PEO Fund: A Buy The Dip Opportunity In This 6% Yield Natural Resources CEF

The Adams Natural Resources Fund (NYSE:PEO) invests across energy and materials sector stocks as an actively managed closed-end fund. The attraction here is a strong record, with PEO outperforming sector benchmarks including several indexed ETFs over the past five years. We also like the compelling 6% yield through a quarterly distribution.

Emerging from a volatile period over the past year, we see room to turn constructive on commodity prices and natural resources. The setup here considers the improved global macro outlook on the demand side with a sense that there is some good value in the sector.

We last covered PEO back in 2022, highlighting a bullish backdrop at the time and the fund’s unique positioning with the fund delivering a positive return in the period since. Our update today suggests the more recent weakness offers a new buying opportunity.

What is the PEO ETF?

PEO’s fund objective starts with the preservation of capital while delivering a reasonable income with the opportunity for capital gain by capitalizing on the long-term demand for energy and materials. Adams Funds is a well-recognized institutional investor with PEO itself among one of the oldest CEFs in the market with a history going back to 1929, an incredible 95 years.

While the investing mandate has a broad focus on “natural resources”, the strategy primarily invests across U.S. stocks that are constituents of the S&P 500 Energy and S&P 500 Materials sectors.

That being said, there is a clear tilt towards the energy sector which represents about 80% of the current allocation. Within that amount, the exposure extends through the supply chain with energy producers at around 55% of portfolio the joined by downstream names at around 25%. In terms of materials, PEO is positioned in the chemicals industry totaling about 15% of the fund weighting, while metals and basic materials are also included.

Keep in mind that since PEO is not intended to track any particular index, the holdings are likely to change over time according to the portfolio managers’ market outlook.

Looking through the current portfolio, Exxon Mobil Corp (XOM) is the largest investment with a 19% weighting, followed by Chevron Corp (CVX) at 12%, and ConocoPhillips (COP) at 8%. Down the list, the materials sector is represented by companies like Linde plc (LIN), Freeport-McMoRan Inc (FCX), and Vulcan Materials Company (VMC) as some notable examples.

While these are all high-profile large-cap leaders, the takeaway is that the overall fund exposure with the cross-sector allocation is distinct compared to benchmarks like the Energy Select Sector SPDR ETF (XLE) and Materials Select Sector SPDR ETF (XLB).

PEO performance

Given the tilt toward energy, it’s expected that PEO’s performance should be a mix between the sector trends, outperforming XLB when XLE leads higher. Over the past year, PEO is down about -6% which is about a 200 basis point improvement relative to XLE, supported by the relative strength from the materials sector exposure which returned 2%.

If we had complete confidence that a certain natural resources sector would lead higher, or a particular stock would outperform, then PEO may not be necessary. Its advantage comes from that underlying uncertainty with the added benefit of diversification and the presumed ability of the portfolio manager to effectively overweight the most compelling opportunities.

We can also bring up that PEO has historically traded at a wide discount to NAV. The current spread at approximately -17% is wider than the average over the last decade and likely reflects what has been poor sentiment towards natural resources.

The potential that the underlying stocks in this strategy put together a sustained rally going forward could lead to some of the discount narrowing as an incremental performance driver.

PEO distribution

The other reason to consider PEO over XLE or XLB is its income component. The Adams Natural Resources Fund distributes a regular quarterly payout of $0.10 per share while that is supplemented with a larger year-end distribution to reach a targeted 6% yield. In November 2023, PEO paid out $1.05 per share and $1.35 for the full year.

Notably, the entire dividend is based on the underlying investment income and realized gains supported by the covered by the strong NAV performance over the last several years.

What’s next for PEO?

We mentioned that 2023 was a challenging period for natural resource stocks, particularly compared to 2022 when various commodities reached record-high prices. The backdrop over the past year has been the headwind of macro uncertainties, coupled with climbing interest rates, and a strong U.S. Dollar.

Fast forward, 2024 has kicked off with improved global growth sentiment with a building consensus that the U.S. has averted a recession and cooling inflationary pressures will open the door for Fed rate cuts.

The first exhibit here is the recent action in WTI crude oil (USO) that has already climbed by more than 10% from its December low and approaching a breakout level above $75bbl.

The latest reports include a surprise U.S. crude inventory draw in early January along with agencies like the International Energy Agency (IEA) and OPEC is forecasting strong growth in global oil demand.

As it relates to other resources, headlines out of China suggest the government is moving forward with stimulus efforts in support of the economy. This is important as China is a major global commodity consumer and a new wave of growth could also work to keep a bid across the materials sector.

While peak pricing levels from 2022 are likely out of reach for the foreseeable future, we sense that the momentum is shifting with room for the market to trend higher. Ultimately, we believe the underlying companies within the PEO portfolio are well-positioned to benefit from a rebound of commodity prices going forward.

From the fund price chart, we like the setup here with PEO making a series of higher lows while consolidating around the $20.00 share price level. A move back towards $23.00 coupled with the dividend income implies a +20% return potential as part of the bullish case for the fund.

Covering risks, it’s clear a deterioration of the macro outlook would drive renewed volatility in the sector. A leg lower in energy and other commodity prices would pressure the earnings potential of companies within the PEO fund as a bearish development.

The case we make is that risks are tilted to the upside and the current level offers an attractive entry point.

Final thoughts

The Adams Natural Resources Fund is a high-quality CEF that performs exactly as intended for diversified exposure to the energy and materials sector. The fund stands out as a compelling alternative to indexed ETFs given its high-yield income and impressive performance history in recent years.

We believe the fund can work for investors in the context of a broader and more diversified exposure to represent a tactical or strategic view of this important market segment. With a bullish outlook for commodity prices, we expect PEO to deliver a positive return in 2024.