Prospecting for value in the resources sector

In the Morningstar resources roundtable this January, MacDonald cautioned investors not to extrapolate the good performance of U.S. energy producers in 2013 into 2014 and 2015, at the expense of Canadian producers. He was right.

When it comes to energy producers, MacDonald favours companies with concentrated assets in high-growth plays such as the Bakken in North Dakota and the Montney lands in northeastern B.C. and northwestern Alberta.

Turning to the materials sector, MacDonald notes that gold stocks were oversold in 2013, "with investor sentiment toward these stocks extremely negative." This year, though the operational challenges, including cost inflation, remain, "investors have warmed to these stocks." Gold stocks have, for the most part, done extremely well, says MacDonald, and "there is a need to be highly selective."

In an industry where governance has been a challenge, management is particularly important in stock selection, he says. Of base-metals stocks, MacDonald says he continues to like select Canadian copper producers that have good assets and an excellent production-growth profile.

At Invesco, MacDonald is responsible for a number of resource mandates including Trimark Resources and Trimark Energy Class.

Trimark Resources, with 40 holdings, is a "fairly concentrated portfolio of high-conviction stocks," says MacDonald. The top-10 names in this fund represent more than half of the portfolio.

Norman MacDonald

Roughly 17% of Trimark Resources is in base-metals stocks, 20% in gold and 3% in agricultural stocks. Energy constitutes some 50% of the fund, with 44% in oil and gas producers and 6% in energy-service companies. Other sectors represent some 4% of the fund, which has 6% in cash.

Of base metals, MacDonald says that he does not read the tea leaves to ascertain the strength of China's economy and the resultant demand for these industrial commodities. "I use constant prices in my valuation models. In the case of copper it is US$3 per pound."

The fund's largest base-metals weighting is in Turquoise Hill Resources Ltd. TRQ. The company's principal asset is its 66% stake in the copper-gold-silver mine, Oyu Tolgoi, in southern Mongolia. The Mongolian government owns the remaining interest.

"The protracted negotiations between Turquoise Hill and the Mongolian government have been a headwind for this company and the stock," says McDonald. "Until an agreement is reached, the development of the underground mining operations will not proceed," he says.

The equity market will rerate the stock, once this agreement is concluded and made public, he says. "The stock is worth more than it is trading at currently, based on the quality of Turquoise Hill's assets and transactions for similar assets."

A base-metals stock that has performed well so far this year, says MacDonald, is HudBay Minerals Inc. HBM. The company has acquired control of Augusta Resource Corp. AZC in a share exchange. Augusta has an 80% stake in the undeveloped Rosemont copper project in Arizona.

HudBay is currently focusing on its existing new copper mine, Constancia in Peru, says MacDonald. "This is expected to be in full production in 2015."

In all, MacDonald says he likes HudBay Minerals for its strong management team and the prospect of significant cash-flow growth as its projects come on stream.

When it comes to gold stocks, MacDonald notes that he uses a bullion price of US$1,200 per ounce in valuing the companies and focuses on those that have high-quality assets and good management.

The biggest gold holding in Trimark Resources is Torex Gold Resources Inc. TXG. This company is developing its 100%-owned Morelos Gold Property in the Guerrero Gold Belt southwest of Mexico City. Since last November, Torex has been building its El Limon-Guajes mine on this property.

"It has received financing in place for the development of its assets," says MacDonald, "and these just get better and better." The stock, he notes, has had a significant run since the beginning of the year, "but there is still room for it to go higher."

MacDonald has been taking some profits in Detour Gold Corp. DGC. "This was based on valuation, as the stock has surged ahead this year." He continues to like the fundamentals. The company's flagship asset is the Detour Lake Mine in northeastern Ontario. "The ramp-up of this mine is progressing as planned. The mine achieved commercial production in the third quarter of 2013."

		Detour Gold Corp.	HudBay Minerals Inc.	Torex Gold Resources Inc.	Turquoise Hill Resources Ltd.
	July 28 close	$13.70	$11.45	$1.55	$3.79
	52-week high/low	$15.62-$2.88	$11.79-$6.02	$1.99-$0.85	$5.68-$3.20
	Market cap	$2.2 billion	$2.2 billion	$1.1 billion	$7.6 billion
	Total % return 1Y*	19.2	65.3	12.3	-30.5
	Total % return 3Y*	-23.1	-3.7	-4.3	-46.8
	Total % return 5Y*	8.7	8.8	25.6	-14.7
	*As of July 28, 2014. Source: Morningstar

Turning to energy, "a new and fairly modest holding" in Trimark Resources is Prairie Sky Royalty Ltd. PSK, says MacDonald. This May, Prairie Sky was spun out of Encana Corp. ECA as an IPO at $28 a share. "It is a strong cash-flow producer. As a royalty company, it has no costs of production and none of the operational challenges of an exploration and development company."

MacDonald's biggest weighting in this sector and the largest holding in the portfolio is still Crew Energy Inc. CR at roughly 9% of the portfolio. Crew production is roughly 50% in oil and 50% in natural gas, he says. "The stock has done well this year, but I consider that there is more upside."

For a company of its size, Crew has assembled a substantial acreage in the high-growth Montney play in Western Canada. Crew's Montney holdings are in B.C. and the company is focusing on developing its liquids-rich natural-gas asset at Septimus and its light-oil-weighted asset at Tower, he says. "Crew has significant un-booked reserves."

The U.S. energy producer, Whiting Petroleum Corp. WLL is also among MacDonald's top-10 holdings. In mid-July, Whiting announced that it would acquire Kodiak Oil & Gas Corp. KOG in an all-stock transaction valued at US$6 billion. The combined company will have a substantial position in the Bakken formation in North Dakota, says MacDonald.

"Some investors have been skeptical about Whiting's ability to grow production at the same pace as that of its rivals in this play, he says. Whiting's takeover of Kodiak, which is expected to close in the fourth quarter of 2014, will, he says, likely result in a higher multiple on Whiting's stock and bring its valuation more in line with that of leading producers in the Bakken.