Vital resource stocks have been pounded during the financial crisis. Some of the losses have come from the liquidation of positions investors piled into—including hedge funds—on the way up. Some have been due to the historic surge in the US dollar, which–in turn–has been due in part to the so-called flight to quality and unwinding of the “carry trade” by large institutions. And some of the losses have been due simply to worries that the liquidity crisis would trigger a steep global recession.

As the upside action this week shows, however, this is one market that can turn on a dime. And when it does, it will be tough to catch up to.

Over the past two weeks, we’ve featured five of our favorites to buy now, and they’ve tacked on an average return of 10 percent.

As we pointed out two weeks ago, a sustained recovery in vital resource stocks won’t happen until there’s real visibility on how low the global economy can go. See VRI, Oct. 16, 2008, Five to Buy Now. What’s happened thus far can basically be explained as an inevitable reaction to the total sector washout—severely oversold conditions that attract bargain hunters and encourage short sellers to take profits.

Many stocks are now well off their lows. But the gains we’ve seen in recent days can just as easily reverse with the next piece of negative news on the economy, either here in the US or overseas. The bad news from Asia is that the source of demand growth in resources during the past few years has the potential to impact negatively.

The fact that these stocks are historically cheap is indisputable. Goldcorp (NYSE: GG), for example, is now trading where it did when gold was selling for less than $400 an ounce, barely half its current price. Giant miner Rio Tinto (NYSE: RTP) sells for just five times trailing 12 month earnings, while Vale (NYSE: RIO) trades at even lower valuations. Smaller plays sell for barely the value of their cash in the bank.

Equally undeniable: The underlying fundamental factors behind the bull market in vital resource stocks of recent years are still very much in force. In fact, the recent drop in prices ensures they’ll be stronger than ever in coming months.

Lower commodity prices and tough credit conditions are already threatening the survival of smaller resource producers. Even the giants we favor are being judicious about new capital spending, as significant new supplies of resources are ever-further away and ever-deeper underground. That means continued pressures on supplies, even as resource nationalism remains on the ascendancy.

And falling prices certainly don’t encourage use of alternatives or permanent changes in consumer behavior that permanently destroy demand. In fact, the steep drop and drying up of capital almost certainly ensure demand will rise faster than ever as the global economy comes off the floor. Given that much of the demand for resources comes from major infrastructure projects, resurgence may happen a lot sooner than most people think.

Most major commodities are still priced in US dollars on global markets. As a result, the surge in the purchase of US dollars during the financial crisis was a major factor that turned the selloff into a full scale rout. With so many dollars issued in this system-wide financial rescue, however, it’s only a matter of time before the dollar’s upward explosion reverses with a vengeance. And with the European Union in arguably almost as bad shape as the US, commodities—not the euro—is the near-certain beneficiary.

The bottom line is we have an exceptionally cheap group of companies in a market still powered by long-term fundamentals that can turn sharply higher literally on a dime. The key isn’t to time the turn exactly. Rather, it’s to have built positions in these strong companies beforehand and to stick with them patiently.

Portfolio Holding China Molybdenum (Hong Kong: 3993, OTC: CMCLF) is the largest primary molybdenum producers in China. Based in the Henan province, China Molybdenum’s output accounts for 21 percent of China’s total output and 7 percent of global output.

Molybdenum (from the Greek word “molybdos,” which means lead-like) is a silvery white, flexible metal with an exceptionally high melting point (2,625 degrees Celsius) used principally as an alloying agent in steel, cast iron and super alloys to enhance hardness, strength, toughness and resistance to wear and corrosion. It’s used as an alloying agent for the production of steel, molybdenum’s most significant end-use. It’s also used in the oil and gas industry for removing sulfur.

The metal is also extremely strategic: It’s used in military equipment (i.e., tanks, aircrafts and aerospace) as well as autos, shipbuilding and energy generation. It’s considered irreplaceable, and its relative rarity makes it even more important.

China is the company’s main market, accounting for 65 percent of its sales. Given the country’s efforts to consolidate its steel industry—and its need to improve the sophistication of its steel products—demand for molybdenum will remain strong.

The stock has been hit hard during the selloff, and the shares remain weak as steel demand is slowing and all projections are calling for further weakness.

It’s true that we’re seeing steel producers cutting production and there’s been weakness in steel demand around the world. Even economies that, until recently, couldn’t get enough of steel are now cutting back on their imports.

The good news is that demand for molybdenum in China remains healthy because of good growth in stainless steel, pipeline steel (for oil and gas) and upgrade of steel products. China has plans to increases its gas pipeline network by 50,000 kilometers, and 20,000 tons of molybdenum per year for the next decade will be necessary for the project’s completion.

One of the interesting growth characteristics of the company is that it’s expected to be involved in the industry merger and acquisition (M&A) action. (See VRI, June 12, 2008, In Size, Sureness). China continues to engineer consolidation across the board in the resource industry, pushing the smaller, inefficient players out of the way. The M&A program will allow China Molybdenum to mitigate some of the risks that it now faces as production comes out of one mine, where any problems can lead to higher costs.

The company has also been diversifying into gold and has acquired three operating mines this year at USD240 per ounce, a good price given the metal’s strength and long-term positive fundamentals. Although we view this as a good opportunity longer term, we have to see evidence that management will adapt to the different requirements of the gold mining business.

