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John Baron has been focusing on undervalued sectors in his recent monthly columns. Technology, commercial property and emerging markets have been featured. Here he makes the case for Commodities - particularly for those investors underweight the sector
November 8, 2013

The secret of good fund management is to identify investments where sentiment has diverged from the fundamentals, and then have the courage to act. Not easy when the consensus suggests you are wrong. But investors can only beat the benchmark or the market if they do something different from the consensus. I suggest this moment has arrived regarding the commodities sector where sentiment trails fundamentals, thereby creating an opportunity for the patient investor.

 

Sentiment

A few years ago, before the financial crash, there was no shortage of talk about the commodities supercycle having years to run. Strong economic growth, especially in China and the emerging markets generally, together with a perceived lack of investment in mining capacity, helped sentiment at a time when markets were still in 'risk-on' mode.

No wonder the S&P GSCI Energy & Metals index of spot prices rose a staggering 320 per cent between 2001 and the 2008 crash, compared with just 23 per cent for the MSCI World index over the same period. But since then it has been a very different story. The commodities sector has fallen while equities have made very good progress. Sentiment now is very depressed, with mining and oil equity valuations and commodity prices still under pressure.

 

 

It is not difficult to understand why the sector is so unpopular. Concerns about China's growth rate have dominated headlines given its importance to the world economy, particularly at a time when growth has been anaemic elsewhere. Estimates have been revised down. Meanwhile, following the financial crash, investors have been cautious and adopting more of a defensive strategy regarding their portfolios - a strategy which has tended to chime with the prevailing economic winds.

The commodities sector itself has also had its fair share of bad news at both ends of the capitalisation spectrum. Asset write-downs and disappointing dividends have resulted in something of a management shakeout among the larger companies, instigated by shareholders unhappy with slumping prices. The smaller companies have struggled to access finance whether through equity or debt - reflecting investors' caution.

So, all in all, it has been a difficult period for the sector. Sentiment is rock-bottom. Little wonder then that research of fund managers' holdings suggests that the commodities sector is close to a record underweight in portfolios. The sector is friendless. But it is exactly at these times that investors should examine whether such pessimism is warranted.

 

 

The fundamentals

I suggest the widespread concerns about China are overblown. It is true that growth may be slowing somewhat and there is uncertainty ahead. The government has a difficult task of steering the economy towards a more consumer-driven and higher value-added path, while meeting the needs of its population. It will not be a smooth journey, and growth will be more volatile as a result. But it is a necessary path to take, and one that will bring rewards in time. Meanwhile, the economy is still strong - many governments would celebrate 7 per cent growth for their own economies.

Furthermore, this growth is taking place at a time when the global economy is slowly picking up. Recent news out of the US has been positive, which means the two largest economies in the world are now expanding - albeit at different speeds. Policies introduced by Prime Minister Abe are having positive results in Japan - the corporate outlook is increasingly optimistic, helped by a depreciating currency. Add in the perception that the eurozone crisis is past its worst, and one can understand why investors are now less risk averse.

This is good news for the commodities sector. Economic growth is positive both for prices - as demand picks up - and investors' risk appetite. We should also remember that growth increases the likelihood of inflation rising - helped in this instance by the policy of financial repression keeping interests artificially low at both ends of the yield curve. Commodities, like other real assets, have been a good way in the past of hedging inflationary risk - and there is little reason to doubt it will be different this time. Not every sector does as well when bond yields are rising.

 

 

Further developments are positive - some short and some long term. Indications suggest at least some company managements are reconsidering the balance between their capital expenditure plans and returns to shareholders. The scaling back of high-cost operations and expansion plans will be good news for investors, including those seeking income. Low valuations suggest such a change in emphasis is not yet fully reflected in prices. Meanwhile, early indications suggest finance is becoming less of an issue for those smaller resource companies with a sound plan, as the banks continue to recapitalise.

But we must also not forget the long-term case for commodities. As commented upon in previous columns, we are presently witnessing a massive urbanisation in the emerging economies. A huge new consumer class is now entering the economic equation - young, increasingly affluent and more likely to spend than the previous generation. Governments around the world - not just in China - have to invest in their infrastructure, not only to sustain economic growth but to meet the requirements of their increasingly expectant populations.

 

Meanwhile, overlaying these seismic shifts, forecasts suggest the world’s population will rise a further 2bn over the next 30 to 35 years. This can only mean increased competition and demand for resources, despite advances in technology. Such considerations will increasingly influence politics and diplomacy, despite already being evident. We would be unwise to allow short-term concerns about our own disappointing growth rates to mask our understanding of these global forces at play.

 

 

Strategy

Both portfolios have direct exposure to the sector. BlackRock Commodities Income trust (BRCi) is held within the Income portfolio, despite standing close to NAV, because of its 5.3 per cent yield and solid track record. Yield is less important to the Growth portfolio and so it holds City Natural Resources trust (CYN) which stands on a 10 per cent discount. CYN has a slightly wider diversity of holdings including a higher weighting to gold.

The strategy is to try and take advantage of the sector’s volatility and add to holdings over time, as happened when I last tweaked portfolios in August. The market responds to new news - not what it already knows. Sentiment is yet to catch up with reality.

Otherwise, once again, there were no changes to either portfolio during October.

 

View John Baron's updated Investment Trust Portfolio.