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GMO Commentary- An Investment Only a Mother Could Love: The Tactical Case

Executive Summary

  • After a rough decade for commodities and commodity producers, we see resource companies trading at record low valuation levels relative to the broad equity market on some measures.
  • Even if commodity prices were to stay flat, public resource equities would be well positioned to generate strong returns, either through a reversion in valuation or through the high dividend yields on offer.
  • At these valuation levels, investors interested in the resources sector don't need to be bullish about commodity prices, but there are reasons to be optimistic. In particular, the capital cycle supports commodity prices by reducing supply when prices are low.
  • Most institutional investors will never go overweight the resources sector due to the perceived riskiness, but if you're not going to go overweight resources now, when will you?




Introduction

In 2016, we wrote "An Investment Only a Mother Could Love: The Case for Natural Resource Equities," a paper underscoring the strategic virtues of investing in the natural resources sector with only glancing comments on the tactical merits.1 We continue to believe that the strategic case for making a significant investment in resource equities is as compelling an investment case as you're likely to come across. From a tactical perspective, resource equity valuations were hovering around historic lows relative to the broad equity market when we wrote that paper. As is often the case when dealing with out-of-favor asset classes, resource equities have gone from cheap to cheaper and now register at the cheapest levels ever recorded on some measures. We write this in the aftermath of oil prices falling below $20 per barrel and the spot month West Texas Intermediate oil future actually going negative for the first time ever, reflecting storage challenges given the level of oversupply. In this paper, we shift our focus to the tactical case for investing in the resources sector.

The Past

First, let's very briefly look back at what has happened over the last few decades in the resources sector. As commodity prices fell throughout the 1980s and 1990s, commodity producers cut back on investment, leaving commodity markets unprepared to meet the China-led boom in commodity demand that started in earnest in the early 2000s. As a result of supply shortages, commodity prices rocketed upwards over the course of the 2000s, eventually more than tripling.

High commodity prices in the 2000s had two notable consequences. First, the high prices helped the commodity producers generate strong returns in a down market. While resource companies move with equities in the short term, they move more with commodities over the longer term; the MSCI ACWI Commodity Producers Index, an index of upstream commodity companies, delivered almost 9% per annum in real terms in a decade in which the S&P 500 lost more than 3% per annum. Second, the extraordinary run in commodity prices spurred a tremendous increase in capital expenditure as producers rushed to profit from high prices.

As the increased investment came to fruition in the 2010s and new commodity supply flooded the market, commodities came back down to Earth, dropping approximately 18% in real terms.2 Oil, the biggest commodity of them all, fell around twice as much, down 35%. In almost a mirror image of returns from the decade before, the S&P 500 delivered over 11% per annum real while the ACWI Commodity Producers Index lost around 1% per annum, approximately the same spread as the previous decade, though obviously the winner and loser swapped positions.3 As 2019 came to a close, we believed the resources sector was very well positioned to rebound after a tough decade.

Then, we watched as Coronavirus swept the globe and shut down large swaths of the global economy in the first quarter of 2020. To make matters worse for the sector, in the midst of an unparalleled oil demand shock, Saudi Arabia and Russia were unable to agree to oil production cuts and instead ramped up production! Oil prices plummeted almost 70% in response.4 A very difficult quarter ended with the S&P 500 down around 20% and the ACWI Commodity Producers Index down almost twice as much.

Valuations

However, from the depths of despair sprout opportunities, and valuations in the resources sector have hit historic levels. As commodity prices fell over the course of the 2010s, negative sentiment helped push resource company share prices down even faster. This is classic double counting. Falling commodity prices have a negative impact on fundamentals, and the fear associated with tumbling commodities leads investors to assign a discounted multiple to the lower fundamentals (see Exhibit 1).


EXHIBIT 1: THE CAPITAL CYCLE

Source: GMO


How much of a factor has valuation contraction been in explaining the poor performance in the resources sector? Energy and Metals companies entered 2010 trading at about a 28% discount to the S&P 500, not far from where they trade on average (see Exhibit 2). By the end of the decade, however, that discount had jumped to 66%, and after the rough Coronavirus-impacted first quarter in 2020, the discount stood at almost 80%.


