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Energy Czar

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While the United States has won the shooting war in Iraq, uncertainty still abounds in the rebuilding of that country and in fact throughout the region–unrest continues in Afghanistan, the Israeli-Palestinian peace process is “proceeding” in fits and starts, and terrorism remains a concern throughout the Mideast and beyond. Back at home, all is not well, either.

Despite some signs of life in the stock market, the economy continues to be sluggish, unemployment rose to 6.1% in May, and gasoline prices are still high–the latest increase of 1.7 cents in early June pushed average pump prices to $1.49 a gallon. Although the price of most commodities is not something the average American follows, the price of energy has become a concern of late.

“Natural gas prices have doubled in the past year and [oil company] stocks are down 10%,” declares State Street Research Global Resources Fund (SGLSX) portfolio manager Dan Rice. “The only reason they are down is because of this fear that oil prices are going to collapse” much like they did during the 1991 Persian Gulf War. “Obviously, they are not,” claims Rice. With nearly 25 years of experience in the energy sector, Rice has piloted the Global Resources Fund since its inception in 1990, and understands the volatile nature of energy costs. At least 50% of the fund is invested in natural gas, Rice explains. In 1991 during the first Gulf War, natural gas prices collapsed, but that didn’t happen this time around, and that fact “has been ignored,” he says.

Playing on what he considers to be the best buying opportunity in the last 20 years, Rice is investing in small- to micro-cap oil, natural gas, and coal companies, in addition to a limited amount of gold companies. When the fear of collapsing oil prices dissipates, oil “stocks are going to make a huge move,” says Rice. “So we have been trying to position the portfolio on that basis.”

But with such concentrated exposure, and avoiding all investments in big-cap integrated oil companies (meaning zero opportunity for dividend payouts), this fund’s inconsistent performance is not for the squeamish. Take the last five years. In 1998 the fund returned -48.39%, 15.76% in 1999, 84.76% in 2000, -2.5% in 2001, and 5.85% in 2002, according to Standard & Poor’s. Even that volatile performance gave the fund an average annualized total return of 8.6%, versus a total return of -3.1% for the FTSE World Index (excluding U.S.), -8.1% for the S&P 500 Composite Index, and 0.3% for all International Equity Sector funds. This fund is ranked seventh within the entire universe of 71 funds in its peer group, according to Standard & Poor’s.

According to Rice, this S&P four-star-rated fund primarily serves as a long-term portfolio diversifier, and is particularly valuable since the fund doesn’t correlate well to the overall market. “An investor should invest anywhere from 7% to 20%” of his assets in investments like his fund that don’t correlate to the overall market, Rice argues.

We recently spoke to Rice about the volatile nature of his fund, why, in his opinion, alternative sources of energy currently aren’t worth the risk, and how after 13 years he hasn’t changed the way he manages his fund.

Tell me about your screening process. [We used to invest] in companies that could show growth of at least 10% per year in units of production or units drilling. But in the last couple of years, the industry has been in a negative growth mode, so we have reduced our standards a bit. Now a company has to show at least a 5% unit increase per year. A unit for our purposes constitutes a barrel of production, or activity levels for an oil service company.

Who built the screens and how often are current holdings reviewed? There are close to 600 companies in our universe, and for the most part the average market cap is less than $2 billion. We will look at companies that are larger than that, but by and large those companies don’t grow fast enough for us to spend too much time on. Within the $2 billion market cap we try to get stocks that are growing the fastest, have the lowest multiples, and that have the best asset value. Company growth is the primary characteristic we look for.

You tend to invest in small exploration companies. What are the risks, and benefits, of investing in these kinds of companies? Typically these companies are selling at anywhere from three to five times cash flow, and if you compare that to the S&P average cash flow multiple for international oil–which is about eight, and six for domestic oil–our companies are trading at substantial discounts compared to the larger companies out there. And if our companies are growing two to three times faster than the average company, and our analysis is correct, and they grow into the growth rate that we expect, then we have no qualms with [our companies] not expanding their cash flow multiple. So if the cash flow multiple three years from now is still at four, but if they are growing in units at 15% per year, then the stock has almost doubled.

Do you only invest in energy stocks or do you ever invest in other resources like precious metals? In the global resources fund we have about 10% of the portfolio that is allocated to non-energy. For the most part, that is going to be gold and precious metals. We felt the fund would be [more successful] and would appeal to [more investors] by adding other natural resources. We’ve had precious metals in the fund since 1994.

What is your allocation among your energy investments? We can do just about anything as long as it has some relationship with energy, specifically more than 10% [of a company's] sales, earnings, or cash flow [must be] derived from energy. For the most part, [our investments] are primarily what you would think of as energy stocks. Right now we have about 20% of our portfolio in coal stocks and 10% in gold, with the remainder in oil and gas.

So you don’t include companies with alternative forms of energy? We would if we found them attractive or if I thought we couldn’t find too many places to invest in oil and gas, but that is not the case. We invested in alternative energies in the past, maybe 5% or 6% of the portfolio, but currently for all intents and purposes we don’t have any investments in that sector. That’s not to say that sector is terrible; it’s to say that there are too many other real-world, touch-and-feel opportunities out there in gas, coal, and gold, so I don’t need to go on the fringe. There are too many alternative opportunities out there right now that are not going to be reporting any earnings for the next five years.

How important is meeting with company management? You would like to think that you could pick good managers, but our experience is that this is an asset-driven business and the assets are almost as important as the management. If the assets are good, it takes real incompetence to screw that up. Moreover, there are very few companies being born into this industry. Most of the companies have been around for a very long time and the incompetent ones just aren’t around anymore. I would say that the emphasis some people have on management is somewhat overblown, [as] existing assets are almost as important.

