The overall performance of the natural resources equity category of funds over the past 10 years has been, on average, as ugly as a slag heap. These funds, which commonly invest mostly in Canadian resources stocks (which constitute about 30% of the domestic market), have endured volatile commodity prices and energy transportation woes that have resulted in price discounts on Canadian exports.
A 50/50 mix of energy and materials, as measured by the two S&P/TSX sectors, would have had essentially a zero return for the 10 years ended Feb. 28. Over that same period, the average natural resources fund returned a similar 0.09%, according to Morningstar Canada.
Yet, dismissing resources funds as an investment black hole would be wrong. While the indices have disappointed, some active portfolio managers in this category have excelled.
One of the attributes of successful portfolio managers has been the flexibility to invest globally. Another is their reach across the full market-capitalization spectrum, enabling them to uncover overlooked opportunities. A third attribute is portfolio concentration: having the conviction to make meaningful bets in a relatively small number of stocks out of the hundreds of possibilities in the resources equities universe.
The $94-million Fidelity Global Natural Resources Fund, which has the top, five-star rating from Morningstar for risk-adjusted returns, holds about 50 stocks. The top 10 make up more than half of the fund’s assets under management (AUM).
“We analyze a lot of companies ourselves and through the many analysts we have at Fidelity [Investments Canada ULC],” says Darren Lekkerkerker, portfolio manager with Toronto-based Fidelity and portfolio co- manager of the fund along with Joe Overdevest, director of research and portfolio manager. “We try to find our best ideas and concentrate our ownership in those best ideas.”
The Fidelity fund’s portfolio managers, whose market benchmark is the MSCI AC world natural resources index, tend to stick fairly closely to the index’s allocation between energy and materials stocks; that allocation currently is about 55% in favour of energy. The fund’s performance under Lekkerkerker’s and Overdevest’s tenure – which includes a category-leading 9.5% average annual return for Series F for the 10 years ended Feb. 28 – is driven much more by individual stock selection than industry weightings.
The Fidelity fund’s holdings are mostly outside Canada. Recently added positions include U.S.-based multinationals Exxon Mobil Corp. and Chevron Corp. Overdevest, responsible for energy stocks, praises these giants for their strong balance sheets, production growth, high returns on capital and diverse upstream and downstream operations.
In contrast, he’s wary of Canada-based producers that lack downstream operations and, therefore, are vulnerable to price discounts because of lack of pipeline capacity.
“You could invest in Canada,” Overdevest says, “but you have to watch [with care] if your company doesn’t have downstream exposure. Are you making a government bet or a bet on pipelines that [would mean] egress will be solved?”
Investing is difficult enough, he adds, without trying to predict what governments will do.
In terms of market cap, there’s ample room in the Fidelity fund for small- and mid-cap picks. Overdevest points to Texas Pacific Land Trust, which is based in that state and collects royalties on the mineral rights and surface rights it owns in the Permian Basin in Texas. He cites the trust’s high free-cash flow yield and the Permian’s large, low-cost reserves. “[The trust] is the type of company we like because it’s not covered by the Street,” Overdevest says.
On the materials side, the Fidelity fund’s best-known pick is Toronto-based Barrick Gold Corp. Lekkerkerker praises its strength in both ore reserves and top management led by president and CEO Mark Bristow. Another plus is the cost-saving joint venture with Newmont Mining Corp., Barrick’s Colorado- based arch-rival in Nevada, to which Barrick recently agreed.
Lekkerkerker’s share of the Fidelity fund’s portfolio includes royalty stocks, including Toronto- based Franco-Nevada Corp., which owns a portfolio of cash- generating mining assets, but doesn’t do any exploration or production. “I really like the royalty business model, [which] is not capital-intensive,” he says. “The management team has done an excellent job.”
Other materials holdings include chemical companies. One is Minnesota-based Ecolab Inc., a global provider of water, hygiene and energy technologies and services. “It’s a great business. It has high returns,” says Lekkerkerker.
