Two Equity-Focused Inflation Fighters

With oil and gold prices falling recently, it might seem that inflation risk has receded. But if you're one of those hawks who believe inflation is dormant rather than defeated, you may still be looking for additional protection. As I noted a few months back, equity natural-resources funds are capable, although sometimes overlooked, inflation fighters. Perhaps more so than direct commodity exposure (via exchange-traded funds or mutual funds that invest in commodity-linked derivatives), natural-resources funds offer both commodity-related exposure as well as a shot at earning real returns above inflation.

Here we explore the fundamentals of natural-resources funds, using two of our favorites from the category as examples. Most natural-resources funds offer broad commodity exposure. By keeping 60% or so of their portfolios in energy stocks on average and another third in materials, which includes metals and mining companies, they are in some ways two parts energy fund and one part precious metals fund. What should investors look for in these funds?

We're Not Talking Exxon Mobil Here
An important first question is this: How much overlap is there between a natural-resources portfolio and one's existing equity holdings? In the case of two of our favorite funds,  Prudential Jennison Natural Resources (PNRZX) and  RS Global Natural Resources (RSNYX), the answer is probably not much. Both funds tend to steer clear of large, integrated oil and gas companies such as  Exxon Mobil (XOM) and  Chevron (CVX) that feature prominently in the S&P 500 index and many other domestic large-cap portfolios. Both stocks are in the index's top 10. But the RS fund recently had just 2% of its portfolio in integrateds, while Prudential Jennison had only 6%. By contrast, the average natural-resources fund keeps about 19% in integrateds and they represent just over a third of the cap-weighted S&P North American Natural Resources Index.

The managers at these two funds underweight such names because, while they tend to be stable cash cows, their diversified natures limit their ability to benefit from rising oil and gas prices. Companies like Exxon and Chevron partly shield themselves from energy prices by operating throughout the supply chain. They extract natural resources, transport them through pipelines, refine them, and then market them. This makes them less vulnerable to swings in commodity prices than many smaller energy companies. For firms focused primarily on drilling oil and gas from the ground or mining precious metals, however, higher energy or metals prices more directly boost the bottom line.

But because commodity prices are highly volatile and notoriously unpredictable, so are the fortunes of companies closely tied to them. Moreover, smaller firms generally have a tougher time setting themselves apart from their competitors. For the most part, commodities are commodities, so one firm's oil, gold, or whatever is largely the same as another's. With fortunes tied largely to prices, there's much more uncertainty surrounding such firms' prospects. While Morningstar's equity analysts tag their fair value estimates of Exxon and Chevron with low uncertainty, they rate drillers such as  Rowan and  Patterson (PTEN) with very high fair value uncertainty. As a result, funds focused on the latter will likely suffer higher volatility.

The story is much the same when it comes to materials companies, which are also highly sensitive to commodity price fluctuations. Indeed, Morningstar equity analysts don't rate any company in the sector with low fair value uncertainty.

There's More Than One Way to Drill a Well
Such feedstock makes all natural-resources funds inherently volatile, but how they deal with these inputs determines how volatile they are relative to each other. Mackenzie Davis and Ken Settles at RS Global Natural Resources take a relatively conservative approach, looking for one of the only competitive advantages--low costs--available to resource-extraction companies. (Resource extraction includes both exploration and production firms, as well as equipment and services companies.) Companies with a cost advantage tend to be less sensitive to swings in commodity prices than those without one because they can remain profitable even as prices fall. Companies with high fixed costs, on the other hand, often live on a knife-edge as projects can quickly shift in or out of profitability based on sharp moves in energy prices.

By sticking to low-cost companies, RS has delivered below-average Morningstar Risk scores across the trailing three-, five-, and 10-year periods. That's true even though it currently has a portfolio of just 30 or so stocks. The fund mitigates this concentration by maintaining one of the category's highest-quality portfolios. It has the lowest proportion of companies with very high fair value uncertainty (less than 2%) and one of the higher proportions of companies with medium fair value uncertainty (45%). Also, even though the fund isn't terribly diversified across securities, Davis and Settles try to keep the portfolio well-diversified across commodities.

If RS Global Natural Resources is the group's sober-minded engineer, Prudential Jennison Natural Resources has the soul of a prospector. Comanagers Neil Brown and Jay Saunders take the opposite approach to RS, as they seek out companies that will jump the most when commodity prices rally. Rather than looking for low-cost operators, they seek out companies that are growing either their reserves or production. Such companies carry a lot of risk because their reserves may not be fully proven. And companies focused on growing reserves have a reputation for putting this ahead of smart capital allocation decisions. That was the rap on  Chesapeake Energy , which this fund holds a tiny 0.15% position in, long before its CEO started sending up red flags.

So while RS Global Natural Resources has been among the least-volatile options in the category, Prudential Jennison Natural Resources occupies the opposite end of the spectrum. It tanked worse than its average peer when commodity prices plummeted in 2008, losing 52.9%, 4 percentage points worse than the category average. It trailed by a similar margin last year when it fell nearly 19%. Yet the fund has made up for such losses by strongly outperforming during rallies. That was the case in years such as 2007, 2009, and 2010. As a result, the fund's long-term returns are very competitive.

Conclusion
Both funds can be used effectively in a portfolio, though neither should be more than 5% or so of assets. As is so often the case, it's more an issue of risk tolerance and fit. RS Global Natural Resources is better suited to relatively conservative investors. Also, with its emphasis on low-cost producers, it would likely fare better should commodity prices remain flat, or even decline slightly, in the years to come.

Prudential Jennison Natural Resources, on the other hand, will do better should commodity prices take off once again. In some ways, that potentially makes it a better diversification tool, even though it's much more volatile. That is, it will likely provide a better hedge should there be an inflationary spike in commodity prices.

Regardless of which fund an investor chooses, energy and materials stocks arguably look reasonably priced, with stock prices trading well below what Morningstar equity analysts believe they're worth. Those two sectors have the lowest average price/fair value ratios, 0.84 and 0.83 respectively, in Morningstar's equity coverage universe. Energy stock valuations are the cheapest they have been this year, although they got far lower during 2011's third quarter. But materials stocks, and especially metals and mining companies, are trading at their lowest valuations since December 2008.

This is not to argue that investors should buy one of these funds simply because valuations seem relatively attractive. Although the long-term resources story remains strong due to growing emerging-markets demand and supply constraints (natural gas notwithstanding), slowing global growth could continue to push prices down in the near term. If that ends up being the case, investors might consider using that time to continue digging their inflation-resistant well.