Energy mining stocks are usually volatile, but can give investors good investment returns over the long term.

Long-time readers may recall that in the mid-1990s, we started writing about three special factors that we felt were likely to make stock prices go higher, and continue rising longer, than most investors expected. These special factors or “economic energizers” were:

1. Economic liberalization and the spread of free enterprise around the world, following the end of the Cold War and the break-up of the Soviet Union
2. The maturing of the baby boomers, who were entering the economic prime of their lives
3. The productivity gains available from modern computer and communications technology.

The 1990s stock market boom did indeed last longer and take prices higher than many expected. Now we’re coming around to the view that we are headed into something similar today. Here is one of the factors that make me optimistic about the long-term outlook for the stock market:

The end of the energy crisis will relieve a major source of worldwide economic uncertainty.

The crisis began with ballooning oil prices in the early 1970s. It grew out of the fact that too much world oil production was concentrated in the volatile Mideast. The supply of oil was precarious due to Mideast politics and the constant risk of armed conflict. However, modern fracking and other technology gains now make it possible to produce oil and natural gas in vast quantities all around the globe. Energy prices may move higher, but energy security is greatly improved.

Does that mean you should invest in energy mining stocks?

We recommend that investors diversify their portfolio across most if not all of the five major sectors, including Resources. Some markets are inherently unpredictable, especially energy and mines.

The markets for fungible goods like oil, interest rates and gold are especially unpredictable.

Markets like these are so enormous that there is no practical limit to how much you can trade in them. It follows that if you could predict them, you could wind up acquiring a measurable proportion of all the money in the world, and nobody ever does that. That’s why it’s a mistake to build your portfolio in such a way that you have to accurately predict the future direction of fungible goods like oil, interest rates or gold.

If you diversify as we advise, you improve your chances of making money over long periods, no matter what happens in the market.

For example, manufacturing stocks may suffer if raw-material prices (including energy) rise, but in that case your Resources stocks will gain. Rising wages can put pressure on manufacturers, but your Consumer stocks should do better as workers spend more.

If borrowers can’t pay back their loans, your Finance stocks will suffer. But high default rates usually lead to lower interest rates, which push up the value of your Utilities stocks.

As part of their portfolio diversification strategy, most investors should have investments in most, if not all, of these five sectors. The proper proportions for you depend on your temperament and circumstances.

For example, conservative or income-seeking investors may want to emphasize utilities and Canadian banks in their portfolio diversification, because of these stocks’ high and generally secure dividends.

More aggressive investors might want to increase their portfolio weightings in Resources or Manufacturing stocks. For example, more aggressive investors could consider holding as much as, say, 25% to 30% of their portfolios in Resources.

However, you’ll want to spread your Resource holdings out among oil and gas, metals and other Resources stocks for diversification and exposure to a number of areas.

How to invest in energy mining stocks

When we’re looking at investing in energy mining stocks, we look for well-financed companies with no immediate need to sell shares at low prices. They typically have strong balance sheets with low debt. If they’re junior mines, we’ll consider them if they have a major partner who can finance the mine to production.

However, we avoid any energy mining stocks that trade “over the counter,” where such things as regulatory reporting are lax. And we don’t invest if the stock is trading at an unsustainably high price, because it’s likely the result of broker hype or investor mania.

Instead, we seek an experienced management team with a proven ability to develop and finance a mine. We make sure they’re not in any insecure or politically unstable regions such as the Congo and Venezuela, or in countries with little respect for property rights and the rule of law such as Russia or Mongolia.

Finally, we look at the market cap of energy mining stocks versus the estimated value of the mineral resource they have in the ground. Sometimes, a company’s marketing efforts are so successful that they drive the stock up too high in relation to the size of its ore body. We like an energy mining stock’s market cap to be no more than half the value of the mine. We assume that the company will be able to expand its reserves after the mine opens, but if the reserves are double the energy mining stock’s market cap, it provides a margin of safety.

Are you willing to hold stocks in more volatile sectors, like Manufacturing and Resources, even when those sectors are down? Leave a comment below.