pack for so long -- more than a year -- that its steam may be running out.
Lately, the fund has boosted its exposure to refiners. We like Valero Energy (VLO, news, msgs), says J.C. Waller, the funds manager. Its the largest independent in the refinery business, and it specializes in high-margin businesses like reformulating gasoline and taking the sulfur out of diesel.
But Waller doesnt like those attributes; a former linguist, he confesses hes no specialist in the oil patch. Rather, Icons computers like the way Valeros stock is behaving. It is relatively low, compared with other oil companies, but it's rising faster than its competitors. We believe companies with the highest value-to-price ratio are the springboards to be the next leaders in the market, Waller says.
Reaching further
The other flavor of natural resources fund is the type that has those words in its name. Many also have a global reach, because most commodities are produced abroad, from pulp for paper in Brazil and oil in Russia, to gold in Canada and South Africa.
What the investing world is picking up is that theres a layering-on of some near-term Iraq noise on top of what is basically a longer-term fundamental upturn in these fundamental industries, says Ivys Sturm.
China looms over commodities markets like Gulliver. Manufacturing is moving there from all over the world, but particularly from the nation that consumes the most the United States. Chronic U.S. trade deficits will grow, pulling the value of the dollar down.
When currencies are debased, investors try to preserve value by investing in hard assets, Sturm notes.
No asset is harder, in that sense, than gold, and resources funds tend to own gold shares. Anticipating a $10-per-ounce fall in gold prices when the U.S. invades Iraq, the Merrill fund has trimmed its gold holdings to about 3% of its portfolio, but is bullish on the metal longer term.
Gold is in a better supply/demand balance, says Shearer. Falling U.S. interest rates removed an incentive for mining companies to hedge production by selling futures, which took a cap off the price. Central banks are limiting their sales, and exploration has withered after two decades of weak markets.
Making a play for natural gas
But the really big play the Merrill fund is making is in North American natural gas. Prices have tripled from less than $2 per thousand cubic feet a few years ago. Almost half of Shearers assets are invested in companies that produce and distribute natural gas on this continent.
We try to look at commodities on a top-down basis, to guide investments toward commodities that have the best pricing outlook, Shearer says. Gas fills that bill. Despite sharply higher prices, production is down -- even in Canada, which traditionally has furnished supplies when they are tight in the United States.
Were just not drilling, says Shearer. The nations current reserve, of 1.52 trillion cubic feet, is well below normal levels for this time of year. Well probably end the year at record low storage levels. With production below existing usage, we could go into next winter with extremely low inventories, he says.
In a bizarre footnote to todays energy scene, the left-wing president of Venezuela has fired most of the top managers and engineers of Petroleos de Venezuela, which once provided about one of every eight barrels the United States imports. Production has been decimated by a general strike, and the firings could condemn Petroleos de Venezuela to mismanagement for years.
A correction is almost certainly coming in resources stocks, so you dont need to be in any hurry to own them. But eventually, you will want to.
What they're buying now
Exploring the frontier: Icon has been buying Frontier Oil (FTO, news, msgs), which mainly refines gasoline for other companies, but also sells gas under the Citgo brand. We currently have them 20% to 25% underpriced, and their relative strength is 1.16, meaning over the last six months the stock has performed 16% better than the market, Waller says.
Into the forest: Aracruz Celulose (ARA, news, msgs) is one of the worlds largest pulp producers. Having the Amazonian rain forest in its back yard gives the company the blessings of geography, and its also highly profitable. Were seeing free cash flow generation of 12% to 13%, says Ivys Strum.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article
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