Natural Resource Stocks: What You Need to Know About

GMO portfolio manager Lucas White discusses why the stocks outperform and lists some of his favorites.

Natural-resource stocks can provide strong returns while offering diversification and protecting you from inflation, says Lucas White, manager of GMO Resources Fund  (GEACX) .

Natural-resource stocks have outperformed the broader stock market by 2 percentage points a year on average over the last 100 years. The GMO Resources Fund has beaten the S&P 500 over the past one-, three- and five-year periods, though it trails for 10 years.

The Fund has annualized returns for those periods (starting with one year) of negative 1.78%, positive 18.65%, positive 12.61% and positive 7.91%

White goes for risky investments to generate hefty returns. He takes comfort in the fact that natural resource stocks are trading at a bigger discount to the market than usual. Also commodity prices may be headed higher for a long time, he said.

Here are White’s comments including stock picks.

TheStreet: What’s your investment philosophy?

White: We find uncomfortable situations. You generally shouldn’t expect to outperform if you invest in stable and safe situations. You get outsize returns taking risk. Mispriced and underpriced assets should be able to outperform. And you don’t want your risks highly correlated..

TheStreet: Why do you like natural resource stocks?

White: They provide diversification and produce equity-like returns in different ways. They are [influenced by] commodities rather than by the economy like most other stocks. Because of that, natural resource stocks are uncorrelated, or negatively correlated, to the broader market.

They provide inflation protection. The last few years have seen the first substantial inflation since the 1980s, and natural resource companies have performed well. Commodities and commodity stocks have been the best-performing assets.

Given the inflation protection and diversification, you would expect natural resource stocks to trade at a premium to the market. But they trade at a discount over all periods, so they perform well long-term.

Also, companies have invested little in commodities in recent years, but demand growth is coming down the pipe. That’s because of population growth and urbanization in emerging markets and the global clean energy drive.

This [supply-demand combination] can lead to higher commodity prices for an extended period of time. It’s exciting how cheap natural resource stocks are. They typically trade at a 20% discount to the broad equity market, but now it’s 55% to 60%. Even if commodity prices are just flat from here, there should be tremendous returns for these companies.

TheStreet: How do natural resource stocks perform versus the overall stock market?

White: If you go back to the 1920s, natural resource stocks have returned about 8.5% a year in real [inflation-adjusted] terms, compared to 6.5% for the broad stock market.

There are wild rides up and down for natural resource stocks. Now, they are still well below levels from a decade ago, according to some measures. They do outperform over the long term, but they can underperform for an extended period of time.

When they perform well is usually when the rest of your portfolio is performing poorly. For example, 2000 to 2010 was a lost decade for stocks, but resource companies performed well. The last year was a tough period for the equity market, but brilliant for natural resource stocks.

TheStreet: What are the advantage of a natural-resources stock fund over a straight commodities fund? [Commodities funds generally consist of commodity futures.]

White: The problem is that while natural resource stocks have returned about 8.5% over the last 100 years as I mentioned, commodity prices themselves have been flattish. There’s no reason for commodity prices to rise: it’s just supply and demand. But equities are priced to deliver return. You wouldn’t buy a stock with a price-earnings ratio of 150. You’d buy at 15.

Natural resource companies are priced for strong long-term returns. But there is no risk premium for commodities. For commodities futures it’s even worse [because of the market’s structure.]

TheStreet: What segments of natural resources have the best stock-investment opportunities?

White: Fossil fuels companies, such as Kosmos Energy  (KOS) - Get Free Report and Hess  (HES) - Get Free Report. Industrial metals companies, such as Vale  (VALE) - Get Free Report and Freeport McMoRan  (FCX) - Get Free Report.

And clean energy materials companies, such as Livent  (LTHM) - Get Free Report. Clean energy stocks aren’t quite as cheap as the other areas, but they have a better growth profile.

TheStreet: Can you talk about a couple of these companies?

White: Vale, based in Brazil, is the world’s biggest iron ore producer. It has higher grade ore than other producers. It also makes nickel, copper and other metals that can be used in clean energy products. It’s very cheap, trading with a forward P-E ratio of 6.

Livent is a lithium producer. It’s an attractive value proposition because of lithium’s use in electric vehicle batteries. And there may be a future shortage of lithium.