Digging for returns in natural resources

David Prosser considers opportunities in the commodities sector.

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Conventional wisdom is that slower periods of economic growth are bad news for investors in commodities and natural resources. After all, when the world’s economies are expanding at a slower rate, there will be less demand for the raw materials that power industry. Still, while you might think that does not augur well for commodities in the current environment – given that global growth is expected to remain depressed for the next year or two – there are reasons to be positive.

One important consideration is the net zero agenda. We often associate commodities with carbon-intensive activities – particularly coal – but there are plenty of natural resources that play a crucial role in decarbonisation. Copper, lithium and cobalt, for example, are all in demand as we move towards electrifying the world’s transport. Uranium is required for carbon-free nuclear energy production.

Another positive factor is that while the economic cycle will always have ups and downs, more fundamental drivers of demand for commodities remain in place. These include the world’s growing population, the continuing trend towards urbanisation, particularly in developing markets, and the need for significant investment worldwide in a range of infrastructure projects.

Equally, on the supply side, the capacity in large parts of the commodities industry has shrunk over the past year or so. The boom in the sector, which saw prices soar in 2021 and the early parts of 2022, subsequently turned to bust; many miners and producers responded with retrenchment, pulling back from less profitable projects and reducing output. Even if prices start to bounce higher once again, it will take time to turn that supply back on.

“While the economic cycle will always have ups and downs, more fundamental drivers of demand for commodities remain in place. These include the world’s growing population, the continuing trend towards urbanisation, particularly in developing markets, and the need for significant investment worldwide in a range of infrastructure projects.”

David Prosser

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The other part of the conversation here is about valuation. With investors still taking a more conventional view of the prospects for commodities, the sector looks cheap by historical standards. As Investors Chronicle points out in a fascinating recent article making the case for commodities, the MSCI World Energy index currently trades on a price/earnings ratio of just 11-12 times. Compare that to the stock market – the MSCI World index is on a PE ratio of around 21 times’ – and you start to think about valuation opportunities.

None of which is to say that commodities are a slam dunk for the months ahead. But this is an interesting opportunity to at least consider, particularly for investors happy to take a more contrarian approach. In which case, what would be the best way to secure exposure to the commodities sector?

Well, investment trusts certainly have a great deal going for them when it comes to commodities investment. In particular, the structure of an investment trust protects its investors from illiquidity in the portfolio – that is, when assets can be difficult to buy or sell quickly.

This is important because commodities themselves can be illiquid. And while most funds hold a large chunk of their portfolios in shares in commodity companies, rather than the physical materials, these can also be illiquid if you’re talking about privately-owned businesses or smaller producers. And it’s often among these businesses that many of the most attractive investments are to be found.

The other factor in favour of investment trusts is their ability to take on gearing, which enables funds to take on broader exposures and enhance their returns in a rising market. If you think commodity prices are set for a bull run, a fund with gearing makes an attractive option.

It’s worth pointing out that the choice of investment trusts offering pure-play commodities exposure is relatively limited – the AIC’s Commodities & Natural Resources sector encompasses only eight funds. Moreover, several of these funds are quite specialist, which may or may not appeal, depending on how you feel about different parts of the market.

Nevertheless, investment trusts are a tried and tested way to secure both broad and focused exposure to commodities. Their progress over the next year and beyond will be fascinating to watch.