So far this year, natural resources funds have been one of the few bright spots in the fund world, with an average year-to-date return of 10.9% vs. a negative 2.5% for the average domestic equity fund, according to Morningstar.
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Within this sector,
RS Global Natural Resources, run by Andrew Pilara, has been one of the top performers, with a year-to-date return of 15.3%. Over the past three years, Pilara's fund has managed an annualized gain of 19.3%, compared with 14.9% for his average peer. His 52-week performance is even more impressive, with the fund up 14.5%, vs. the category average of -0.2%.
The fund, which Pilara has managed since its inception in November 1995, got off to a rocky start, though. After gaining 41.2% in 1996, it slipped 17.1% and 34.5% in 1997 and 1998, respectively. Since then, though, Pilara has changed his investment thesis, sought out more diversity and focused on nitty-gritty balance sheet details to help choose his stocks.
With Middle East turmoil driving the price of oil higher and much uncertainty in the region, natural resources could be a volatile investment. Pilara isn't concerned, however. He says his fund focuses on the long term, and he believes the prospects for natural gas, coal, mining and paper stocks are strong.
Fund: RS Global Natural Resources
Managed Since: Inception, Nov. 15, 1995
Assets: $29 million
One-Year Return: 11.6%, beats 88% of Peers
Five-Year Return: 2.1%, trails 82% of Peers
Expense Ratio: 1.98%
Maximum Sales Charge: None
Source: Morningstar. Returns through 4/10/02. Top holdings as of 9/30/01.
1. After spending more than six years helming the fund, you've seen your share of ups and downs in the energy market. With the recent events in the Middle East driving oil prices to a six-month high and Iraq curbing its supply -- how does this change your investment strategy?
As far as the current events are concerned, our strategy hasn't changed. We focus on long-term trends in the energy market and we look at supply and demand on the oil side. So if we looked at oil, we say we're looking -- on a supply-demand basis -- of a price for WTI Cushing justified in the $20 to $22 range and then tack on to that the war premium. And the war premium -- that's anyone's guess -- but tack on another $4 to $6.
So you can get yourself $24 to $28 on a short-term basis. But that short-term war premium is outweighed, on a long-term basis, by the fact that OPEC has about 7 million barrels of excess capacity a day. The OPEC market share has continued to decline over the last 10 years. So yes, the events of today show us that oil is $27 to $28, but we look at the long-term trend for oil -- it's closer to $20.
As far as the fund is concerned, we look at natural gas and coal in the energy sector. What we're saying is that we love natural gas. Even though the inventory levels are the highest we've seen on record, that's another short-term phenomenon. Long term we've seen a decline in drilling for natural gas and expect a recovery in industrial demand in the next two to three years.
TSC: What do you like about natural gas and coal?
Supply and demand. Plain and simple. They're different. Because gas prices have declined into the $2 level -- we've just had an increase in the past 60 days -- but gas was at $2 and with that we've seen a decline in gas drilling. And really, in the last 10 years, the U.S. has not been able to keep up with gas demand. Our natural gas resources have declined, so we like the supply and demand in gas. And on the coal side, we've seen mine closures over the last 10 years and an increase in electricity demand, except for 2001.
On the Comeback Trail
Source: Morningstar, Data through April 10, 2002
2. Recent reports show the manufacturing sector is starting to recover. How are the better-than-expected economic reports changing how you view companies, especially in the industrial sector, which accounts for 30% of the fund's holdings?
We were kind of kind of positioned for an economic recovery, but we thought this economic recovery would have a different tone. That is, the consumer did not pull back this time around. So we're not going to have that classical consumer recovery -- we're going to have an inventory recovery. We're looking for companies in capacity-constrained sectors where we have not seen capacity grow -- that's mining and paper. Global demand will drive the resource sector.
And the last thing
driving demand, from a long-term perspective, is China. You want to sell to China. You don't want to compete with China. China consumes a lot of raw materials, and that is having a positive effect on mining and paper both. And energy in the long term.
They're consuming commodities like newsprint, aluminum, coal. There's a very large universe of companies selling to China.
3. Has the portfolio changed at all in recent weeks?
We have low turnover. We're kind of long-term guys. And so there hasn't been a lot of turnover in the past few weeks. We don't change too much on a weekly basis.
Our favorite stocks in the small-cap area right now -- we have a large position in a company called
(OLT:Toronto), a natural gas company in Canada that primarily hunts for natural gas. They have three major prospects, any one of the three could double the size of the company.
Another company we like is
. It's primarily a water and agricultural company. They have a significant water-storage project in southern California. And you could take the cash flows expected from that water project and we're looking at an analysis that would create a present value significantly above the current market price.
Another company we like is
(U:Toronto), a Canadian coal, nickel and oil company. It's selling significantly below asset value.
4. As your fund's name suggests, you invest in natural resources. Currently, 38.1% of your holdings are in the energy sector, yet your top holding is Fresh Del Monte Produce (FDP) - Get Report, which accounts for 14.57% of net assets, according to Morningstar. Why is a consumer staple the top holding in a natural resources fund?
