Performance Review 2007
Joachim Berlenbach: "The Earth Exploration Fund UI could outperform its peer group during the first year since inception (October 2006 – July 2007). This outperformance was achieved due to the focus on well researched and significant undervalued small and mid cap stocks.However, during phases of significant market corrections (e.g. July 2007, November 2007), the less liquid stocks invested in showed a higher downward correction than the benchmark. As a general characteristic it can be observed, that the fund performance can drop faster than the benchmark’s which focuses on larger cap stocks.
The portfolio management team addresses this by investing in higher cash quotas and especially the investment in put options on indices, which have a high correlation with the fund. These “protection tools” will in future allow for a reduction in volatility during phases of severe market corrections."
Performance Review 2008
Joachim Berlenbach: "During the 2008 financial crisis equities fell sharply. However, small and mid cap stocks fell even faster, due to higher perceived risk and lack of liquidity. The general flight out of equities and in saver asset classes resulted in a severe drop in the fund performance. As a result the fund underperformed its peer group.
Stocks were severely undervalued at the end of the panic selling phase (November 2008), with the first “contrarian” investors taking advantage of the attractive fund valuation and re-investing into the fund."
Performance Review 2009
Joachim Berlenbach: "After the severe selloff in 2008, which was partly driven by panic selling and not by fundamental valuations, the invested stocks showed historically low valuations. For example, some market caps were below net cash holdings, which emphasised the attractive valuations of the fund. With a return of the market to value investing, the fund could significantly outperform the shown benchmark (+153% vs. 31%).
The performance was aided by subsector allocation, with emphasis on gold and base metal (especially copper) producers and explorers, which showed a quicker recovery than for example oil stocks.
The positive performance during 2009 emphasised the observation that the Earth Exploration Fund UI can outperform its peers in times when the market is driven by fundamental valuations."
Performance Review 2010 - Year-to-Date
Joachim Berlenbach: "During 2010 (ytd) the fund continued its positive performance. In addition to subsector allocation (e.g. overweight in precious metals and base metal stocks until Q3 and then switching into oil stocks from the end of Q3), the attractively valued small and mid caps invested in resulted in a wave of take-over activity, of which the fund could significantly benefit in the second half of the year.
Many companies in the portfolio were taken out during M&A activities, which also supported the fund performance.
We expect this trend to continue, since stocks remain attractively valued, amid continued high demand for natural resources (precious metals, base metals, and energy resources), falling supply for many commodities and rising costs. Subsector allocation remains an important portfolio management tool."
Performance Review since 2007
Joachim Berlenbach: "The fund performance graph since inception shows the drawback of investing in mid and small cap stocks: these perform worse during times of strong market corrections (2008). However, the solid bottom-up stock selection approach can result in superior returns when the market is focused on fundamental analysis.
Due to its long-only character (UCITS III) the fund cannot “go short”. However, from past experiences it is believed, that volatility can be better controlled during phases of strong corrections by investing in put on indices which have a high correlation with the fund and by increasing the cash holding (to 30%)."
Investment Process and Strategy – How does the Fund Manager Invest?
The ERIG Funds are “long-only” fund. The management strategy focuses on the active management of the portfolio, i.e. the aim is to provide a portfolio return that exceeds a fixed return (7%). The decision process consists of two parts: macro and micro portfolio construction.
1.1 Macro component
Top-down inputs for commodity prices, currencies and inflation rates will be derived from a centralized database. Commodity price forecasts are divided into two sections: short/medium-term (5 years). The database is adjusted regularly (on quarterly basis). A wide network of highly ranked brokers and commodity analysts provides guidance in the top-down approach.
The macro component of the portfolio compares market capitalizations, outlook and liquidities for the various commodity sub-sectors, aiding the definition of weightings of these sectors in the portfolio. Further consideration in the weighting process is given to geographical distribution, liquidities, and market capitalization of the sectors. In the weighting of sub-sectors, special consideration will be given to the correlation of different sub-asset classes (e.g. the correlation between gold price and oil price).
