The equity of natural-resource producers is not perfectly correlated with commodities, but that is why they represent a useful, diversified exposure to the long-term commodity story, finds Lynn Strongin Dodds
The merits of capturing the natural resources story has been well documented but opinions diverge as to which is the best investment path to take. Some fund managers advocate equities, others commodity futures and some both - but all agree that it depends on an institution's objectives, risk appetite and time horizons.
"There is no perfect correlation between shares and commodity prices, which is why both strategies are complimentary," notes Ian Henderson, fund manager of the JPM Natural Resources fund. "It depends entirely on market conditions. For example, in the 1980s when oil prices were weak, stock markets were strong but that turned in 1987 during a bear market. Fast forward to 2006 and the end of 2007 and physical commodities did much better. If I were running a pension fund, I would put a portion of that allocation to an active commodity trader and a portion to an equity fund manager. "
Aurèle Storno, senior vice-president at Lombard Odier, also believes in offering investors the best of both worlds. He points out that, with the exception of gold mines, over the long term equity performance regularly diverges from that of the commodity thanks to the element of broad equity beta they contain, which drags them down in bear markets, and company-specific operational issues. For example, if an oil producer has already sold its supply on a forward basis, its stock price may not fully benefit from an oil price rise and returns can also be affected by the company's financial structure or the performance of unrelated businesses. However, Storno observes that some markets linked to broad commodity trends - such as utilities, water or alternative energy - are easily accessible through equities.
"When looking at the long-term correlation and beta relationships between resource stocks and their respective commodities, the time horizon is of great importance," he says. "Also, futures are homogeneous, while equities have often diversified underlying operations and produce various commodities."
Research conducted by Lombard Odier looked at performance for the S&P500 Metals & Mining index versus the GSCI Industrial Metals index, as well as S&P500 Energy versus GSCI Energy Total Return, over one, three and five-year rolling periods since the early 1990s. Over the short term, correlation and beta were relatively unstable. Over the medium term there was a stable but not high correlation until the latest bull run of futures, between 2003 and 2007. The research noted that during that period, while correlation moved higher, beta remained below 1.0 for both industrial metals and energy. The long-term analysis again shows a stable and rising correlation, but still not very high, with a similar pattern for the beta.
While the futures markets offer the most direct gateway to commodity exposure (with its diversification and inflation-hedging benefits), passive investors have to be aware of contango, which is when future prices rise significantly above the spot market. And David Donora, executive director of commodities at Threadneedle, suggests that pension funds are just too big to play commodities direct. "When investing en mass they can distort commodity markets which are too small to absorb the flows," he says. "Although it depends on your timeframe, some commodity-linked equities offer a better proposition during a recession and there are a number of companies which are well positioned to take advantage of the recovery."
As important is an investor's appetite for risk. There are, of course, two ways to look at the unstable correlation of commodity equities and the underlying commodities. As Anne Ruffin, head of global thematic equities and sector funds at Credit Agricole Asset Management, points out, you can lose a lot of money trying to time commodity markets, whereas an equity represents a company that has different components which help diversify the risk. "For example, if there is a mining company with mines in different countries, it can improve production in one place if another is experiencing problems," she says.
Further diversification can be built into your exposure to the broad commodities story with investments in companies involved in production of derivatives. "Investors can capture and diversify long-term commodity exposure efficiently through equities. In addition, they can look at resources from a different perspective," says Pieter Busscher, portfolio manager of SAMs Smart Materials fund. "For example, plastics are a derivative of oil and account for roughly 10% of oil consumption. Within that, bio-plastics are increasingly becoming a substitute material for packaging and companies involved in this type of product are expected to benefit."
When analysing commodity producers, Bradley George, head of Investec Asset Management's global commodities and resources team and a proponent of the two-pronged approach, is in good company when he says that investors have to focus on companies' balance sheets.
"If you look at the top mining companies such as Rio Tinto and Anglo American, they all had high debt/equity ratios," he observes. "The other factor to look at is whether companies are low or high-cost producers, because that will impact their earnings. For example, the more leveraged names will perform better in a rising commodity market because their margins will rise - but that is not sustainable in downturns. But companies such as BHP Billiton and Exxon on the other hand, are low-cost producers that have not been as affected by commodity price fluctuations and as a result they have benefited relative to higher-cost producers on the downside."
Indeed, marginal, high-cost producers with highly geared balance sheets should be avoided, says David Whitten, head of global resources at First State Investments. "These types of projects are often built or reopened at times of high commodity prices, when capital is often made available at or near the peak by less informed investors," he says. "Investors should also look to see if a company's interest cover is adequate and that its debt to equity is not excessive. We prefer to invest in companies with an interest cover greater than three times and a debt to equity ratio of less than 50%. One of the most useful tools to use is net present value analysis (NPV) of discounted projected cash flows. Key assumptions such as commodity prices, exchange rates, production targets, operating costs, metallurgical recoveries, and so on, are run to stress test the valuations."
Research from T Rowe Price notes that while the overall environment remains challenging, balance sheets are generally in good shape. It predicts that energy industries will lead a cyclical upturn in the natural resources sector as demand for oil shows signs of improvement in the second half of the year, particularly in the US gasoline market and in China.
Henderson adds: "There has been a substantial recovery in commodity as well as share prices in the past few months and the leading indicators are showing that things are improving. The emerging markets will continue to be a driving force, as about 55% of most commodities are consumed by these countries and that story will continue over the long term."
Ruffin also points to the supply/demand imbalances within natural resources. "Demand is currently weak but it will improve and there are still constraints on the supply side. It takes a long time to build a new mine and there are also environmental pressures as to where to build these new mines. As a result, this will keep prices up."