The Gannon Report

It will take a while to forget the first quarter of 2008. Fallout from the bursting credit and housing bubbles continued to paralyze many parts of the domestic and global economies, while volatility remained high and rumors—of recession, of financial collapse—were rampant. The Federal Reserve continued its seemingly endless campaign to find creative ways to unwind the excess leverage throughout the financial system, all part of its effort to stave off a recession that may already be here.  So it was not surprising that the Russell 2000 made a fresh low on March 10, 2008, down 24.1% from its peak on July 13, 2007.

And yet all was not awful during the quarter.  A closer look at the performance of the Russell 2000 shows that the Natural Resources sector continued to be a bright spot in this difficult environment, specifically the energy and the precious metals and mining industries. From the July 13, 2007 peak to the recent March 10 low, the Natural Resources sector was down just over 7%, while the precious metals and mining industries rose more than 2%, and oil and gas were up more than 3%.

In a number of our portfolios, we have focused primarily on the energy and the precious metals and mining industries within the Natural Resources sector.  We think that natural gas stocks should continue to benefit from the significant commodity price divergence between oil and natural gas prices.  The traditional 6-to-1 relationship (a barrel of oil to Mcf [1,000 cubic feet] of natural gas) is broken—oil has been trading at an estimated 11 times the price of natural gas, which continues to create interesting opportunities for us, especially in those companies that we think can benefit from a significant "investment phase."

We have been active investors in the precious metals and mining industry over the last several years. More recently, the industry has garnered attention from the wider investment world as the prices of many commodities—gold, silver and copper—have made dramatic advances. However, the performance of many precious metals and mining stocks has not yet reflected the price appreciation of the underlying commodities. In most cases, the base commodity or metal itself is more highly rated than the shares of the precious metal and mining companies that produce it. A research report from CIBC World Markets recently stated that "the total market capitalization of all the publicly traded gold companies on a global basis is $341 billion.  The world equity market is $57 trillion, making gold equities about 0.6% of what can be bought." To put that into perspective, the current market capitalization of Exxon Mobil is roughly $466 billion.  Finally, it is also worth noting that most major research firms on Wall Street have models predicting a peak for the price of gold and silver sometime in 2008, with commodity prices retreating in 2009 and 2010.  At the same time, many top-down earnings estimates for the S&P 500 remain north of 13% for the next several years. To be sure, this juxtaposition makes little sense, and expectations remain quite low for many precious metals.

From our perspective, potentially rewarding opportunities abound throughout the current smaller-company market. Many companies in the Natural Resources sector continue to be a source of keen interest. We like the combination of low industry expectations, strong balance sheets, and quality business models.

Stay tuned...
FDG