Q: What is the history and mission of the fund?

We’ve always been dedicated natural resource equity investors. My partner Leigh has been exclusively working in the field since 1991. He managed the entire family of natural resource funds at Prudential-Jennison and later ran a $5.5 billion natural resource equity fund at Chilton Investment Company. We started our new firm in 2016 and spent a year managing only our own assets.  We launched the mutual fund and a series of separate accounts in 2017.

Q: What core principles guide your investment philosophy?

We are value investors and we believe that the best time to find value is when the commodity market is entirely depressed, investor interest and prices are low, and many companies have little or no profitability. Then we do fundamental research at the supply and demand levels of the different commodity sectors to uncover when the bear market might be nearing an end and when a new bull market is about to begin.

We look for trends that the broad market is missing or not properly understanding. The market is no longer willing to devote time and effort to understand these industries properly, so we believe that by careful and creative work we can uncover trends that other people don’t fully realize. Once we find a trend and identify a sector, we make that a core investment theme and allocate a certain percentage of the portfolio to it.

Q: How does the fund differ from its peers?

A main differentiator is our original research. We do a lot of differentiated work both at the macro and the security levels and we publish our research. We have been publishing for more than 10 years and we’ve also worked with the press. Ideally, our views are in the public domain nine to 12 months before the mainstream analytic community picks up the trend.

Once we have done the research, we try to find creative ways to get exposure to those trends from the bottom-up stock selection process. So, our investment process combines original top-down and bottom-up research and that’s how we differentiate.

While we provide quality natural resource investment expertise, we aim to keep our fees as low as possible, or towards the bottom half or quartile of our peer group. That has been a major focus at our new firm and we view it as an important part of our ethos going forward.

Q: Why should investors consider a natural resource fund?

Because of the unique opportunities in the space. First, natural resources provide a less correlated return in a client’s portfolio. Historically, we have been able to achieve a correlation to the broad market of about 0.4, so the sector is an important source of diversifying return in a broader portfolio. Today we have a tactical overlay because the natural resources segment, as a percentage of the S&P 500 index, is at a 30-year low. The price of commodities relative to the stock market is at a 100-year low.

Historically, such opportunities have represented good entry points for natural resource investors. We believe that today there is a huge value opportunity in a market, where the exposure can be otherwise expensive. The sector represents deep value with quickly improving fundamentals, so it probably merits an overweight allocation in a portfolio.

Q: How do you measure the relative valuation of the space?

We measure relative valuation by dividing the price of commodities by the price of the stock market. In the last 100 years, only three times natural resources have been incredibly cheap relative to the broad market and every time was a fantastic time to be a commodity investor – in 1929, 1969 and 1999.

In 1929, the trend was led by gold and gold-related securities as the U.S. revalued the dollar and increased the price of gold during the depression. In 1969 was the beginning of the inflationary period of the 1970s, led by the U.S. dropping the gold standard and the oil price shocks of the 1970s. It was a great time to be a resource investor. In 1999 the price of commodities relative to the stock market fell to the levels of 1929 and 1969.

It is important to study what these periods had in common. In each of the three cases, there was a huge pull back of commodity prices of 50% to 60% and that’s critical for value creation. The second factor is the ample credit creation at the central bank in the prior decade. Third, this excess credit found its way into the investment boom in a different sector.

In the 1920s there was a broad market euphoria. In the 1960s there were several crazes throughout the decade, including the conglomerate phase and the mutual fund craze. All of them represented investment manias of the day. In 1999, we had the dot-com craze. Such booms are important for two reasons. First, they increase the stock market price relative to the price of commodities but, more importantly, they suck capital away from the natural resource industry and place it into other areas. That in itself creates supply problems that lead to the next bull market in commodities.

So, the situation was quite similar in all of the cases. It involved a decrease in the absolute price of commodities and ample credit creation, which resulted in credit-fueled speculative boom in a sector that attracted capital away from the resource market. Each of these periods has been a wonderful opportunity for natural resource investors, both at the equity and the commodity levels.

