Focus On: Natural resource funds

March 1, 2005

(Published 03/01/05) When we started the MAXadvisor Newsletter in early 2002, natural resources was one of only three stock fund categories that had our top rating of “Most Attractive”. We give this rating to fund categories we think will beat the U.S. stock market and 80% of fund categories over the next 1 to 3 years.

It turns out that our optimism for this category was well-founded. Natural resources funds have been near the top of stock categories over the last three years.

As we often do when an area comes into favor, we downgrade the ratings – but not until we think things are really getting overblown. We kept natural resource funds at a “Most Attractive” until May of 2004, when we downgraded the category to “Attractive” (these funds should beat the market and 60% of fund categories).

The category kept performing well, so we downgraded the category again to “Neutral” in October of 2004. The million dollar question: what should we do now?

It’s not enough for us to recommend an out-of-favor category that goes on to do well. We need to tell you when to sell, or at least cut back on your stake of categories that have done well but are heading for a downturn. This is where things get a little tricky. To be perfectly frank, we tend to get out of hot categories a little too early, as long-time subscribers to MAXadvisor (and MAXfunds readers) know. Real estate and precious metal funds come to mind.

Natural resource funds have been hot because commodities have been hot. These funds largely own mining and energy related companies. Until more resources can be explored for and produced, stocks in the category tend to do well when natural resource prices rise.

Natural resource stocks have also done well because they were cheap before but aren’t so cheap now – valuation expansion. Nobody wanted anything to do with such dull, old-fashioned businesses back in the new economy days. Today, the benefits of buying a business on the cheap are obvious, as are the negatives from paying too high a price. The five-year average annual return on the typical natural resource funds is about 18% - good enough to turn a $10,000 investment into $23,000. (The five-year average annual return on tech-nology funds? Try a negative 21% per year, enough to turn a $10,000 nest egg into a $2,700 cracked egg.)

Among the signs we look for that a category might be heading south are 1) huge inflows of fund investor money in the category, 2) new category focused mutual funds being launched, 3) increased ‘buzz’ about the category, 4) over-stretched valuations.

1) Inflows And this is where we are a bit on the fence concerning the natural resources sector. We’ve seen big flows of cash to energy funds. One of our favorite funds in this category, Vanguard Energy, just closed with $6.5 billion in assets. It had $2.5 billion in 2003 and $1.3 billion in 2001. Shareholder inflows to funds here make us negative on natural resources.

2) New Funds As for new funds, there have been a few, notably Guinness-Atkinson Global Energy (GAGEX) – a decent but expensive choice (full disclosure: Jim Atkinson of Guinness Atkinson is a former MAXfunds executive). We’d like to see more fund launches to really mark a top here. The “new fund” signal produces no clear verdict one way or the other on the future of natural resources.

3) Increased Buzz Recent trends suggest that you just can’t get away from Johnny-come-lately energy bulls. I’m not going to name names, but guys I recall touting tech stocks five years ago are now ga-ga over Exxon- Mobil. Amazing how the new economy gurus crossed over to the old economy. Too bad they didn’t change their minds earlier. They could have saved investors some money…
And of course, the experts talk a good game, and energy seems to make sense. Things look good for energy stocks, which is why they’re up a gazzilion percent, for Pete’s sake! Many natural resource funds were up 15% or more last month alone! But then, didn’t tech stocks look pretty good back in the day?

This week on CNBC one energy bull showed a chart of energy stock’s percentage of the S&P500. Unlike tech stocks, which peaked out as a bigger chunk of total market cap in the S&P500, energy stocks are a mere 10% or so. This analysis was compelling because we look at the bigger parts of the S&P for contrarian signals as well. Then he went on to show how energy stocks used to be 20% or more of the index a few decades ago. So therefore, we have got a long way to go in this new bull market in energy.

Or do we? A few decades ago we didn’t have mega cap software and computer companies with billions in earnings. By the same historical logic, buggy whip stocks should stage a comeback. What about textiles? Agriculture? Railroads? Autos? Tech bubble or no, companies like Microsoft earn billions and deserve to hog up some of the index – the economy has evolved to the point where old industries like transportation and energy will never be the percentage they once were in the stock market, or in the economy for that matter.

4) Valuations While energy earnings are very strong right now, they are tied to sky high oil prices. While there is no law that says oil prices have to fall again, they could, and drastically. With commodities, you’re always one global recession away from a 50% haircut in prices. Profits could get cut sharply at energy companies in short order. Does Microsoft have to worry about such a situation? Maybe commodity based businesses should have lower P/Es than stocks that are more in control of their own near term destiny.

Even worse, Vanguard Energy now has a LOWER dividend yield than the Vanguard 500 Index – 1.1% compared to 1.6% (only some of this is because of slightly higher fees on the former). This is troubling because energy stocks are largely owned for dividends as long term growth prospects are expected to be average at best. Stock valuations point to a below average future for energy stocks.

Three out of our four sell-warning bells are ringing; the other (new fund launches) isn’t giving us a clear indication one way or the other. Our signals are clear – natural resources stocks have peaked. We’re now downgrading the category - for the first time in MAXfunds history - to a negative rating.

We are dropping the category; going to a “Least Attractive” should under-perform the market and 80% of stock fund categories over the next 1 to 3 years.

We recommended an energy fund in our 2004 hot sheet and we own energy funds in many of our managed accounts. We are now in the process of selling at least part of the stakes and locking in these gains – something you should consider if you followed our advice with this area in recent years.

When you do sell, be wary of short term redemption fees and short term tax rates if you own these big-gain funds in taxable accounts. Vanguard Energy is up 50% over the last year- you don’t want to pay a short term tax rate on that gain if you can push it off a few weeks and trigger a long term gain.

Remember the golden rule of fund investing with MAXadvisor: The (fund) customer is (almost) always wrong!

Sell when they buy and buy what they sell and you’ll do just fine over time.

Category Rating: (Weak) – should underperform the market and 60% of stock fund categories

Previous Rating (12/31/05): (Neutral) - Should match the markets return and perform in the middle of other
stock fund categories

Expected 12-month return: 5%

OUR FAVORITIE natural resources FUNDS
1. T. Rowe Price New Era Fund (PRNEX) 9/01 101.71% 80.95% 10.96% 38.67%
1. Vanguard Energy Fund (VGENX) 9/01 138.38% 117.61% 14.78% 49.65%
2. Excelsior Energy & Natural Resources Fund (UMESX) 9/01 101.37% 80.60% 14.16% 48.20%
3. iShares Goldman Sachs Natural Resources Index (IGE) 4/04 40.64% 31.91% 11.89% 37.93%