Consider the Unloved

Consider the Unloved

by John Goltermann, CFA, CPA, CGMA

January 23, 2017

“Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. The safest and most potentially profitable thing is to buy something when no one likes it.”
– Howard Marks

Between 2012 and the beginning of 2016, investing in resource companies challenged even the most stoic and patient of investors. The chart below shows the price returns of the S&P 500 and an ETF of global resource equities (with the symbol GNR) over the last five years.

The dramatic divergence in returns between the S&P 500 and resource equities accelerated with the big decline in oil prices that began in mid-2014. The S&P 500 was not much affected by this drag from the resource sector because those stocks only make up about 5% of the index. And as index investing itself gained in popularity, the S&P 500 outperformed resource stocks by a lot.

So why would one consider investing in resource stocks when they are such obvious losers?

It is important for serious long-term investors to understand that there are advantages to resource investing beyond potential commodity price appreciation. Those benefits include diversification and inflation protection. With one foot in the equity market and the other in the commodity market, resource equities are unique in that they sometimes move more with broad equity markets and sometimes more with commodities. For this reason, they are generally unloved and (probably) largely misunderstood. It is often in misunderstood and neglected areas of the market where the most compelling opportunities exist. In general, and especially today, long-term investors could benefit from a larger allocation to resource companies than index investors have.

One advantage of resource producer stocks is that they are equity claims in companies - companies charged with investing shareholder capital in projects with favorable risk/return profiles. As stocks, they capture significantly greater rewards than straight commodities:

source: CRSP as of 6/30/16

As you can see, oil prices have barely risen since the 1920s in real (after inflation) terms, while oil and gas companies (in aggregate) have risen over 8% per year in real terms. The public equities of oil and gas companies have clearly been far superior to direct commodity investing. Important to note: The oil price figure in the chart above simply uses the reported price -- it does not account for storage, transportation and other costs.

The other benefits to holding equities are that they are liquid, cheap to trade and offer a diverse set of business models from which to choose. Moreover, the ability to value and select stocks within resource equities can yield additional returns.

Yet another benefit to holding resource equities within a broad portfolio is the diversification benefit. In the chart below one can see that the Financials, Consumer Staples, and Utilities sectors, those sectors that generally prosper during periods of economic expansion, are highly correlated with the rest of the market both on a monthly and on a long-term basis. But resource equities tend to be negatively correlated with the overall market on a greater than 10-year basis. Intuitively this makes sense as sustained high energy and materials prices can create a drag on the rest of the economy.

source: S&P, MSCI, CRSP

The implication of this is very powerful. Stocks of resource companies deliver equity-like returns with low to negative correlations to the broad market over long periods of time. Investors in hedge funds pay enormous fees to their managers for the exact same thing. If they understood this dynamic, the hedge fund industry would certainly be in big trouble!

Resource equities also perform well during periods of inflation. Inflation is one factor that can destroy wealth very quickly, especially for those who are averse to volatility and hold large amounts of cash and fixed income. Moreover, periods of inflation cannot be predicted, so it is important to hold assets (at a significant level) that hedge against it in a broad portfolio.

In inflationary periods, a portfolio of energy and metals companies kept up with or beat inflation six out of eight times, and in all eight periods the resource equities outperformed the S&P 500. In fact, they delivered real returns of more than 6% per year on average during those inflationary periods, as compared to a loss of purchasing power of around 1.6% per year for the S&P 500.

source: CRSP, Federal Reserve

It appears that since resource equities generally trade at a discount to the S&P 500 (20% on average based on price-to-earnings, price-to-book value, etc.) most investors are understandably uncomfortable with the wild swings of the industry and large periodic negative price moves. These swings occur because of over/underinvestment cycles, unexpected changes in demand, etc. For investors focused on short-term returns this volatility can be really unnerving. In fact, from April 2011 to January 2016 the MSCI ACWI Commodity Producers Index fell 54% and that was in a broad equity market (as measured by the S&P) up over 50%! This is why professional investors have been quiet about the opportunities in resource equities – because they are reluctant to speak opportunistically about what their clients are presumed to loathe. Many believe they lose credibility in recommending the unloved – especially after a period of such drastic underperformance! Unfortunately, career considerations often take the front seat in the investment industry.

It is not widely understood, however, that for investors willing to tolerate price volatility resource equities have been safe investments. The real returns for resource equities have been very stable as they have almost never delivered negative real returns over any 10-year period, but in those few times that they have, the loss of purchasing power was negligible. And when compared to the much more popular S&P 500, resource equities have shined! As shown below, the S&P 500 has seen many 10-year real returns periods that were significantly negative and lasted longer. From this standpoint resource equities have been much safer.

source: CRSP, S&P

Where are we now? Resource equities have never been so cheap:

source: MSCI, S&P, Moody’s

Whenever a group of securities trade near all-time lows on a relative valuation basis (such as resource stocks today), there will naturally be a lot of bearishness. Conversely, when something is near an all-time high (such as broad US market indices), there will be a lot of positivity, self-reinforcing behavior and money pouring in. This is how markets work. We have recently heard predictions that oil could fall to as low as $20/barrel and that iron ore and copper will languish for many years. If this is true, then the stocks of producers are not as cheap as we think.

However, such predictions are virtually meaningless. The average one-year oil forecast from leading commodity analysts compared with the actual oil price one year later is on average more than 30% off. And more importantly, the experts got the direction correct only slightly better than half the time[1]. With the impossibility of correctly predicting commodity prices, it makes sense to wonder whether the bearishness surrounding the sector is justified. And if one is skeptical of this, current valuations merit some attention.

The case for investing in resource equities is compelling. Historically, investors in resource equities have enjoyed strong returns, along with effective diversification and inflation protection. They also provide exposure to global growth and potential commodity price appreciation. From a timing perspective, valuations have now been hovering around historic lows relative to the broad market, and when resource equities have been cheap relative to the broad market, they have performed quite well going forward. Yet, individual and professional investors alike are still naturally wary of the volatility (recently manifest) and the always uncertain commodity price outlook. As such, one must make these investments with the intention of being very patient. So for those investors with a long-term orientation (and who are willing to tolerate periodic adverse price moves and the prospect of underperforming the broad market) they are well-advised to strongly consider whether they have allocated enough to this neglected segment of the market.

As Howard Marks reminds us, the time to buy something safe and potentially very profitable is when no one likes it. Resource equities may be it. Despite a strong year in 2016, resource equities still trade more than 30% below their highs while broad market indices trade at or near their all-time highs and index investing is arguably reaching its peak popularity.

[1] Source GMO

DISCLOSURE: Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable for an existing or prospective client’s investment portfolio. Therefore, no existing or prospective client should assume that future performance of any specific investment or investment strategy (including the investments or investment strategies recommended herein) will be profitable or equal any historical performance levels. Certain portions of this communication may contain discussions of recommendations as of a specific prior date. Due to various factors, including changing market conditions, such discussions may no longer be reflective of current positions or recommendations. Information included herein should not be construed as the receipt of, or a substitute for, personalized individual advice. A copy of our current written disclosure statement discussing our business operations, services, and fees is available upon written request.

 

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