MAY 2012 Head start on energy stocks
As an early player in the energy sector, Tim Guinness began when oil prices were low. Now he combines topdown analysis with concentrated stock selection as demand for oil rises.
TIM GUINNESS Chief investment officer, Guinness Asset Management
The importance of energy within the global economy is now widely recog- nised, and the potential of energy invest- ment has caught the eye of a number of fund management groups. Yet it has not always been so fashionable and one fund manager recognised its significance before anyone else.
Tim Guinness, chief investment officer of Guinness Asset Management, was drawn into energy investment by accident, when Investec took over Guinness Flight – the firm he had estab- lished with Howard Flight.
The group wanted to close a number of relatively small energy funds in the interests of efficiency, but Guinness thought it would be doing a disservice to shareholders, closing at a time when the oil price was at rock-bottom and had the potential to move higher. Investec acquiesced, but said it had no one to run the funds, so Guinness volunteered. He says: “I had already run a global equity fund, so I was very comfortable with global investing – and energy is a global business.
“When I looked around, the fund’s opposition was not that strong. All the hot-shot fund managers had gone to manage dotcoms. I learnt my trade from there.
“After a few years, we realised it was working and that we might be onto something. It wasn’t until 2005 when other good people came into the indus- try, but I had a six-year head start.” Guinness has now re-established an independent firm, specialising in energy and emerging market invest- ment, areas that can bring nuance and depth when added to a portfolio for the long term. The group’s process com- bines top-down macroeconomic analy- sis with concentrated stock selection. He believes this is what creates the group’s edge: “To be completely bot- tom-up is to miss out on a trick. Energy lends itself to the top-down – you need to look at where the oil or gas or ura- nium prices are going. There is a lot of politics involved in determining the supply and demand characteristics for any commodity.”
For the flagship Global Energy fund, Guinness reasoned that he could not cover 350 stocks in any depth, so needed a system for prioritising and cutting through the data glut to gener- ate stocks on which he could focus. For this, he uses a tool called HOLT, a sys- tem based on the premise that the ulti- mate value of a company is determined by future cash flows. It is strongly based on mean reversion and searches for companies that are cheap and have a history of good return on capital. From there, he will look at individ- ual stock characteristics – return on capital, cash flow and sentiment indi- cators. He will track analysts’ esti- mates, plus technical factors – what the share price is doing – to pick up on any- thing that the group’s analysis might have missed.
He adds: “We consider ourselves old-fashioned value investors and we want to keep things simple. We only own 30 stocks and we equal-weight them in the portfolio. This creates a fantastic sell discipline. When we want to buy a company, we have to commit 3.33% of the portfolio to it. That makes us quite cautious, not traders, and means that we tend to buy and hold.” Equally, Guinness does not con- sider himself an asset allocator, mean- ing that he will not retreat into cash at difficult times in the market. The result is a flexible portfolio that will adapt to the changing environment for energy. For example, when the fund started out, oil services and E&P stocks became cheap.
By 2000 the price had recovered and oil services had had a good run. At that point, Guinness exited, finding better value in smaller companies. After 2003 and the market collapse, mainstream markets had stabilised, and emerging markets looked promising. In 2006, the fund shifted to accommodate opportuni- ties arising from the cheaper gas price. At the heart of the Guinness process are some important judgements on the likely outcome for energy markets. He points out that over the past 35 years, oil has been displaced as a fuel source from many areas, such as urban heat- ing or railways. The area in which it has remained dominant is in transport. At the moment, the growth in the use of cars in emerging markets such as China, India and the Middle East is driving oil demand higher. This is in spite of some natural threats to the oil
‘ ‘ At the
moment, the growth in the use of cars in emerging markets such as China, India and the Middle East is driving oil demand higher
price, such as the advent of electric of gas-powered cars.
Guinness says: “Our view on elec- tric cars is that the price point is some way off for mass adoption. In 10 years’ time, we can see how the electric car market might have reached 1m, but this remains a relatively small part of the overall fleet. We can see that up to one-third of the trucking fleet could be powered by natural gas in 10 years’ time. Eventually, the oil price will get so high that the two will converge.” But for now, the growth in China and other emerging markets is winning out. Guinness believes the oil price is settling at around three to four times higher than previously. The valuation of energy companies has not caught up and this is creating an opportunity. He adds: “The price/earnings multi- ple of our portfolio is about 8x. Investors are pricing stocks as if the oil price was going to come crashing back to $70 and below. The downside is not significant because it is in the price and if it doesn’t happen there is 50% upside.” He also believes opportunities still exist in natural gas. From a macroeco- nomic point of view, he believes the strength of the US recovery and the pos- itive effect of that recovery globally will surprise investors. This will buoy demand and support energy prices. The natural gas price has weakened because of developments in horizontal drilling or fraccing, over-expansion and the warm winter in the US. It may not recover until 2013/14, but demand will drive it higher as the US increas- ingly moves towards natural gas for electricity generation. China, too, is heavily dependent on coal and likely to shift towards more eco-friendly natural gas in order to unclog its cities. Guinness concludes: “It is impor- tant to remember that the energy industry is quite volatile. Investors are best advised to adopt a tuck-away and hold-for-their-grandchildren approach and not get excited by volatility. “But over the long term this volatil- ity has a beneficial side-effect. Return on capital is very good. It is required to be so to compensate for the volatility. There are high barriers to entry and the industry is capital intensive.” Energy provision is at the heart of the global economy and demand contin- ues to expand. While it does so, shares in companies that control and service energy production are likely to rise.
FUND PROFILE
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