Aside from the exuberance surrounding the tops of bull markets, the general investment public is uninterested and underinvested in natural resource equities. There are quite a few reasons for this avoidance:
1. The volatility of commodity prices scares many potential participants from the space.
2. Due to urbanization, environmental regulations, and a host of other factors, investors from the western world in particular are more separated from natural resource extraction than ever before. A shrinking percentage of the world is directly involved with the mining industry.
3. The natural resource industry is unsexy and old fashioned. Many investors would rather bet on the next big social media or biotech story. Very few understand the importance of metals and minerals to our continued technological advancement.
4. The long-term outperformance of energy/mining equities over the broader market is not very well known. Many would be surprised to learn that energy/mining equities have outperformed the S&P 500 by roughly 2% annually since the 1920s (as reported by GMO in 2016).
We view the general apathy towards natural resources as an opportunity. Legendary value investor Jeremy Grantham does as well. For those unfamiliar with Mr. Grantham, he is a British investor and founder of GMO - a Boston-based asset management firm with roughly US$120 billion in assets.
In the second half of 2016, Grantham and colleague Lucas White authored a research report entitled "An Investment Only a Mother Could Love: The Case for Natural Resource Equities." I've included an excerpt below. The full report can be accessed at www.gmo.com.
We believe the prices of many commodities will rise in the decades to come due to growing demand and the finite supply of cheap resources.
Public equities are a great way to invest in commodities and allow investors to:
■ Gain commodity exposure in a cheap, liquid manner
■ Harvest the equity risk premium
■ Avoid negative yields associated with rolling some futures contracts
Resource equities provide diversification relative to the broad equity market, and the diversification benefits increase over longer time horizons.
Resource equities have not only protected against inflation historically, but have actually significantly increased purchasing power in most inflationary periods.
Due to the uncertainty surrounding, and the volatility of, commodity prices, many investors avoid resource equities. Hence, commodity producers tend to trade at a discount, and they have outperformed the broad market historically.
While resource equities are volatile and exhibit significant drawdowns in the short term, over longer periods of time, resource equities have actually been remarkably safe investments.
Despite all of this, investors generally don't have much exposure to resource equities. Typically, they don't have large specific allocations to resource equities, and the broad market indices don't provide much exposure to the commodity producers. The S&P 500's exposure to energy and metals companies has dropped by more than 50% over the last few years, and the same is true of the MSCI All Country World Index. Those investing with a value bias may be particularly underexposed to resource equities, as value managers tend to be especially averse to the risks posed by commodity investing.
So what does this mean for the portfolio of your average investor? There are two points that I'd like to emphasize:
1. For proper diversification, it is my belief that a minimum of 10% of one's overall portfolio should be exposed to natural resource equities. This includes mining, farming, forestry, and water-related investments. Unless you have experience investing in juniors with no producing assets, it is best to stick to companies that are already in production.
2. Natural resource extraction is inherently unsexy. However, every once and awhile, the mainstream investment community becomes enamored with the industry. This is generally the sign of a maturing bull market. Better to take profits and buy back in when resources return to being unsexy.
For those underweight natural resources, it is not too late to adjust one's portfolio. While valuations across the resource space were admittedly more attractive in 2015 and early 2016, there is still plenty of money to be made in this current bull cycle.
Additionally, we are seeing signs that the next eight years will be starkly different from what we've seen over the past eight (rising US dollar, low interest rates, currency devaluations in the western world, rising stock markets, falling commodity prices, low inflation, etc.). Times are changing, and it would be prudent to shift exposure from the S&P 500 to natural resource equities.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.