Today the commodity sector is very low relative to the broad market. There has been an unprecedented amount of credit creation over the last decade. We’ve had an investment mania for FANG stocks, as well as massive speculative booms such as those for crytocurrency in 2017 or cannabis stocks in Canada in 2018. We believe that, just like in the previous instances, this will be a fantastic time to be a natural resource investor.

Q: What is your investment process?

We are value investors and for us best time to find value at the sector level is when everyone thinks that the sector is under a huge amount of distress. The next step is technical top-down work to uncover turning points. Then we do a lot of work at the security level to find names that offer exposure to those turning points.

Once we determine the desired weighting of a sector or a theme, we select the stocks through a creative bottom-up process that looks for deep value stocks, based on our long-term view on the commodity price. We look for names with exposure to an upward move in the commodity price that we envision. Instead of relying on Wall Street analysts, we use our own long-term commodity price forecasts. We often end up with a portfolio that looks very different from the index and our peers both at the sector and the individual company level, because it’s predicated on our future belief in the commodity price.

One of the issues in managing a natural resources portfolio is the measure of value. Because we use our own long-term commodity price, we can compute discounted cash flows and net asset values for all the companies. We look for the ones that trade at the deepest discount to net asset value.

The companies that seem worthless today might actually be worth something if the commodity price would have moved higher. These companies provide the biggest exposure to the commodity price movement, but also carry a lot of risk. For us, the process is weighing the risk of permanent capital impairment with gaining exposure to the upside move in the commodity that we forecast. That’s what we look for in all our investments. Ultimately, we try to minimize that long-term risk of permanent impairment of capital.

Leigh and I work together and all of our modeling, research, trips; everything is done in concert as co-portfolio managers.

Q: What is your investable universe? How do you define natural resources companies?

Historically, we would invest in anything that extracts value from natural resources and in any companies that support it. We can be involved with mining companies, service providers, energy, drilling, agricultural companies, including fertilizers, and even oil tankers and shipping, although the latter isn’t a core focus.

On the mining side, we have been involved both in precious and base metals, as well as coal, uranium, diamonds or even rare earth materials. Historically, we are not involved with banks or financial companies, exclusively focused on the mining sector, or with Master Limited Partnerships. But we are involved in all the stages of a company’s lifecycle, from early stage exploration to development and production. We mitigate the inherent risk in some of the earlier stage investments through portfolio weightings. Such investments will have smaller weighting and will be more diversified than core names, which would likely be producing entities.

We only invest in listed companies, but they can be listed globally. Historically, most of our investments tend to be focused on companies listed in the U.S., Canada, Australia or Europe, but their assets can be global.

Q: How important are the macro views in your process?

We tend to have three or four key themes at a time. We don’t necessarily hold macro-economic views, although some of our demand models inherently have an embedded view on emerging market growth, for example. But we try to avoid making explicit directional macro calls. We are diversified natural resource investors, so we would invest in all facets of energy, mining, agriculture, and shipping. We have no minimum mandates on any of those themes or sectors at any time. Our allocations are opportunistic and based on where we find best value and where we think the fundamentals are about to change.

Q: Could you illustrate your research process through some examples?

We’ve owned Pioneer Natural Resources Company since the inception of our fund as well as in previous funds that Leigh has managed. To determine the value for a name like Pioneer, we look at its future drilling inventory and the reserves that they can book per well. We try to compute the PV10 or we make discounted cash flow analysis using a 10% cost to capital over the next five years. Our goal is not just to model the financial statements, but also to model the PV10 statement or the reserve statement based on assumptions of the drilling productivity reserves per well, pipe locations and drilling costs. That projection over a five-year period represents a good proxy for the intrinsic value the company can create.

We have met with Pioneer many times over the years in our offices, their offices or at conferences. We followed the progression of the Permian Basin from the original joint venture with the Chinese oil company in the Southern Midland acreage all the way through the development further to the Northern Midland side of the basin. That has been very productive. In fact, we followed and invested in the company when they were drilling vertical Spraberry wells, before shale oil was even thought to be a possibility.