1.2 Micro component and Ranking
The stock selection process within the portfolio construction process focuses on a bottom-up analysis (see below) and the subsequent ranking of stocks. The ranking process is crucial in this regard and will be integrated within the ERIG FUNDS database, taking into account the following valuation parameters:
• Expected return
• (2-year) NAV growth
• Project Financing
• EBITDA margin
• Liquidity
• Market cap
2 The ERIG value approach
The ERIG Funds invest “away from the benchmark”. Investments will only be guided by the company valuations. Focus will be on “undiscovered” companies and projects. The value approach should offer potential for capital gain, regardless of the long term increase of underlying commodity prices. Underlying the capital gain estimate is the “valuation curve” of resources companies.
3 Portfolio construction
The portfolio consists of 35-45 stocks. Although stocks with market caps below US$300m will be considered, liquidity constraints will limit the number and weighting of such stocks. Such companies do not present more than 10-20% of the portfolio. Target fund size is €500m.
The portfolio is actively managed, i.e. a stock will be sold, if a company’s share price exceeds its determined target price. Target prices will also include a take-over premium (in general 30-40%).
Investment Outlook
Introduction
Amid the background of rising demand and falling supply, natural resources are expected to remain an important investment topic over the next years. However, maximising returns of a natural resources portfolio requires a combination of investment and mining and energy industry knowledge. ERIG’s investment team therefore combines solid operational and industry experience as well a sophisticated fund management experience.
The portfolio management process of the proposed fund will be guided by a combination of top-down market analysis and bottom-up stock picking, whereby sector allocations (e.g. oil, base metals, precious metals) will be based on the macro outlook (e.g. of commodity prices, global demand trends, inflation rates, exchange rates etc.).
The management strategy relies on an active review and management of the portfolio relative to market conditions and the macro outlook, and positions will be selected and monitored by a combination of top-down and bottom-up processes.
The Market for Industrial Metals and Materials
The extraordinary economic and population growth experienced by China, India and other developing countries will result in an unprecedented competition for natural resources over the next decades. In order for developing countries to sustain their high rates of growth, they will require an increasing amount of oil, copper, steel and other natural resources. From historic data it can be estimated that the per capita demand of resources will grow with a per capita increase in GDP.
“... for the first eighteen centuries of the Christian (or Common) Era, the two largest economies were China and India. They didn’t experience the Industrial Revolution and therefore ceded leadership to America and Europe. In the first half of this century, the world will revert to normalcy.”
Christopher Patten, Chancellor, University of Oxford and former Governor of Hong Kong
Figure 1: China’s and India’s Growth in Perspective
The Energy Sector...
Figure 2 below shows the historical correlation between GDP per capita and oil consumption per capita for developed and developing nations. Using the regression formula deduced from these data and the recent population growth rates for China and India, it can be estimated that China will reach a GDP per capita of $15,000 and an average annual oil consumption of 7bbl/capita by 2023. At the same time India will reach a GDP per capita of $8,000 and an average oil consumption of 4bbl per capita. Multiplying these numbers with the expected populations of 1.4bn (China) and 1.5bn (India), respectively, will result in an oil demand of approximately 43mmbbl/day – that is equivalent to four times the amount of oil these countries use today and at least half of today’s worldwide oil demand!
Figure 2: Oil Consumed per Person per Year as a Function of GDP per Capita
Source: IEA, ERIG
Concurrently, we see that, globally, the discovery and development of new oil reserves have not been sufficient to replace production on an annual basis. This is illustrated in Figure 3 below.
Figure 3: Oil Reserve Replacement vs. Exploration Expenditure
Source: SEB Enskilda, ERIG
We therefore expect that oil supply may be sustained at current levels, at best, or even decline with diminishing exploration success. Another unmistakable trend is that new oil reserves are found in more remote locations (deeper offshore areas), or are more difficult or costly to extract (e.g. Canadian oil sands). As these new reserves replace the declining cheap reserves of the past, it is clear that the current low oil price of $70-80/bbl is therefore not sustainable and the world has to prepare for permanent oil prices above the $100/bbl level.
