Natural-resources equities are generally an unloved bunch, but is it because they are a bit misunderstood?

Yes, they can be volatile, are tied to unpredictable commodity prices and are a sort of hybrid investment in that they can move with either the commodity or equity markets.

Over the past few years, the S&P 500's exposure to energy and metal companies has dropped by more than 50%, according to a white paper published this month by Jeremy Grantham and Lucas White of global investment management firm GMO.

The paper is appropriately titled, An Investment Only a Mother Could Love: The Case for Natural Resource Equities.

About this time last year, commodity prices were under pressure due in part to an oversupply of oil and a subsequent plunge in prices, a stronger dollar, decelerating growth in China, and disappointing performance in emerging markets. Lackluster commodity-related returns led to apprehension regarding natural resources as either short- or long-term investments.

However, strategists such as James McDonald of Northern Trust asserted that an equities-based approach to natural-resources investing held promise over the long term.

In the GMO paper, Grantham and White argue for natural-resources equity investing based on the following:

  • The growing demand for and finite supply of cheap resources will push up future prices;
  • The diversification that natural resources can provide, as evidenced by low to negative correlations with the broad equity market over long periods, while delivering equity-like returns;

 

  • Natural-resources equities usually trade at a discount due to their short-term risk, but tolerating short-term volatility can pave the way for long-term out-performance. In fact, over 10-year periods, commodity producers have rarely delivered negative returns;
 
  • Equity investing offers an inexpensive, liquid manner to access commodities while avoiding the costs associated with related futures contracts, i.e. selling out of cheaper, near-term contracts to purchase longer-term, more expensive contracts.
  • There is an equity premium available because returns are higher than if the investor purchased the raw materials themselves.

 

Although there are compelling reasons to consider natural-resources stocks, they should be considered as part of a balanced portfolio rather than an asset class to be loaded up on indiscriminately. The first step, therefore, is to find fundamentally sound companies.

Using our Guru Stock Screening models identifies the following six highly scoring natural-resource stocks that deserve a look as potential long-term investments:

1. Cameco  (CCJ - Get Report)  
This company is engaged in the exploration, development, mining and sale of uranium as fuel for nuclear-power reactors. Our Joseph Piotroski-based investment strategy favors the company's book-market ratio of 1.15 which, given its positive return on assets (0.74%, up from a year earlier) and its positive operating cash flow of $342.97 million, indicates that the underlying business is sound.

Long-term debt is modest at 0.17% of assets (a slight improvement over the prior year).

2. Dow Chemical  (DOW)
This company manufactures and supplies raw-material products for many businesses around the world including Agricultural Sciences, Dow Automotive Systems and Performance Materials & Chemicals. Under our James O'Shaughnessy-based screen, Dow Chemical earns high marks for its cash flow of $9.55 a share, compared with a market mean of $1.39 a share, and a solid revenue base of $46.15 billion.

Shares outstanding total 1.22 billion, well above the market average of 627 million.

Dow Chemical is a holding in Jim Cramer's Action Alerts PLUS Charitable Trust Portfolio. See how Cramer rates the stock here. Want to be alerted before Cramer buys or sells DOW? Learn more now.

3. NK Lukoil PAO  (LUKOY)  
This energy company engages in oil exploration, production, refining and distribution. The company earns a perfect score under our O'Shaughnessy-based investment strategy due to its market capitalization of $41.02 billion, coupled with its cash flow of $10.39 a share, substantially above the market mean of $1.39 a share.

Trailing 12-month sales of $83.31 billion meet the requirement of exceeding the market mean of $20.60 billion by 1.5 times. Our Kenneth Fisher-based screen favors the company's price-sales ratio which, at 0.49, is well under the 0.75 maximum.

This model also likes the company's moderate leverage, with a debt-equity ratio of 28.64%.

4. Rio Tinto  (RIO)
This mining company processes and markets mineral resources including aluminum, coal, copper, diamonds, iron ire and minerals. Our O'Shaughnessy-based screening model likes Rio Tinto's market cap of $61.5 billion and operating cash flow of $2.03 a share, compared with the market mean of $1.40 a share.

Trailing 12-month sales of $32.34 billion add appeal, as does the 1.8 billion shares outstanding, which is more than twice the market average.

5. Total  (TOT - Get Report)
This oil and gas company engaged in exploration, production, refining, marketing and shipping. The company earns a perfect score under our O'Shaughnessy stock screen based on its market cap of $115.91 billion and cash flow of $8.49 a share, which is well above the market mean of $1.39 a share.

This model also looks for companies whose number of shares outstanding exceed the market average of 626 million shares. With 2,428 million shares outstanding, Total passes this test.

In addition, this model favors the company's trailing 12-month sales of $126.4 billion, which is more than 1.5 times the market mean of $20.57 billion.

6. Universal Forest Products  (UFPI - Get Report)
Through its subsidiaries, this company supplies wood and wood products to the construction, industrial and retail markets. Our O'Shaughnessy-based investment model favors the company's consistent growth in earnings and its price-sales ratio of 0.70 (the model sets a maximum of 1.5).

This model also finds favor with the company's relative strength of 91. Our Kenneth Fisher-based screen gives high marks to the company based on its low debt-equity ratio of 10.59% and its inflation-adjusted earnings-per-share growth of 60.12% (minimum requirement of 15%).

At the time of publication, Reese was long DOW, LUKOY, RIO and TOT and UFPI.