Looking at the risks, China Molybdenum is a leveraged play that’s more volatile, and its earnings are very sensitive to molybdenum price changes. For every 5 percent change in molybdenum price, earnings can be impacted by around 10 percent.

On the positive side, the company is one of the lowest producers in the world with cash cost of between USD4 to USD5 per pound. Furthermore, China Molybdenum has a net cash position of USD870 million or HKD1.25 million per share, which can be viewed as a floor for the stock.

That said, the share price has been hit hard, and it represents good value at these levels. China Molybdenum remains a buy.

As always, we prefer the local shares to the over-the-counter (OTC) listing. And because Hong Kong is easily tradable thorough serious brokers in the US as well, we strongly recommend you buy the stock locally.

Nucor Corporation (NYSE: NUE) remains highly competitive globally as a mini-mill. This process uses scrap steel and is better insulated against spikes in raw material costs. Also, located in the Carolinas, Nucor enjoys access to relatively cheap electricity.

And unlike many of its competitors, Nucor is faring well in the current financial crisis. Despite a decline in total tons sold, falling from 7,734 tons in the second quarter to 6,701 tons in the third, earnings continued to rise as higher prices were realized. The average sales price per ton in the second quarter was $917, which jumped to $1,111 in the last quarter. So despite the lower sales volume, the dollar amount of net sales actually increased to just over $7.4 billion from just over $7 billion. Earnings per ton increased to $179 from $118.

All told, net income climbed to $734.6 million, or $2.31 a share, from $381.2 million, or $1.29 per share, a year earlier. And this occurred as the global economy was weakening.

A large part of that success was due to increased steel demand from the Middle East, Brazil and India, which helped fuel a European expansion program to allow greater access to those regions. Part of that plan involved acquiring half a joint venture with Duferco SA in Italy for $658 million to produce steel beams.

Plans to build a new pig iron plant are also on track, and though final site selection hasn’t been made, it is expected to be built in either Louisiana or South America, with Louisiana the favorite. Financing isn’t expected to be a problem with more than $1.6 billion in cash on hand. There are also plans for the new plant to generate its own electricity, and in the event of Louisiana site, talks are under way to sell excess into the regional grid.

Fourth quarter results may not be quite as bullish as a continued global slowdown could cut further into steel demand, but Nucor is probably one of the best positioned steel producers to weather the storm.

Paladin Energy (Australia: PDN, OTC: PALAF) has performed well in the past two weeks. And in an effort to gain exposure to bigger, more diversified companies during this period of uncertainty, we’re removing Paladin Energy from the “Five to Buy Now” list. We still like the company and it will remain in the VRI Portfolio, but if you bought in recently and have some solid paper gains to protect, we recommend taking some profits.

We’re replacing Paladin with long-term favorite Vale. The Brazil-based iron ore giant and portfolio denizen recently reported good third quarter results. Although iron ore is its main product, copper, nickel and lower production costs allowed for the USD6.25 billion in earnings before interest, taxes, depreciation and amortization (EBITDA).

That said, investors are still very negative on steel and its materials. In the short term, the stock may lack a catalyst, so we expect to participate in the relief rally.

Longer-term we continue to like Vale because it continues to offer the best-quality iron ore in the market. And the Chinese will eventually use more as they increase the quality of their products. 

Given China’s stunning steel requirements, it isn’t a surprise that iron ore is the most leveraged commodity to China. As a result, it’s been hit hard as steel production in China has been reduced and industrial production has slowed down. Consequently, Chinese iron ore port inventory is still elevated and is moving slowly.

The current price weakness is driving high-cost producers either on the sidelines or out of the game all together, thus allowing the major producers to control new production growth. This development fits well with our on-going theme of investing first in bigger, more diversified companies. Investors are still trying to limit risk and, therefore, aren’t chasing small, commodity-leveraged, low-volume companies as was the norm a year ago.

We do think that this is a good time to allocate funds into Vale, in order to get exposure to the eventual increase in production in Chinese steel.  Furthermore, Vale is more diversified than most investors think, as the chart below demonstrates, and will be able to navigate the current turmoil. Buy Vale.

China Green Holdings (Hong Kong: 904, OTC: CIGEF) is a China-based producer and supplier of fresh produce, processed and pickled products, branded food and beverage, rice and rice flour products.

Monsanto (NYSE: MON) is the leader in the genetically modified (GM) seed industry. Its business consists of two segments: Seeds/Genomics and Agricultural Productivity. The Seeds/Genomics segment consists of the company’s global seeds and traits business, and genetic technology platforms, including biotechnology, breeding and genomics.

Switzerland-based Xstrata (UK: XTA; OTC: XSRAF) is the world’s fourth-largest copper producer. It also has substantial positions in nickel, thermal and metallurgical coal, zinc, aluminum and an alloys division for chrome, vanadium and platinum group metals.

UK-based Rio Tinto (NYSE: RTP) is the world’s second-largest mining with operations in Australia, Africa, the Americas, Europe and Central/Southeast Asia. Rio Tinto is the world’s largest producer of aluminum, second largest producer of iron ore and a top five producer of alumina, uranium, mined copper, thermal and coking coal and diamonds.

Vale (NYSE: RIO) is one of the world’s largest miners of iron ore and nickel. The 2005 acquisition of Inco, a Canadian nickel producer, initiated Vale’s transformation from a Brazilian iron ore miner into a global player, with assets and operations on six continents.