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Resource stocks are driven by demand

Despite correction, stocks should continue to rise

INVESTMENT REPORTER

Resource stocks have corrected in recent weeks, but the rally in the sector is far from over, according to fund manager Margot Naudie.

Ms. Naudie has been the lead manager on the $160-million TD Resource Fund since April, 1999, and was co-manager for a year prior to that. The fund is up almost 11 per cent so far in 2005. It returned 22.39 per cent in the 12 months to Feb. 28, and 21.96 per cent annualized in three years, 21.29 per cent in five years and 9.07 per cent in the 10 years.

"What is going on with resources in general is secular" and the secular positive trends are "extremely strong," said the vice-president and director of Toronto-based TD Asset Management Inc.

"Strong demand and supply that is not able to respond quickly enough to meet the increasing demand that we have seen out of China and India, I think, will combine to keep commodity prices strong for the next several years," she said. Also, there are more investors playing commodities directly as an asset class, which is buoying resources as well.

In choosing core positions for the fund, Ms. Naudie looks for companies that have a solid management teams focused on creating shareholder value, high-quality resource assets that typically are in the lowest quartile in terms of production costs and the ability to internally finance growth.

Montreal-based Alcan Inc. (AL-TSX, AL-NYSE) fits that bill. Moreover, it is in the aluminum business, which she thinks will have positive fundamentals over the next few years as China moves from being a net exporter of aluminum to being a net importer.

"Alcan happens to have a very good exposure to changes in the aluminum price; a 1-cent [U.S.] change in the price of aluminum translates to a 10-cent change in the [annual] earnings per share for Alcan," she said. She describes Alcan's takeover of Pechiney SA in late 2003 as a "very accretive acquisition" and notes that Alcan is running ahead of its target for cost savings arising from the merger.

The spinoff of Novelis Inc., the rolled products division, was "very clever financial engineering," Ms. Naudie said, because it helps Alcan reduce the debt on its balance sheet. She has a 12-month target of $47 (U.S.) on Alcan, whose shares closed yesterday on the New York Stock Exchange at $36.62.

She also finds shares of Sherritt International Corp. (S-TSX) attractive. Toronto-based Sherritt has exposure to nickel, coal and oil and is a large strategic investor in Cuba.

"Sherritt is in my view a particularly inexpensive stock; it is one of the few resource companies that I see that is currently trading at a discount to its net asset value," Ms. Naudie said. She has a 12-month target of $12 (Canadian) on the shares, which ended yesterday's session on the Toronto Stock Exchange at $9.92.

Sherritt recently announced plans to boost output of the Moa Bay nickel-cobalt operation it owns jointly with the Cuban government, by 16,000 tons to 49,000 tons a year. That expansion project has "among the best economics of any of the nickel expansions currently contemplated by major mining companies," she said.

Freeport-McMoran Copper & Gold Inc. (FCX-NYSE) also gets her nod. The New Orleans-based firm "is an exceptionally well managed company," she said. The Grasberg copper-gold mine in Indonesia is in her view "the best mine in the world." Grasberg is expected to produce 1.5 billion pounds of copper and close to three million ounces of gold this year. With the price of gold at $420 (U.S.) an ounce, the company should be able to offset the cost of producing the copper with its gold output, making the cash cost of the copper zero this year.

At current gold and copper prices, Ms. Naudie calculates that Freeport-McMoran will generate almost $1-billion of free cash flow this year, most of which will likely be returned to shareholders through regular and special dividends. She sees the Freeport-McMoran shares climbing to $45 over the next 12 months from the $38.93 they closed at yesterday on the New York Stock Exchange.

About 12 per cent of the TD Resource Fund is invested in existing oil sands producers and other Toronto-Dominion funds also have material investments in the sector, she said. "We have long been fans of the oil sands business."

It has long life reserves with low political risk, minimal geological risk and very high returns on invested capital. "Your economics get better as you expand these oil sands operations." With companies such as Shell Canada Ltd., the large expenditures associated with the projects are behind them.

© 2007 The Globe and Mail. All rights reserved.

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