Finding Value in Natural Resource Stocks
A number of noted value investors have completely missed the booms in energy and natural resources over the past few years. At Oakmark funds, Bill Nygren -- co-manager of Oakmark fund and Oakmark Select -- and overseas specialist David Herro shunned commodity stocks. Legg Mason's Bill Miller not only avoided oil stocks but also made matters worse for his shareholders by actually betting against the hot sector.
Many value investors have trouble getting their arms around energy and resource stocks. It's hard to say whether oil prices are too high or too low, and it's hard to figure how producers can add value to a product over whose price they have little control.
The managers of RS Global Natural Resources A (symbol RSNRX) are bona fide bargain hunters, but they approach stockpicking differently from most value investors. Andy Pilara, MacKenzie Davis and Ken Settles Jr. spend no time trying to forecast energy or commodity prices. Instead, they study companies project-by-project to identify the lowest-cost producers and the most skilled allocators of capital.
The fund's managers are more akin to business analysts than stock analysts. They seek to identify natural-resource producers with low-cost, high-quality assets that can make money over a five-year cycle of varying commodity prices.
The managers start by studying the economics of each project. After all, the profits a resource producer will earn three to five years out depend on the viability of today's projects. "Companies deplete their asset bases every day," says Davis. "The next project's return profile is where we spend our time."
More specifically, Davis and his colleagues look for projects that will generate a return on invested capital well in excess of the company's cost of capital.
XTO Energy (XTO) is an example of a stock that has worked out perfectly. Because of its low-cost assets, this Texas-based natural-gas producer has earned high rates of return on capital even in periods of low gas prices. Davis notes that XTO's high, sustainable return on invested capital has enabled the company's stock price to outperform both natural-gas prices and an index of the stocks of gas-producing companies. In other words, the company's success stems from its internal allocation of capital rather than such uncontrollable external forces as the price of natural gas.
Another winner has been Denbury Resources (DNR). This company controls the largest supply of natural carbon dioxide east of the Mississippi River. It injects its low-cost CO2 into aging oil fields to coax out more crude. Davis says Denbury earns an adequate return on capital when oil is just $40 a barrel.
Successful value investors such as RS Global share in the upside of bull markets but should show their real worth by outperforming their more aggressive counterparts in down markets. In the ten years through June 30, the fund returned an annualized 19%, an average of four percentage points per year better than the Standard & Poor's North American Natural Resources index. Year-to-date through July 25, the fund surrendered 4.7%. Its Class A shares come with a front-end sales commission of 4.75% and charge annual expenses of 1.45%.