Currently, the energy sector is a value opportunity, London-based Waghorn told our sister publication Fund Selector Asia during a recent trip to Asia.
His forecast for the cyclical industry is for a 7% average return-on-capital-employed (ROCE) ratio in 2018 and 2019, which is still under the average of 11% based on data from the past 20 years.
Wagorn said that, in terms of ROCE, the energy sector is expected to perform better over the next two years if oil prices remain relatively high. He said the whole sector should also start benefiting from infrastructure investments made over the past few years.
A question of cash flow
At the end of September, Guinness AM’s 30-stock portfolio had roughly 30% of its assets allocated to large-cap companies that were under-valued and are expected to generate higher free cash flow than historically, Waghorn said.
“The oil price is a factor in the performance of energy companies, but not the only factor.”
“The free cash flow level among the large-caps is dramatically higher than we have seen for a number of years,” he said. In 2016, energy companies on average had negative free cash flow. He believes that was the worst period and it has now reversed.
“But the market remains very sceptical. It doesn’t believe that the energy industry around the world will keep its capital expenditure low and deliver much cash. Therefore, the market is unwilling to pay a larger premium for that.”
According to data provided by Guinness AM, energy stocks are priced at around 1.5x price-to-book ratio, reflecting the same valuation multiple as in 2015 and 2016, when the energy sector reported zero and even negative cash flow.
Waghorn noted the operating environment for oil and gas companies has largely improved. Operating costs today are significantly lower than five years ago, when the oil price per barrel stood at $100 and above.
This low-cost environment enables energy companies to retain cash, which is reflected in the small growth of capital expenditures among companies in the sector.
“The companies will need to increase their capex at some point to invest for the future. But at the moment, they show that they are being careful and disciplined on how they spend their money,” he added.
Although the manager is bullish, he said one risk is that oil and gas companies resume spending irrationally.
In addition to bottom-up research on company cash flow and profitability, Waghorn’s team analyses data for oil price movements and demand and supply to plot the valuation estimates for each stock in the universe of 370 publicly-listed companies.
“The oil price is a factor in the performance of energy companies, but not the only factor,” he said.
Moreover, the fund adopts an equally-weighted structure. This compares to other equity funds which typically allocate assets with reference to each stock’s market capitalisation.
Therefore, in Waghorn’s fund, none of the 30 stock holdings exceed 3.33% in weighting after rebalancing every four to six weeks. He believes the mechanism can help control stock-specific risk and provide a level of sell discipline.
Three-year performance of the Guinness Global Energy Fund
Source: FE, in US dollar terms. The fund is distributed to professional investors only.
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