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Are resources running out?

Liontrust has started a debate with its suggestion that small cap funds invested heavily in resources could be on the verge of a crash.

Director Anthony Cross says UK small-cap managers have been leaping on growth opportunities in resources and mining but he thinks the stocks are overvalued.

JP Morgan Fleming natural resources fund manager Ian Henderson says there is no question that the recent rise in resources and commodity prices has been dangerously fast. He says there have been some incredibly speculative price movements in the sma-ller companies sector which smack of the technology and dot.com bubble.

Henderson says: “What Cross is saying is in one sense correct because there has been tremendous euphoria for some small cap companies which do not necessarily have any real justification. There have been companies that have gone up in value many times but are yet to prove themselves as proper operators.”

But he does not believe that the broader resources market will suffer as a consequence of small cap froth. He is certain that the long-term growth prospects remain strong and believes that the market is going through a growth period in resources not before experienced.

Henderson says: “If you hypothecate that China is eventually going to become an ind-ustrialised nation, that is, to assume that it is going to follow the same growth curve of Japan and Taiwan in the post-war years, then there are 20 years of 10 per cent compound growth a year to come. That means that resources are no longer cyclical and have ent-ered their biggest sustained growth period ever and it is not just the Chinese but the Brazilians, the Indians, you name them. The market for natural resources is basically doubling overnight.”

Credit Suisse multi-man-ager manager Gary Potter says some of the small cap funds are investing heavily in natural resources and clearly doing extremely well. He says there are many examples of stocks going sky-high in the past and not continuing to do so.

Potter says it is important to be flexible and to pick stocks regardless of the crowd and is concerned when people enter a sector just because they want a piece of the action.

He says: “It is always worth reflecting on where valuations have come from and where they have gone to in a short period of time. In the frothy end of the market, people are quite rightly thinking of taking some profits but whether or not resour-ces collapse depends on the macro picture. People are wrongly making a comparison with the tech boom because many of the tech companies of 2000 did not have any earnings but these companies do.”

Potter cites global supply and demand imbalances in resources as fundamental evidence for their continuing rise. While some managers are taking profits, he sees too many reasons for their continued strength.

First State global resources analyst Todd Warren says that with 25 million Chinese a year moving from regional to urban areas and all needing cars, roads, houses and an 8.5 per cent yearly GDP growth, he is sure that the China’s demand for resources is not going away.

Warren says: “On the supply side, there is still a great deal of catch-up going on. There has been a sustained period of lack of investment in the sector, which is continuing to flow through. There may be some hot money in the small cap sector but by positioning our funds in the good quality stocks, we are sure of making a good, consistent return. We are investing in world-class players such as BHP and Rio Tinto.”

BHP is currently bidding 3.5bn in cash for Western Mining Resources, a sum Warren is confident that BHP will make in income over the next year. He says by bidding in cash, BHP is putting its money where its mouth is.

He says: “We are not seeing big lumps of supply coming onto the market. With the exception of Inco adding some nickel mines at the end of the year, there is little to suggest that prices are going to fall. From the time of discovery to the point of production, there is a seven to eight-year gap. You cannot just flick a switch.”

Some smaller companies managers believe that there are grounds for caution about some stocks. Jupiter UK sma-ller companies fund manager Philip Matthews says people have views on the Chinese growth story but the key factor is a lack of supply. The opportunities in resource explor-ation have arisen because there are few new copper and nickel mines to replace those that are currently being mined out. It is here, in exploration, that he sees potential problems.

Matthews says: “Because these companies are not making any money and there is a long process between making a discovery and turning it into production, it is a question of what you are prepared to value discovery at.

“It is the riskier end of the spectrum and there have been a few examples of companies coming on to Aim that have been overvalued relative to the risk of these exploratory plays. It is important to look at every single one of these new plays in terms of the specific project they are undertaking.”

Chelsea Financial Services managing director Darius McDermott recommends Henderson’s global resources fund but because it is a diversified portfolio with holdings in gold, precious metals, energy and renewables as well as giving exposure to mining and oil prices, although he says this is a high-risk fund not to be recommended for more than 5 per cent of a portfolio.

McDermott says: “I am sure there are frothy companies in mining and oil but with good stock selection and strong fund management like Ian Henderson’s, there is still some great mileage to be had in the natural resources sector.”

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