What is your research team like? Well, it isn’t as if we don’t know almost every company out there because I have been doing this for 24 years. But behind that, we pay about $600,000 a year to consultants who provide specific sector analysis that I can’t get. The way I run things, it is much better for me to be paying outside consultants than it is to have two or three analysts in-house, because I would have to manage them, which I don’t want to do, and they wouldn’t be as qualified as the consultants we are paying in terms of knowledge.

Do you ever visit any of your investments? I have obviously visited every company out there so the need for me to continue to visit the same companies is pretty low. I have already spoken to three companies today as they come and visit me, so I get plenty of face-to-face time, though for the most part it’s on my turf. I see [about] 700 companies a year, probably average two or three companies a day.

The global resources fund only has about $212 million in assets (for all of the fund’s share classes), but we have institutional portfolios with about $500 million in energy-only money, and [another] $250 million in an energy hedge fund, so we have close to $900 million of energy money, [and that] puts us up as the second-largest in the country. Our emphasis here is top down; we probably spend at least half of our time on the macro analysis, and 30% of our time on company analysis. The rest of our time is spent trying to get oil, gas, gold, and coal prices correct, and determining where those prices are going to be and what we think the stock market is discounting, vis-?-vis what our expectations in price are.

Then we determine how we are going to put the money in subsectors, [since we found] that is at least 50% of the battle. If you don’t have a handle on determining where future commodity prices are going to be, then you are going to be relegated to doing individual company analysis. That’s how we have distinguished ourselves in the past. Everyone can do company analysis and everyone is a decent stock picker, and when we do our attribution analysis on a long- term basis we find about half of our out-performance is due to individual stock picking and half is due to macro considerations.

For instance, if we don’t like oil prices then we are not going to be aggressive in the portfolio, or if we really like gas prices then we are going to be really aggressive in terms of the kinds of companies that make up the portfolio. Once we determine how aggressive we are going to be in terms of commodity prices and what we think the market is expecting, then we determine what the individual companies are that we are going to have in the portfolio, but not until we make a macro decision.

Does this fund’s inconsistent return history make it a hard sell to investors? Yes, it’s the nature of the animal for it to be very volatile. In fact, the volatility is much like a small company growth fund. It is not suitable for most investors, especially those that have a short-term trading horizon, because undoubtedly short-term traders are going to get it wrong. Our recommendation is you have to be long term, and you have to put in anywhere from 7% to 20% of your assets into something like this. I am not saying that it should all go into our fund, but something that doesn’t correlate with the general market. We have very little correlation with the general market; the fund trades in its own little world.

[As far as this fund's returns,] you bring up a good point, but for the last 10 years we have outperformed the S&P quite nicely. Since we have outperformed our index, you would think that we would have more than $200 million in the fund. The reason we don’t is because of the reasons you have listed–it is very difficult for people to understand the volatility behind it, not only as a sector fund but as a forecast sector fund. That is just the nature of the animal.

Have you experienced much in the way of inflows or outflows into the fund? They are both small. When we make an investment, we want to see it double within a three-year period. That would imply a 25% rate of return, which obviously is high, because when the smoke clears we should see between 10% and 15%.

You currently have 80 holdings. Is that about your average? I would say we have anywhere from 70 to 100 holdings. That implies a pretty diversified portfolio, [but] keep in mind the top 10 names represent about 40% of all the assets, so it is not all that diversified.

Currently cash is just under 4%. Is that standard for the fund? Yes. Depending on redemptions and sales, cash can be anywhere from 0% to 5%. I’m not a cash holding manager. I haven’t used cash for the last three or four years, and we don’t use that as a market timing device.

Your turnover rate is a 37.57% compared to an average 134.70% for your peers. Is there a reason why you keep it so low? Is it just because there are a limited number of companies to invest in? If you look at our individual companies, half of our turnover is due to companies being bought out, so our actual turnover is more like 10% to 20%. We are classic buy-and-hold managers. We buy stocks thinking we [will hold them] for two to three years down the road. We don’t think of what is going to happen three or six months down the road. That is way too soon, and we sell the companies when we think they are very close to what we think they are worth. We are not traders; we wait for the markets to get to our valuation levels, or the companies get bought out.

Currently your foreign investments account for about 14% of the fund. How do you determine your international exposure? Ninety percent of our international exposure is Canadian, so we are just playing the North American natural gas markets. We are also playing Canadian Royalty Trusts. Royalty Trusts are out there buying good asset companies relatively aggressively. We don’t have a similar concept for most of the other countries in the world, which is why we will have almost all of our foreign assets in the Canadian sector.

Do you manage this fund to any specific index? Internally, we have a Wilshire Modified Energy Index that we look at. We also look at the Lipper Natural Resource Index. We follow those companies in the index but only for comparison, since we are very different from the indices. We might have a high correlation [to the index] but we don’t always have the same performance. We tend to move in the same direction at the same time, but the makeup of our stocks versus the indices is entirely different. Typical market cap for Wilshire Modified Energy Index is just under $2 billion and our average market cap is $1 billion. It’s a different animal, but the correlation is a very high 0.9294.

You’ve managed this fund since June 1993. Has your management style or investment strategy changed in the last 10 years? I haven’t changed. I analyze things in almost the exact same way. The only change we have made is that we used to say we needed at least 10% growth in units to qualify. Now it’s 5%.

What’s the advantage of investing in your fund rather than investing in the overall sector through an ETF? Our fund tends to be more leveraged to the underlying commodity price [than other funds]. We all correlate to some degree, but our companies are much more sensitive to underlying prices because they are smaller and tend to grow faster than larger companies in this sector.