Taking a Shine to Commodities

Aaron Dunn explains how his U.S. Global Resources Fund rode the wave of rising prices for metals, oil, and other materials

Driven by historically high commodity prices, mutual funds that invest in natural-resources stocks are surging. The average portfolio in the sector gained 43.8% for the year ended in March.

The $239 million US Global Investors Funds: Global Resources (PSPFX ), lead-managed by Aaron Dunn, did even better, soaring 102.6% for the 12-month period. For the three years ended in March, the portfolio rose an average annualized 31.8%, vs. 8.9% for the peer group. Based on return and risk characteristics during the last three years, Standard & Poor's gives the fund its highest overall rank of 5 Stars.

Reflecting the volatile nature of the commodity markets, the fund has a high standard deviation of 28.9, vs. 24.8 for its peers. Its annual portfolio turnover rate of 101% is somewhat lower than the peer group. Though the fund had an unusually high expense ratio last year -- 3.75%, vs. 2.0% for the peer group -- expenses have now been reduced to 1.42% since the portfolio's assets have almost quintupled in 12 months.

Dunn, who joined the management team in September, 2000, is assisted by Ralph Aldis, Brian Hicks, and U.S. Global's Chief Investment Officer, Frank Holmes. Palash R. Ghosh of S&P's Fund Advisor spoke recently with Dunn about his strategy. Edited excerpts from their conversation follow:

Q: How do you select stocks for this fund?


We begin with a top-down process that evaluates the global environment for natural resources, currencies, political risks, and, most importantly, commodities. We then use price-risk models to derive a rough asset-allocation profile for the portfolio.

We look for companies that are highly leveraged toward a particular rising commodity. These companies should possess strong balance sheets, growing reserves, production, and cash flow. We typically purchase stocks trading at a price below the value of underlying assets. We pay close attention to criteria such as price-to-cash-flow, enterprise value to EBITDA, five-year average revenue growth rate, and five-year-average return on capital. Essentially, we're GARP [growth at a reasonable price] investors.

Q: Do you have any market-cap restrictions?


We can invest without regard to market-cap size, but the fund is mostly invested in small-cap stocks, since the resources industry around the globe is characterized by smaller companies. In addition, the portfolio is dominated by foreign stocks, simply reflecting a lack of U.S.-listed resource companies. We currently have about 150 stocks in the fund. We like to keep it diversified.

Q: What are your largest holdings?


As of Mar. 31: Northern Orion Resources (NTO ), 3.42%; Wheaton River Minerals (WHT ), 2.33%; Energy Savings Income Fund, 1.81%; Enerplus Resources Fund (ERF ), 1.73%; Bonavista Energy Trust, 1.71%; Southern African Resources PLC, 1.44%; Alcoa (AA ), 1.31%; Vermilion Energy Trust, 1.29%; Focus Energy Trust, 1.28%; and Acclaim Energy Trust, 1.24%.

Q: What's your current sector allocation?


We have 50% in energy (oil and gas), 40% in basic materials and metals, and 10% in utilities and transportation. A year ago, we had 30% in energy and 70% in materials/metals, because, at that time, we didn't think the outlook for energy was too favorable.

Earlier this year, we took profits in metals stocks, following a surge in the fourth quarter of 2003. Going into 2004, we took a more balanced approach, and added to our oil and energy positions.

Q: Generally speaking, what's the state of global commodity prices?


Commodities have been in a secular bull market since 2001, and we believe these high prices will be sustainable for several years. Part of the reason is because of the enormous demand for natural resources from China, an economy growing 8% to 10% annually. Other factors driving high commodity prices are continued high demand from the developed economies and tightening supply.

Q: How does the weak U.S. dollar affect commodity prices?


The price of gold is almost perfectly negatively correlated with the U.S. dollar. Other commodities are not quite as inversely proportional to the dollar's strength. For example, while the dollar has declined over the past year, crude oil prices in Europe have generally remained flat, albeit at a high level.

Q: What would happen to commodity prices if the Fed raised interest rates?


If the Fed raises rates, first the U.S. dollar would bounce, then some commodity prices would be hurt, gold most dramatically. However, higher rates would indicate that the U.S. and global economies are getting stronger. As a result, some commodities would be in higher demand, and their prices would remain stable.

Q: If commodity prices sank, how would you handle that in this fund?


The thing to remember is that commodity prices do not behave uniformly. When some decline in price, others rise. Our diversified investments give us the flexibility to move in and out of certain commodity-based sectors.

For example, if crude-oil prices go down, chemicals stocks will do well, because their feedstock costs would be reduced. In the event that most or all commodity prices go down, we would move into cash or utilities, which are stable and defensive.

Q: Why are oil prices so high now?


Oil is priced at about $38 a barrel now, but it has been pretty flat since the outbreak of the Iraqi war last March. Moreover, oil stocks did not start moving upwards until December, 2003, and have been strong through the first quarter of this year.

The principal factor behind the sustained high price of oil is rising demand from China, which is now a major importer. This has caused a tightened global supply. Also, an increase in government strategic reserves in the U.S. (40 million barrels) has tightened global supplies. Continued geopolitical concerns in the Middle East and OPEC's commitment to cut production promises to keep oil prices at a stable, level, although it could fall modestly to the low $30s.

Q: What's the situation with gold now?


Gold is currently priced at about $420 an ounce, up from $350 a year ago. At the beginning of 2004, as the price of gold continued to rise, investors took their profits on gold stocks, and the gold equity sector corrected a bit. We strategically reduced our gold exposure somewhat. However, we remain quite bullish on gold due to the budget situation in the U.S. government, and the expected prolonged weakness of the U.S. dollar.

Q: Are most of your metals holdings tied to gold?


No. For example, one of our top holdings, Northern Orion, produces both gold and copper, and it tripled in value last year. We are not a gold fund. We also have significant exposure to copper, platinum, and nickel companies. Prices of all these commodities have been strong. Every metal is different, their prices are determined by a complex range of factors, including supply/demand, inventory, production profile, and political risks.

Q: What are your sell criteria?


We sell when a stock's price gets overvalued based on our price-risk models. We may sell out of one stock if it's trading too high relative to its peers. Also, if something negative happens on a top-down basis, we review our holdings on that whole sector. Commodity outlooks play a big role. In recent years, since commodities have been strong, we have primarily sold out of a position due to rich valuations.

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