Energy and mining stocks cheapest for a decade

In his latest update on commodity markets, Ian Henderson, manager of the JPM Natural Resources Fund, refutes the opinion that the ‘party is over' and offers the rationale behind his strong conviction that the long-term investment case and fundamentals underpinning the commodities sector are sound:

Henderson cites:

Buying opportunities for cash rich majors created by recent sell-off
Comfort to be found in oil-based equities less leveraged to the oil price
Gold remains a safe-haven
Predictions for robust growth in Emerging Markets

"It is a mistake to assume that current volatility within the commodities sector is proof that the prolonged rally in commodity stocks is running out of steam," said Henderson. "It is also misrepresentative to attribute it to a change in the basic fundamentals of supply and demand which have historically resulted in such compelling returns for investors. In reality, it is the self-perpetuating irrational market sentiment in itself which is causing a sell-off for profit taking purposes, thus provoking the fall in prices. Despite this short-term volatility, we hold true to our belief that the long-term investment case is as strong as it ever was. Indeed, energy and mining stocks have not been this cheap for a decade. I find it astonishing that energy stocks have fallen to such an extent, given the sector's potential earnings growth. We would urge investors to focus, not on theory and speculation about the bursting of some mythical commodities ‘bubble', but on the very real and tangible opportunities that are yet to be unearthed in this vast sector. The commodities story is far from over."

Buying opportunities for cash-rich majors and investors

The recent sell-off from commodities has created attractive buying opportunities for cash-rich majors (the sector's largest companies) and it is predicted that acquisition activity will only accelerate in the coming months. The JPM Natural Resources fund is well positioned to capitalise on this trend, holding potential targets, as well as cheap cash-flow generating companies, within the portfolio. Recent investor risk aversion to small cap companies, in spite of their generating the greatest returns over the last 5 years, is also an opportunity to be exploited. This indiscriminate underinvestment has created cheap opportunities to buy small cap companies with solid fundamentals and growth prospects.

Oil price versus oil equities

Over the last 12 months, oil based equities have lagged the oil price and the sector has been harshly de-rated. However, earnings and cash flow within companies have been exceeding expectations and thus they remain lucrative prospects. Opportunities are particularly acute amongst upstream, early exploration oil companies, being less leveraged to the oil prices and underpinned by solid organic growth from exploration to production. New discoveries and increased projection from these companies translate into strong returns.

The matter of metals

Gold remains a well-supported safe haven and a hedge against inflation. Supply constraints manifest in the persistently tight market and inflated price. Major producers have just 10-15 years gold reserves (compared with 50+ years of Iron Ore resources) and it takes approximately 10 years to set up a new mine and deliver gold to the market.

Emerging markets ‘bulking' up

Henderson's view is that, "To believe in the emerging markets story is to believe in the commodities sector. The strong appetite for commodities in the emerging markets' due to increasing populations and infrastructure growth is far from satisfied."

As a result of this sustained boom, bulk commodities such as iron ore and coal generated growth well in excess of forecasts in 2007 and continue to provide strong returns in 2008. Projected infrastructure spend in China, for example, remains robust. It is estimated that China will need to build at least 170 Gigawatts of new coal power capacity from 2005-2010 - equating to approximately 50% of the global total.

Henderson concludes: "The unconstrained and flexible approach exercised in the management of the JPMorgan Natural Resources Fund will allow us to capture the compelling opportunities that are clearly there for the taking in the second half of 2008. By trusting in the fundamentals of supply and demand, we have much to be heartened by, and through continued careful selectivity, I am optimistic we can unlock significant growth potential from the commodities sector in the coming years. We would encourage investors to look beyond the short-term volatility and instead focus on the returns to be gained when the markets stabilise. After all, it would be foolish to leave a party before it gets into full swing."