2 long-term winners (and why you can still uncover value in resources)

In the first half of 2022, there were two main winners that dominated markets around the globe - energy and materials stocks. Resource-reliant investors would have outperformed only until quite recently when the rally in those raw commodities cooled.

Having said this, GMO's Kim Mayer says it's not too late to find compelling value within this sector. Mayer believes that many resources, agriculture, and energy-focused equities are still trading at discounts to what we have historically seen. 

Mayer and his team invest in both fossil fuel energy companies as well as renewable energy companies, arguing that both will be important in the transition to a cleaner future. They do not discriminate against traditional industrial metals and clean energy metals as well. It just comes down to valuation. 

"If you can buy those business models at the right price, those are going to be great investments," he says. 

In this wire, Mayer outlines the benefits of global resources and energy stocks within portfolios right now and names two quality stocks that stand out within their respective fields. 

Note: This interview was recorded on 16 August 2022. You can watch the video or read an edited transcript below.

Edited Transcript  

Ally Selby: Hello, and welcome to Livewire Markets. I'm Ally Selby, and today we're joined all the way from Boston by Kim Mayer from GMO. We're going to be talking about all things resources, as well as two of his favourite stocks. Thanks so much for joining me today, Kim, I'm really excited for this chat.

Kim Mayer: Thanks, Ally. It's great to be here today.

Ally Selby: Resources and commodity stocks and energy companies have been the major winners in the first half of 2022. We've seen a recent pullback in some of those names. Are you still finding value in these sectors?

Kim Mayer: Yes. And so there's been no shortage of volatility in all things resources so far in 2022. We had that rocket ship ride upwards, particularly in energy, during the first quarter. Energy producer stocks were up about 40% for the quarter on average. And as you mentioned, we have seen a bit of a pullback in the second quarter and continued volatility in the third quarter so far.

So the question is, are there still opportunities to be found? And I think the short answer to that is yes. When we think back over the longer-term history, resource equities went through a pretty dismal decade of performance, which matched a pretty dismal decade of what was going on in the underlying commodity prices. 

That's changed dramatically, and the attention of investors on resource equities has really sharpened as well, but it's by no means too late. We came into the recent period of strong performance for resource equities, trading on average at about a 60% discount to broader markets.

And so while we've come back upwards in terms of price and the relative valuation has changed a little bit, we're still trading on average at discounts that are well beyond what we historically have seen. 

So there continue to be tremendous opportunities in energy,  whether it be fossil fuel energy companies or renewable energy companies. 

We invest in both of those in our portfolios at GMO. Also, within materials more broadly, in both clean energy materials or more traditional industrial metals. And also I would include in that group, resource agriculture producers. You can build a diversified portfolio and still find some very attractive valuations.

Ally Selby: Okay. We've seen over the last few days that recession risk seems to be cooling off at the moment, but there are obviously still headwinds out there in the market. Do you think resources can still provide investors with some portfolio protection?

Kim Mayer: If you think about what exposure to resources can do to an equity portfolio, there are a couple of nice features that are sometimes overlooked. One thing that's not overlooked is inflation protection. We've seen historically that a portfolio of resource equities provides strong inflation protection. During this inflationary event, that has absolutely held true, and it's been one of the reasons that they have been as strong performers as they have been.

Another perhaps less well-known feature is that they provide a very diversified stream of returns, and so they tend to do well when the rest of your portfolio is doing less well. We're seeing that so far in 2022, so they can be a diversified source of returns.

Finally, they can straddle what we think of today as the energy transition. So if you're invested in a diversified portfolio, you can continue to have exposure to fossil fuel energy companies, for which there's going to be continued demand for oil and natural gas for many decades to come. 

If you can buy those business models at the right price, those are going to be great investments. 

But you can also invest in renewable energy producers, as well as those producers of those key clean energy transition materials. Think lithium, nickel, and cobalt.

Ally Selby: What are the key ingredients of quality resources companies? What are the factors that you're looking out for before you invest?

Kim Mayer: We do certainly have a quality focus. I think it's important, and where that comes into play for us is really as we're forming our investment universe. We think about the quality of the assets on the ground. We think about where a particular producer sits on the cost curve. 

We want to avoid those really high-cost producers. We want to avoid those companies whose business model is dependent on, for instance, oil that's less high quality, that's more expensive to extract, that's lower density. The same would apply to copper producers where there's less high-quality ore. It's going to be more expensive to produce that ore.

So we think a lot about that. We also think just about where a company sits in terms of how its capital structure is formed today. So we are avoiding those companies that are more highly levered, that are going to be less able to weather a long-term economic downturn. So paying attention to quality absolutely does matter. 

For us, if you're a low-quality producer, you're not even going to make it into our universe, much less into the portfolio.

Ally Selby: Over the short and long term, are there different commodities that you think can outperform?

Kim Mayer: That's a great question, and I'm going to give you an answer that's probably a little bit different than you're looking for. 

I think where a lot of commodity resource investors get into trouble is trying to think about what commodity is going to do well over the short-term versus another commodity. So is oil going to do better than natural gas, going to do better than copper, going to do better than iron over the short term? But that's a loser's game. Nobody does very well over time making those types of predictions.

What I can tell you with a high degree of confidence is that there is resource scarcity over the long-term across energy, whether we're talking about renewable energy or fossil fuel energy, across industrial metals, and many agricultural commodities. 

Think about the key materials that are going into the input. So phosphate and potassium are key inputs for fertilisers. There's just not enough of many of these key materials around the world to supply the long-term demand. And so that thesis of resource scarcity is very much intact. 

Over the long-term, there is a very strong argument for having a balanced portfolio of fossil fuel companies and renewable companies, in order to manage through that energy transition. But I would counsel you to avoid playing that short-term price prediction game.

Ally Selby: Okay. I'm going to push you for two stocks then that you think can outperform over the long term. I did have one for the short-term and one for the long-term, but I'll switch it up for you. So just two stocks for the long-term that you think can outperform within their sector.

Kim Mayer: And so I'm going to focus on a couple of different sectors here. So one would be within renewable energy. So we always think about solar and wind. Increasingly, we're excited today about renewable diesel biofuels. And so there are some players there that really stand out that have these long-term partnership agreements, either from a supply chain side, but also from a distribution standpoint as well.

So Darling Ingredients, which is a renewable fuel company here in the United States, has those long-term supply contracts locked up. They essentially use the waste from food production. For example, they might use cooking oil, animal fats, et cetera, and transform that into biofuels. 

They also have those key distribution contracts as well, not only from a distribution standpoint but also from a refining standpoint as well. So they have both ends of the supply chain very well covered. That would be stock number one, Darling Ingredients.

Stock number two would be one of our lithium producers. When you're thinking about lithium producers, you want to own those producers that are able to produce what we think of as battery-grade lithium. That tends to be companies that use the evaporative technique for producing lithium. SQM, which is again a US-based company, but which has a lot of its operations in Latin America, is a standout from that standpoint and continues to represent a very good valuation opportunity.

Ally Selby: Well, I've absolutely loved talking to you today, Kim. Thank you for your time. If you enjoyed that video too, give it a like, and remember to subscribe to our YouTube channel. We're adding new content every week.

Access a portfolio of high-quality companies

Kim and the team believe that companies with established track records of historical profitability and strong fundamentals are able to outgrow the average company over time and are therefore worth a premium price. To learn more about GMO's Quality Trust, please visit their website.