The $101-million dynamic Strategic Resource Class fund’s portfolio has been co-managed since its inception in November 2011 by energy specialist Jennifer Stevenson and mining expert Robert Cohen, both of whom hold the title of vice president and portfolio manager with Toronto-based 1832 Asset Management LP. Their past hands-on industry experience has been instrumental in the superior returns of the fund, which can invest anywhere in the world and in companies of any size.
Stevenson, whose office is in Calgary, was an investment banker specializing in the energy industry and who also worked for two energy companies. Cohen has worked in Canada and abroad as a mining and mineral process engineer.
The Dynamic fund’s Class F shares are rated five stars by Morningstar and, for the past four years, the fund received the top FundGrade A+ rating from Toronto-based Fundata Canada Inc. for risk-adjusted returns during the calendar year in this volatile category.
The Dynamic fund’s AUM tend to be divided evenly between the portfolio’s co-managers, although there is a slight tilt in favour of materials. The portfolio is concentrated in about 30 names, with a little more than half of AUM held in the top 10 picks.
“If [a stock] is a top name,” Stevenson says, “you want to have a weighting that’s going to have an impact on the fund, so the investors can benefit from that stock’s performance. There’s a point at which diversification is not going to add value.”
Although the Dynamic fund has an all-cap mandate, energy holdings are primarily in larger-cap companies, both domestic and foreign, because of market conditions.
“In this environment,” Stevenson says, “in which the market is much more selectively rewarding companies that have free cash flow, return on investment and return of capital to investors, that whole structure is much better achieved in a larger company.”
Calgary-based Suncor Energy Inc., which has both production and refining operations, is among Stevenson’s top picks. Another is Canadian Natural Resources Ltd., also of Calgary, which, she says, is less affected by pipeline constraints than pure heavy-oil producers because the firm upgrades its output in Canada. Both Suncor and Canadian Natural Resources “are huge free-cash flow generators,” she says.
Other energy-related holdings in the Dynamic fund are TransCanada Corp. and Enbridge Inc., both Calgary-based pipeline utilities companies that are running at capacity to transport oil and gas. “They’re not affected by the discount at all,” Stevenson says. The fund also invests in Steel Reef Infrastructure Corp, a private company based in Calgary. Steel Reef owns and operates gas plants and other energy facilities. “Its returns are great; it pays a dividend. It grows its dividend every year,” Stevenson says.
Cohen, for his part, isn’t averse to well-established and profitable large-cap mining names: e.g., BHP Group Ltd. and Rio Tinto Ltd., both based in Australia – “big, boring stocks” – are among the Dynamic fund’s holdings that he oversees. But he takes pride in getting in early on promising but little-known mining plays: “You have to be living [stock research] and breathing it, being really in the middle of the information flow to home in on some of these stories.”
One of Cohen’s early finds is Vancouver-based Ero Copper Corp., which operates in Brazil. The company went public in October 2017 and trades on the Toronto Stock Exchange. Cohen began buying shares before Ero went public; then subsequently for an average acquisition cost of $2.67 a share. The stock recently fetched $16.75. “It’s just been a beautifully performing stock, and this copper district is very high-grade,” Cohen says. “The core that comes out of the ground – we’re just amazed at how good it looks.”
Cohen, who once worked in Australia’s mining industry, travels to that country to attend an annual mining conference and meet with management of companies, some in which the his fund invests.
Among the Dynamic fund’s top holdings is Northern Star Resources Ltd., a mid-cap Australia-based gold-mining company that Cohen praises for having a strong technical team that acquires underfunded, ignored mines and turns them around to achieve fast paybacks.
Gold-mining companies conspicuous by their absence among the Dynamic fund’s holdings are Barrick and Newmont, despite their cost-saving joint venture. “There’s so many moving parts [to this agreement], we are staying on the sidelines, for sure, while the smoke clears,” Cohen says. “We’re not sure of the synergies that [the companies] say they can get, and when [those] will actually come to fruition.”