From the October 2007 issue of Wealth Manager Web • Subscribe!

It's Only Natural

After languishing in 2002, natural resources funds began climbing. During the past three years, the average fund in the category returned 28.8 percent annually, according to Morningstar. The cause of this rally is no secret: Prices for a range of commodities--including copper, oil, and iron ore--have been booming.

The current commodities rally can be traced to market conditions that emerged during the bull market of the 1990s. At the time, investors poured money into technology stocks of all kinds, and few people were interested in sinking cash into new copper mines or oil refineries. When global growth accelerated early in this decade, shortages began to appear, and resource stocks started to soar.

Thanks to the big rally, many of these stocks are no longer cheap. But there is good reason to believe that the sector can remain healthy. Despite rising commodity prices, few new mines and refineries will come on line for years. Political problems in countries such as Venezuela and Iran are holding back production. In addition, environmental concerns are blocking efforts to build facilities. Once companies do get permits to start projects, it can take as long as 10 years to finish a new mine or refinery. While supplies can only grow slowly, demand for commodities continues its relentless climbing. Throughout the developing world, countries like China and Brazil are racing to build new highways and airports. The building of such infrastructure requires a wide range of commodities. Meanwhile, consumers in the emerging markets are also demanding more goods, including new cars, placing additional strain on energy supplies.

Whether or not natural resources funds continue to race ahead, the sector may still be worth holding because it can provide effective diversification. As markets have demonstrated in recent years, commodity stocks often climb during periods when other sectors of the market are stagnating.

To find the best choice in the resource sector, Wealth Manager again turned to the eight-part screens developed by Donald Trone, chief executive officer of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that have more than $75 million in assets and are at least three years old. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must surpass category medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

The screens reduced a field of 134 funds to 26 finalists. Top performers included Jennison Natural Resources, RS Global Natural Resources and Vanguard Energy. But we awarded the title to U.S. Global Investors Global Resources, which recorded the highest five-year returns of any contender.

U.S. Global won the award by seeking stocks that seem poised to deliver the highest returns on capital over long periods. To make their picks, the portfolio managers monitor a variety of indicators. Sizing up oil companies and gold mines, the managers look for companies with growing reserves and production. When they analyze oil services firms, they focus on growth of cash flow. In all cases, the U.S. Global managers like to find bargains--growing companies where the reserves per share still look cheap. The fund sometimes buys producers with low returns on capital--provided the company seems on the verge of enjoying a big production spurt that will translate into profits.

Because the fund is global, it can roam the world seeking the best values, emphasizing the U.S. one year and the emerging markets the next. A big winner for the fund has been Petroleo Brazileiro, a Brazilian oil giant. The managers started buying the stock in 2004--a time when oil sold for less than $35 a barrel--and oil stocks were not market favorites. "The Brazilian company was growing at double-digit rates, but the stock was only selling for seven-times earnings--well below the prices of U.S. companies," says Evan Smith, a portfolio manager.

Besides being diversified globally, the fund also makes an effort to hold a mix of currencies and industries. When one industry sags, others may pick up the slack. With the dollar weakening lately, strong foreign currencies have helped to boost the value of the fund's foreign holdings.

The fund's managers aim to exploit global cycles and trends. Lately they have been buying coal stocks. A favorite holding is Fording Canadian Coal, which produces metallurgical coal used in steelmaking. "Many companies are having trouble getting enough coal," says Frank Holmes, chief investment officer of U.S. Global. "China has become a net importer. Australia has been attempting to increase its exports, but there have been bottlenecks with dozens of ships waiting in line for supplies."

Besides buying commodity producers, the fund also takes companies that depend on natural resources. A big holding is DryShips, a Greek company that hauls coal and grains. "There is a growing need to transport commodities, but not enough ships are being built," says Holmes. "That is translating into higher rates for shipping companies."

The U.S. Global managers often take contrarian positions, buying stocks that other managers shun. Early this year, many Wall Street analysts became convinced that oil prices had peaked. When energy stock prices sagged, U.S. Global began snapping up shares of PetroChina, a growing producer. "People on Wall Street were bearish on commodities because they figured that rising interest rates would slow the world economy, "Holmes says. "But prices of oil and other commodities are going to remain firm over the long term because demand is so strong."

Stan Luxenberg (sluxenberg1@nyc.rr.com), Wealth Manager's "Best of Breed" columnist, is a New York-based freelance business writer and a regular contributor to the magazine.

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