Smart Folks, Exciting Commodities

This article is part of our Rising Star Portfolios Series.

Investing is all about capital protection. Right now, hard assets such as precious metals and other natural resources have me more excited than financial assets, because of inflation and overheated equity and bond markets. I'm particularly bullish on precious metals, but Fools should consider other commodities such as oil, gas, and farmland as well. In this article we'll look at an interesting way to invest in all three -- with some gold bullion on the side.

How to buy commodities
First, let's set the ground rules. For non-precious-metal commodities (i.e., those that are used up), I want to get exposure by owning the asset that produces the commodity, like farmland or mining companies, rather than exchange-traded funds (ETFs) or financial products that speculate in the commodities themselves. Some of these instruments, including United States Oil Fund (NYSE: USO  ) and PowerShares DB Agriculture ETF (NYSE: DBA  ) , are very popular, and they purport to track commodity prices. Still, I want to own the physical asset; by doing so, you can 1) better ride out price fluctuations and 2) avoid the counterparty risk associated with derivative contracts.

The business
My Canadian colleague Jim Gillies recently pointed me to a stock I knew only faintly: Sprott Resource (PINK: SCPZF.PK). Sprott is a holding company that attempts to create value in the early stage of natural-resource exploration and production, by identifying talented professionals and taking equity stakes in their businesses. This is similar to what Rob McEwen of US Gold (NYSE: UXG  ) and Minera Andes (OTC BB: MNEAF.OB) is doing in the gold-mining space -- investing early in small exploration companies with talented people who can unearth and delineate excellent natural resource deposits. Eventually, these businesses can either be sold to bigger companies or developed internally.

Through this process, Sprott hopes to reap much higher gains than it could achieve later in the development cycle. Sprott invests earlier and with more equity financing -- a typical approach for higher-risk ventures, and different from that of Brookfield Infrastructure Partners (NYSE: BIP  ) , which uses more debt to invest in established assets.  

What's good about it
Sprott Resource has five main investments: three in oil and gas, one in phosphates, and one in farmland, with an additional tiny stake in uranium. It also owns gold bullion. Its farm business is particularly interesting, because there aren't many vehicles to invest in farmland on stock exchanges. Sprott works with Canadian native tribes to lease tracts of farmland, then farm that land on a large scale to bring greater efficiency and profitability to the sector -- an intriguing idea. The remainder of Sprott comprises oil and gas exploration and production in Canada, development of phosphate deposits in Peru & Idaho, and the aforementioned smallish uranium investment.

So far, Sprott hasn't disappointed. It's posted excellent financial results, with large mark-to-market gains on portfolio holdings and a fantastic $186 million gain on a coal company, sold after coal prices spiked in 2008. That said, there are perhaps one or two less positive spots.

What's not so good about it
I'm a big fan of Eric Sprott (Sprott Resource's chairman and 7% owner), but I became less enthused when I learned of the 2% management fee and its additional performance fee. The latter expense totals 20% of the difference between Sprott's pre-tax return and net asset value, multiplied by long term bond rates. This hurdle ensures that you don't pay the 20% if pre-tax returns don't match long-term bond returns, but the 2% annual fee might look steep if the value creation slows down or commodity prices weaken. I prefer Rob McEwen's model, where he typically takes no salary and owns 20% stakes in his companies; that way, he more closely shares the risk and reward of shareholders.

Another issue is the size of the market premium or discount. Book value as of September was $333 million, yet the market cap of the company is now $475 million. A few of Sprott's investments have risen in price since September, notably the phosphate assets, which appreciated by 75%, and it appears the oil and gas businesses are understated. Still, there could be a premium in the stock, which would make it less attractive.

One to keep an eye on
Sprott Resource is doing a fantastic job with some exciting natural resource assets, and its managers have so far been worth every penny, placating my thrifty nature. There truly is a lack of offerings like this on the market, and Sprott has shown that it can create value, making this a worthy option to explore if you are looking for commodity exposure. I haven't decided yet whether it's worth a spot in my portfolio, but it is certainly worth a closer look.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Andrew Sullivan, CFA, owns shares of no companies listed above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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