Alternative energies will be needed to fill the growing gap between conventional oil supply and demand, but these will only partly be able to substitute natural energy resources over time. In order to allow for the exploration and development of ever deeper and more costly oil deposits (including oil sands), we believe that oil prices must rise in the future (hopefully with low volatility due to speculation activity). Attractively valued oil companies with good exploration upside will benefit from this scenario.
The Steel Sector
Similar observations to the energy sector can be made for other commodities such as iron ore which is used for to produce steel products. The future demand for steel in a rising GDP growth scenario for China and India can be quantified, using historical data of developed nations (Figure 4). We again use the $15,000 GDP per capita benchmark for China, expected to be achieved by 2023. At this point, China would use at least 840mt (1.4bn people x 600kg = 840mt) and India a minimum of 488mt (1.5bn people x 325kg = 488mt). Thus, both countries together would require more steel than the total current world supply of 1.3bn tonnes! Considering that it can take up to 10 years to develop a mine from the first borehole until it achieves production, it is predicted that finding the required iron ore and bringing it into production is a challenging and capital intensive task.
In addition to iron ore, steel fabrication also needs a significant amount of other metals to produce the required steel alloys (e.g. molybdenum, chromium, nickel etc.). We believe that the supply-demand of many of these metals will tighten significantly in years to come. For example, we see a significant shortage in molybdenum supply. Attractively valued producers of molybdenum therefore remain an attractive investment. Rising commodity prices will become a challenge but also provide an opportunity for resources funds which recognise the growth potential in this sector.
Figure 4: Steel Consumed per Person per Year as a Function of GDP per Capita
Source: BHP, ERIG
The Copper Sector
As a third example for a looming shortage of industrial resources we turn to copper. We expect copper prices to increase due to the imbalance in future demand and supply. We emphasise that copper is one of the most important industrial metals, used for power lines, electrical appliances, housing, air conditioners etc. Demand will continue to rise, also due to new applications (e.g. for alternative energy such as wind mills, solar power stations etc.), which all use significant amounts of copper. Using a similar approach as for oil and steel, we predict the future demand of copper from China and India, using again $15,000 GDP per capita in China as benchmark. Figure 5 shows the resulting demand pattern expected by the year 2023. At this point China is expected to use at least 12kg per Capita, i.e. an annual demand of 17mt (1.4bn people x 12kg), whereas India will be using at least 8kg per Capita, i.e. 12mt (1.5bn people x 8kg).
India and China alone would demand 29mt of copper! Considering that the current annual copper production is 17mt it is evident that copper is becoming an increasingly scarce resource. China’s interest in copper producing countries like Zambia, Congo and Chile is a manifest of this gloomy outlook.
The newer copper projects coming into production are of lower grades (i.e. lower percentage of contained copper per tonne of rock) and becoming increasingly expensive to build and operate. In our opinion it will be difficult to avoid a strong rise in copper prices to enable more projects to be economically viable and attract investment.
It is estimated, that over the next 25 years the global demand for copper will be greater than in the total history of mankind up to now. Increasing copper prices are therefore likely and attractively valued copper producers and explorers will be an important sector allocation for the proposed industrial resources fund.
Figure 5: Long Term Copper Demand
Source: BHP Billiton
Rare Earth Elements
An increasingly interesting sector within the industrial resources universe concerns the Rare Earth Elements (“REEs”). REEs are crucial for high tech applications (cell phones, hybrid cars, superconductors). 95% of REEs are supplied by China. However, China has indicated that it will prohibit or restrict export of REEs in the future, resulting in concerns in countries such as Japan, which depend on the import of REEs for the production of high tech appliances (Figures 6,7). New REE projects are therefore very attractive for an industrial resources fund but require detailed knowledge about the industry and the valuation of new projects. Similar “Crunch” scenarios can be highlighted for many other natural resources and support the case for an Industrial Resources Fund.
Figure 6: Global Production of Rare Earth Oxides 1950-2000
Source: USGS (United States Geological Survey)
Figure 7: A Crunch for Resources
From the above review we remain optimistic regarding the natural resources universe and believe that well researched resources companies can also in future provide superior returns.