So, we have good understanding of the asset package of the basin that they operate in. As soon as they started to produce profitable well results in the Permian Basin, we realized the value accretion potential of their future development plans. At the same time, they maintained a conservative balance sheet, so the risk of financial distress was low if oil prices moved down. The company has one of the core positions in the Permian Basin, which is the only material source of growth in the non-OPEC world. Our base case is that oil prices will be substantially higher and, therefore, the value of Pioneer’s asset is dramatically higher than the current stock price.

Q: How do you construct your portfolio? Do you follow a particular benchmark?

The portfolio construction begins by trying to identify individual commodity sectors where investor interest is low, the commodity price is cheap, companies are trading at depressed valuation and our fundamental research tells us the bear-market is ending and a new bull market is about to begin. Once we do that, we decide how much the portfolio will go into that theme. A core theme for us will be 20% of the portfolio with the exception of energy, which can be as much as 60% or 65%. We tend to run about three to four core themes at a time and a couple of smaller ancillary themes that we have less conviction about.

When choosing the stocks within a theme, we look for the right tradeoff between exposure to the commodity price and to the movement that we expect in that price versus the risk for permanent capital impairment, which can take various forms, including financial leverage, jurisdictional risk, single asset risk, development risk, etc. When we find a name with strong upside and limited risk of permanent impairment of capital, we allocate about 5% to 6% of the portfolio to it. That is the allocation for a core high-conviction name.

Then we may evaluate a series of names that carry slightly more risk. They may be in an area or basin that’s less proven, but they may offer more potential upside. We would allocate about 2% to 3% to such names. We may also own a handful of positions of 1% or less. Such positions represent more risk either due to the earlier stage development or due to jurisdiction with some lingering concerns. We diversify these names and own a handful of them at small weightings.

Typically, we own about 50 to 70 stocks, with the top 10 names representing 45% of the portfolio. Lipper Natural Resource Equity Fund Index is our mutual fund peer group index. We use the MSCI World Index as our broad index, as well as the S&P North American Natural Resources Sector Index. The ETF that tracks that is the IGE.

Q: In what way does an active manager add value in the sector that an ETF cannot?

The dynamics with the ETFs in our space is quite different; it is two-fold. First, we’ve generated a lot of value over the years by being able to move from one sector to another. At different times different sectors represent substantial value versus the other, so having the flexibility to move between sectors is crucial. We don’t change our themes that often, but we need the ability to have long copper exposure at times or ample gold exposure at other times or strong uranium or oil exposure. That’s a key part of our process that the ETF cannot provide.

Second, given the large weighting of mega-cap mining and energy companies, any ETF will be disproportionately weighted to those companies. That means that the investor will end up with a highly concentrated exposure. Except in mining and energy, our portfolio tends to avoid the integrated companies because we find better value elsewhere. Again, that creates a dramatically different dynamic versus the passive indexes.

Q: How do you define and manage risk?

For us, the major risk is permanent impairment of capital. We are not concerned about commodity price risk because, ultimately, we believe that our research leads us to exposure to forthcoming commodity price movements that we see. The exposure to commodity price is inherent to the fund and our research helps us manage this risk.

Our major concern is being too early in our commodity view, which happens more often than being wrong. So we make sure that there is a limited risk for capital impairment if we are early or wrong. By permanently impaired capital we mean situations where a company is forced to issue massive amounts of dilutive equity, potentially go into receivership if it carries debt, or a project would not be developed and would be worthless.

These are the key types of risk for us and we manage them by understanding exactly where every project lies on a cost curve, by understanding the balance sheet, debt, industry trends and geopolitical concerns. We stay away from companies that employ financial leverage and to invest in companies with high-quality assets. Sometimes that means lower company exposure to a sharp upward move in the commodity price, but also less risk if we are wrong and the commodity price moves down. That’s a key part of our process.