Fund manager's comment/Tom Elliott
Commodity shares should be a value investor's dream. Technical supply constraints benefit the oil sector, while over the longer term, metals stand to gain from the huge potential of the rapidly growing Chinese market. Meanwhile, valuations are cheap because of a de-rating that occurred throughout the 1990s.
That de-rating can be attributed to a drop in inflation fears, overcapacity in many resource-based industries and low earnings growth. The end of the decade saw crude oil fall to less than $9 a barrel and commodity shares being dumped in favour of technology, media and telecoms and some old economy sectors.
But the rebound in value stocks over the past 18 months has helped lift many resource firms' share prices. The resource-biased stock markets of Australia and South Africa have recorded all-time highs. This is despite low metal prices and because of consolidation taking place in recent years in the resource sectors, a strong dollar, and a huge increase in demand from China for industrial raw materials. Oil has benefited from the price spike in 2000, and the prospect of a $20-$25 a barrel price range continuing for another year, given recent production cuts agreed by Opec.
Given these factors and indicators that suggest the US slowdown has begun to bottom out, we suspect global commodity stocks have a chance of being re-rated. After all, you don't get much more cyclical than resources stocks, or more value than in the current trailing P/Es of many mining and oil stocks.
In the UK, resources are on a historic P/E of 13.2 times. Rio Tinto is on a trailing P/E ratio of 14.9, a discount of 25% and it compares with a five-year average discount of 12%. BP is on a trailing P/E of 13.5 times. These low valuations are not confined to the UK ' the trailing P/E of the global oil sector is at a 45% discount to the MSCI world index, which is a 10-year low
Second quarter outperformance by the US stock markets suggests investors are beginning to price in an upswing, with cyclicals outperforming non-cyclicals. We anticipate commodity sectors maintaining their strong performance if leading indicators continue to improve. There are also short-term capacity constraints in the energy sector, which have contributed to brown outs in California and Brazil. There is a severe energy supply problem in the US, with no new refiner having been built in the past 25 years in response to environmental pressures.
China's consumption of industrial raw materials was second only to that of the US last year. But it has a faster growth of demand, as its economy continues to grow at 7%-plus a year. A thriving export sector is one factor likely to ensure it becomes the largest consumer of industrial raw materials during the next decade.
This puts a growth spin on many international resource stocks, which will be supplying China.
• Cheap valuations in commodities.
• Industry consolidation.
• Favourable demand and supply factors.
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