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A very long engagement

The global resources sector will pay out if a long-term investment perspective is adopted

Joanne Warner grey

We remain positive about the long-term prospects for the global resources sector, supported by a healthy level of mergers and acquisitions activity.

Valuations are attractive in our view, especially among major diversified miners and we continue to invest in quality companies at the low end of the cost curve.

The global resources sector was subdued over the first quarter of 2011 despite commodity price strength, with the oil price looking strong on the back of political upheaval in north Africa and the Middle East.

While the higher oil price has increased inflation across the globe, the question is whether this is temporary or if it will result in pricing pressures more broadly.

The events in the Middle East coupled with the crisis in Japan and the downgrade of Portuguese sovereign debt are all expected to lead to higher demand for gold. This could continue to have a knock-on effect on the price of silver.

One of the key trends we are expecting to play out in the course of the year is an increase in M&A activity. High commodity prices have resulted in very strong cashflow generation for mining companies and the market anticipates that some of them will look to deploy this cash through value-accretive transactions.

Already this year we have seen Rio Tinto bid for Riversdale, Equinox bid for Lundin, Minmetals make a play for Equinox and BHP Billiton buy Chesapeake’s Fayetteville Shale gas assets. We expect continued corporate activity to support valuations in the short term.

The market is also expecting further capital management programmes in the form of special dividends and buybacks during the year. This is anticipated particularly from large-cap diversified companies, some of which are expected to move into net cash positions this year.

We have added to our positions in the oil services sector as we expect demand for services to rise as spending on oil exploration increases. We have selectively added to positions in the gold sector following the sharp sell-off in gold stocks, focusing on smaller companies that are in the process of bringing new operations into production and therefore have value catalysts beyond the gold price.

Valuations in the oil services sector are attractive, especially among the big diversified miners that have experienced a de-rating over the last 12 months.

There is, though, a lack of forecast earnings growth for resources companies in 2012 because the market is anticipating a decline in commodity prices.

However, if commodity prices stay as high as they are now, forecasts may need to be revised up from the currently conservative levels. This would result in resource company earnings upgrades.

We believe that investment decisions based primarily on a directional view of commodity prices introduce unnecessary risks into a global resource equity portfolio. Commodity prices are notoriously volatile and trying to time the market is a risky and thankless task.

Instead, we employ a conservative approach better suited to long-term investors by focusing on some of the world-class, low-cost global resources companies that look well placed to benefit from positive long-term trends in the sector.

We continue to invest in quality companies at the low end of the cost curve, carefully monitoring firms’ balance sheets and stress-testing their ability to meet financing obligations at lower commodity prices.

Rather than speculating on short-term movements of commodity prices, our philosophy is to focus on quality companies that are able to deliver growth at relatively low cash costs.

Dr Joanne Warner is manager of the First State global resources fund


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