EXHIBIT 2: VALUATIONS ARE AT HISTORIC LOWS

Valuation of Energy and Metals Companies Relative to the S&P 500

As of 3/31/20 | Source: S&P, MSCI, Moodys, GMO

Valuation metric is a combination of P/E (Normalized Historical Earnings), Price to Book Value, and Dividend Yield.


Over the last 100 years or so, we have never seen resource companies trading at anything close to these levels relative to the broad market. Furthermore, we can't recall an asset class trading at such a large discount when investors can be fairly certain that the asset class will exist more or less in its current form 10 years hence, climate concerns notwithstanding (we will address them forthwith).5 While the prospects for individual commodities or companies will change over time, the global economy will continue to need the resources sector to function, as it always has.

THE IMPACT OF CLIMATE CHANGE, STRANDED ASSET RISK, AND ESG ON VALUATIONS

Within the investment community, we have led the charge on the importance of climate change as an investment consideration and have long believed that investors must carefully consider the prospects for fossil fuels. Stranded asset risk is the risk that fossil fuel companies will be unable to produce all of their reserves due to climate change-related carbon pricing/regulation or technological disruption (e.g., electric vehicles displace internal combustion engine vehicles and drive down demand for oil). More generally, many ESG-oriented investors have qualms about commodity producers. Divesting from fossil fuels completely has gathered considerable momentum across the industry, and many huge pools of assets have either already divested or are in the process of doing so. Some institutional investors have taken it a step further and eschew extractive industries, including metal and fertilizer mining, altogether.

However, the global economy couldn't function without extractive industries. Furthermore, the world can't transition from fossil fuels to clean energy without the materials that clean energy relies upon (e.g., copper, lithium, nickel, vanadium, etc.). Regardless, ESG concerns have seemingly impacted the pricing of resource companies and are perhaps the most likely explanation for why Energy and Metals companies are trading at all-time lows relative to the market. For return-oriented investors interested in the resources sector, this lack of demand, driven to some extent by non-investment considerations, creates a unique opportunity and likely leads to higher expected returns.

With regards to stranded asset risk, we certainly consider the possibility of stranded assets in our analysis. Since the launch of our Resources Strategy in 2011, we have excluded coal, oil sands, heavy oil, and most fracking from our investable universe due to concerns about stranded assets. However, the vast majority of traditional oil and gas producers have significantly less than 15 years of reserves, and no matter how quickly the world transitions to clean energy, we will need oil and natural gas for the foreseeable future. It would be different if oil and gas companies had 30 or 40 years of reserves, but that's not the reality that investors are confronted with. Furthermore, given the availability of high single-digit or even double-digit dividend yields in the resources sector, investors don't need these companies to exist for 30 or 40 years to make them excellent investments in expectation.

To be clear, climate change, stranded asset, and ESG risks should be incorporated in decision making when assessing investments in the resources sector. However, to the extent that investors overreact or take non-economic approaches to these risks, opportunities will abound.

The Future

Where do we go from here? In the short run, who knows? In the long run, we believe this could prove to be an excellent entry point for investors. There are reasons to be optimistic about commodity prices.6 First and foremost, the capital cycle drives commodity prices. When commodity prices are relatively low, as has been and continues to be the case, capex is slashed and supply is taken offline, more or less guaranteeing future supply shortages. In this way, low commodity prices cure low commodity prices.

There's evidence that the capital cycle had been playing out, even before the pandemic and oil crash last quarter. Despite production levels much higher than a decade earlier, Energy and Metals companies cut capex by around 40% over the course of the last decade (see Exhibit 3). Without vast amounts of maintenance and expansion capex, commodity producers inevitably see production decline. With the reduction on the supply side, not only do commodity prices rise, all else equal, but sentiment becomes much more positive and tends to push valuations up (once again, see Exhibit 1). The double counting, which helps to explain the big runs in the resources sector, becomes a positive.

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This article first appeared on GuruFocus.