Adding high-quality resource stocks to your portfolio can provide you with a valuable hedge against inflation and provide other hidden benefits.

“A client of mine, Dr. J., recently said to me, “Pat, you advise investors to spread their money out across most if not all of the five main economic sectors. Why not just leave out the resource sector?”

I think that’s a bad idea. It disregards the one key contribution that resource stocks make to a sound portfolio, as you’ll see below. But I’m sure many investors agree with Dr. J. After all, the weak performance of the resource sector goes back several years.

Diversification paid off

Dr. J. calculates that his resource stocks have produced negative returns in five of the past seven years (although the sector gained 158% in 2009). He also found that in the past 20 years, the compound return on resource sector stocks has been the lowest of all five sectors. The resource sector was also more volatile than any of the other four sectors.

Overall, though, Dr. J. is quite happy with the returns he has had since we began managing his money for him, prior to the start of the financial crisis. That’s because the diversified portfolio we built for him included a number of above-average performers, which more than offset his resource underperformers. But he wonders if the resource sector is simply plagued by too many drawbacks to deserve a permanent spot in his portfolio.

During our talk, he focused on three of these drawbacks.

1. Resource companies need to make large, high-risk capital investments;
2. They operate in commodities businesses, so it’s hard for any one of them to build a lasting advantage over its rivals;
3. While companies from other sectors can build up hidden value from research they carry out, and from appreciation of real estate they own, resource companies can have hidden liabilities from unknown and unpredictable environmental clean-up costs.

There’s something to each of these negatives, of course. But it’s human nature to dwell on drawbacks like these after a long period of weak performance in the sector.

More to the point, none of these setbacks is unique to the resources sector.

For example, manufacturing companies also have to make large, high-risk capital investments in plants and equipment. Drug makers in particular have to invest vast sums in every new drug they try to bring to market. Despite huge investments in time and money, a new drug can fail to win regulatory approval.

That’s why we stayed out of drug stocks in the late 1990s, when these stocks were broker/media darlings. We only bought drug stocks for our clients after the 2008 stock market plunge. By then, drug stock prices had come back down to much more attractive levels.

Investor awareness goes through cyclical swings

When times are good, investors ignore investment drawbacks and pitfalls. When times are bad, investors pay too much attention to risk.

Resource companies produce and sell commodities. So it’s hard for them to bring a distinct product to market. But they can distinguish themselves by how well they find and produce their products.

Today’s resource projects call for a great deal of engineering, financial and political expertise. The top resource companies—like Imperial Oil or Encana—acquire a lasting competitive advantage by developing their expertise in these areas.

This expertise is another type of hidden asset. It doesn’t appear on the balance sheet, but it gives resource stocks an advantage in every project they undertake.

Resource companies do sometimes turn out to have hidden environmental liabilities, as do companies in other sectors. But the top resource stocks also create their own hidden assets. They accumulate rights to promising acreage long before the land rush starts. They have the technical and political skills they need to foresee and deal with environmental and political obstacles.

This expertise becomes more important as resource technology advances. For instance, recent advances in oil and gas drilling technology helped bring on the plunge in oil prices. The new technology made it possible to vastly increase oil production, even from deposits that were once considered worthless.

Resource stocks, though volatile, tend to rise with inflation

The resource sector is subject to wide and unpredictable swings in the prices it gets for its products. In the rising phase of the business cycle, when business is booming, resource demand expands faster than resource supply, so resource prices shoot up. This balloons profits at resource companies. When the economy slumps, resource prices fall, and this drags down resource profits and stock prices.

In addition to rising and falling with the business cycle, however, resource stocks have a history of rising along with long-term inflationary trends. This gives them a rare ability: they provide a hedge against inflation.

Back in the inflationary 1970s and 1980s, investors used to see this hedge-against-inflation ability as the main reason for buying resource stocks. Now they rarely think of it. That’s because inflation has been waning for three decades.

Inflation peaked at a yearly rate around 13% in the early 1980s. It fell by two-thirds from that level by the middle of the decade. It has gone through a series of peaks and valleys, but has been working its way downward ever since.

Right now would be a particularly bad time to give up on resource stocks. This highly cyclical sector has gone through many booms and busts. It’s now in the midst of a deep bust because prices of so many commodities are at multi-year lows.

No one can say when the current bust will end, but it will end. When it does, prices of resource stocks are likely to move substantially higher than they are today.

You may feel resource stocks could languish for years. You may think it’s best to stay out of them until inflation moves up. But these stocks could give us an early warning of coming inflation. They may shoot up long before inflation revives.

Your best overall defence against inflation in my opinion is to stick with the Successful Investor portfolio approach. It has three key rules:

1. Invest mainly in well-established stocks with a history of revenues, earnings and dividends.
2. Spread your money out among most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities).
3. Downplay or avoid stocks in the broker/media limelight.

Our Successful Investor approach has a big advantage: It’s likely to pay off in the long run, whether we have deflation, inflation, or something in between.

Have you made resource stocks a part of your long-term investing portfolio? Share your thoughts and other clever inflation hedges in the comments.