Fresh Del Monte is now 9% of the fund, but we believe that food commodities belong in a resource fund. Food and energy are probably our most important commodities. And we want to be in agriculture because the population growth in developing countries leads to better diets, which leads to increased consumption of grains to feed the livestock. That population growth, as it leads to a more developed country, their consumption of fruits and vegetables should increase.
Why'd you reduce your holdings in Del Monte?
The stock had run from $4 to $20. It was really primarily a portfolio decision. We like to keep our portfolio investments below 10%. At cost, when we entered the stock, it was a 4% position.
5. The majority of your holdings -- 63% -- are in small- or micro-cap companies. What makes the smaller companies a more attractive investment?
The smaller stocks are just cheaper at the present time. And especially in the natural resources sector, they have better production growth opportunity.
6. Unlike other funds, which can hold hundreds of stocks, you're in just 29 companies -- with more than 60% invested in just 10 stocks. Why did you choose to spend more on fewer companies instead of spreading the wealth?
As a resource fund, we have a limited universe from which to choose. So our investors do expect us to have fewer stocks than the general portfolio. But with fewer companies, we get to spend more time with our companies. We get to take time to understand how they deploy their capital. We have time to understand the value drivers of the company.
I kind of go along with what Warren Buffett said -- as far as the portfolio is concerned, we don't want a Noah's ark portfolio, which is two of everything. And I kind of agree with that. It is very difficult, when your mandate is resources, to find 150 to 100 resource companies that you love their prospects and the prices are cheap enough.
7. While the fund has an excellent annualized three-year return of 19.61%, its five-year annualized return is slightly above break-even, according to Morningstar, gaining under 1%. Why did the fund fare so poorly in 1997 and 1998 and what lessons did you learn from underperforming?
We had a resource mandate and when resources are out of favor, it becomes very difficult to perform well. Having said that, I think we've learned a couple of lessons. We needed to be more diversified amongst the resource sector.
And we also refined our energy analytical procedures. We did a couple of things. We spent and put more emphasis on what we call the recycle ratio in the energy area, which is the cash flow per barrel of oil equivalent (BOE) vs. the finding cost. We spent more time on decline ratios -- the decline in the first year after discovery in your production of oil and gas. Having concentrated on these two microfactors has improved our performance and company selection.
8. With Enron raising the issue of corporate disclosure and accounting, has that changed the way you analyze companies from an investment perspective? It seems there's a big premium put on management credibility.
We haven't changed the way we analyze companies. We've always paid close attention to the accounting. Some people would say we're a little pedantic about accounting issues. We're balance sheet and funds flow guys. We always tell our analysts that we want them to read the annual reports backwards. We want them to read them from back to front, starting with the footnotes. We've always read the 10-Ks and 10-Qs and they've become much more important.
As far as management credibility is concerned, there's a lot of leeway in GAAP (generally accepted accounting procedures). We've always tried to take our analysis from what we call GAAP to cash. When you're analyzing the cash and making those cash conversions on the funds flow statements and analyzing the funds flow statements, it's hard to play games with the cash. You either got it or you don't.
9. According to Morningstar, you reduced your holdings of Brookfield Properties (BPO) sometime last year, despite the fact the company has a year-to-date return of 12%. Why did you pare down your holdings?
When we looked at the real estate sector, we were looking at the late 1990s, which saw a historic demand for office property -- demand we might not see for another decade. What we're seeing now is the aftermath of that demand bubble. We're seeing vacancies increase. We're seeing rent rates decline. And therefore, we think the cap rates for real estate are probably going to increase here as well as the interest rate environment has probably troughed. Also, Brookfield Properties closed the gap between its asking price and its net asset values. Then there was a management change at the company. So there are a number of factors specific to Brookfield that were involved in our decision there.
10. You also seem to have quite a thing for Canadian companies, with Canadian Natural Resources (CED) , and Falconbridge (FL:Toronto) in the top 10 holdings. Aside from the fact that many natural resources companies are Canadian, what else do you like about investing in Canadian companies?
Not only is that a resource economy, but as an example, if you like
the commodity nickel -- which we do -- and like the prospects for nickel, you have to go to Canada. There's nothing available in the United States.
And also as far as the Canadians are concerned, it's easier to find companies that can grow their production. And that is in mining, especially in energy. If you have commodity companies that don't grow their production then you're solely reliant on the commodity price. At least when you have growing production, you're somewhat less reliant -- although you always are -- to the commodity price.
In Canada, we have a cheaper dollar, which allows them to compete a little easier. You have cheaper resource stocks. I would say there is one, two, three multiple points of difference
in valuations. Canadian stocks are cheaper. And I don't have to make any concession as far as science is concerned. The mining and engineering is as good as it is in the United States. The geophysical work on the energy side is as good as it is in the United States.