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.