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The Wise Investor
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Table of Contents
Put your financial adviser on a leash
February 11, 2000
100% Foreign content for your RSP
December 22, 1999
Tax Loss Selling or Dealing With Your Mistakes
November 26, 1999
Life Stages of your RRSPs
November 12, 1999
Just give me boring (but great) rates of return
November 3, 1999
De-mystifying Demutualization - part Two
October 25, 1999
De-mystifying Demutualization - part One
October 19, 1999
Seg funds for the simple minded
September 14, 1999
The interest rate game Part 2
August 12, 1999
The interest rate game Part 1
July 30, 1999
Choosing funds: Five for the long run
July 14, 1999
New Funds: To buy or not to buy
July 2, 1999
Making sense of momentum investing
June 18, 1999
Rating the fund managers
June 4, 1999
Resource recovery hinges on supply and demand
April 30, 1999
Tech funds draw strength from favourable trends
March 24, 1999
Withdrawing from your RRSP
March 9, 1999
The economic implications of the euro - An interview with Ranga Chand
February 12, 1999
Underperforming small-cap funds have strong upside potential
January 29, 1999
How to pick a winning equity fund portfolio
January 15, 1999
View the Weekly Insight archive

Resource recovery hinges on supply and demand

Related articles from The Globe and Mail

Resource-loving managers fly with commodity stocks
- May 4, 1999

Is it time to play the resources card?
- April 15, 1999

Buoyant markets lift equity funds
- April 15, 1999

Most funds missing out on resource sector surge
- March 17, 1999

Dividend funds best sector over five years
- February 27, 1999
Co-manager, Trimark Canadian Resources fund
Friday, April 30, 1999

Canadian stock markets have underperformed their counterparts in other countries such as the United States for the past few years. The heavy influence of resource stocks on Canadian markets is a primary reason. While markets in Canada are less dependent on the resource industry than they were in the past, a pick up in resources would certainly provide a boost.

Although the past few months have seen glimmerings of a rally in resource stocks, many investors are wondering when a full-throttle, cyclical recovery in resource stocks is likely to occur. The answer is not clear for a few reasons. Among them:

  • All resource industries should not be classified together. The resource sector includes various industries, each of which has unique price, demand and supply considerations.

  • There is an infinite realm of possible events that could stimulate a recovery in various resource industries. But it's a common occurrence for forecasters to be correct on a commodity or sector call for all the wrong reasons. Often bright analysts successfully predict countless sequential events in the future, yet get the pricing trend wrong or overlook the fact that their predictions have already been discounted in the market.
Here's the problem of lumping all the different resource sectors together, including gold, base metals, oil and gas and forest products. Each group is affected by different factors. For example, a pick up in housing demand might increase lumber prices, while the threat of worldwide financial instability might boost the price of gold, and war might boost oil prices. There are also wildcards such as inventory cutbacks by OPEC members, that are unpredictable and only affect certain commodities.

In Focus
Trimark Canadian Resources

Style: Bottom-up

Focus: According to co-manager Geoff MacDonald, the fund focuses on "Companies with low-cost assets and clean balance sheets."

Stock selection criteria: "How do we determine the true value of a company? In resource stocks, it is simply valuing the cash flow stream of a company, on a normalized basis, over the life the company's assets. If you stick to the discipline of buying resource companies at discounts to this value, you'll do well over the long term."

Measuring growth potential: "Another strategy and perhaps more appealing for resource investing is finding companies that can grow their earnings independently of a higher commodity price. Concentrate on companies that have high quality assets, above-average return on capital, and growth potential. These companies will have the cash-flow-generation ability to grow production, or increase dividends when competitors are struggling.

"When you find these kinds of companies, you can take the commodity price risk out of the equation. Examples of quality companies that we own in our Trimark portfolios include, Suncor Energy Inc., MacMillan Bloedel Ltd. and Barrick Gold Corp."

Resources funds sorted by year-to-date performance.
In general terms, the outlook for the various industries is dependant on three factors - demand, supply, and, price. Demand is tough to predict and I will not make an attempt. Supply is much easier to get a handle on. Other than unplanned supply disruptions, supply growth over the next couple of years is the easiest part of the equation to evaluate. In most resource commodities, production increases over the next couple of years are expected to be relatively non-existent compared to the previous three or four years. Why? The reason is the third factor, which is price. The prices of many resource commodities have been depressed for some time now, and that's hindered the expansion of production capacity. But eventually, that reduced production will contribute to a rebound in prices.

The current low commodity prices are part of a cyclical pattern. Producers of resource commodities have not been very profitable in the recent past. This lack of profitability reduces the financial reserves that these companies have for investment in developing or acquiring new resource properties, which in turn limits supply of their product.

Investors who flocked to resource companies when it was popular to do so, now shun them even though resource stocks are trading at a third of their former highs, in many cases. This lack of investor interest limits capital availability. Reduced capital is another reason why it's difficult to expand and increase production (supply). Eventually, this reduced supply will put upward pressure on prices and lead to superior performance in resource stocks.

The timing of such an occurrence is impossible to predict, but hundreds of years of history show that this is how the cycle works. As long as you believe the world will still use oil, copper, zinc, aluminum, and paper products, today's depressed commodity prices will prove low relative to where we expect to see them over the next 10 years.

In conclusion, many factors are in place for a recovery. Sentiment has been negative for a few years, prices are low, supply is being constrained and a large number of high-quality companies with clean balance sheets are attractively valued in current markets. We're seeing signs of recovery in Japan. If such a recovery catches hold, it will stimulate world demand for a variety of commodities. Growth is also picking up in other Asian countries, and U.S. growth remains strong. The exact timing of a turnaround is tough to predict, but the pieces are in place for generating attractive returns in resource stocks during the next few years.

Geoff MacDonald, MBA, CFA, is co-manager of Trimark Canadian Resources.

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