Jonathan Waghorn, Guinness Asset Management
Currently, the energy sector is a value opportunity, London-based Waghorn told FSA during his recent trip to Asia.
His forecast for the cyclical industry is 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.
However, the price-to-book multiple is also lower than the trend line based on estimated ROCE.
Measured with ROCE, the energy sector is expected to perform better the next two years if oil prices remain relatively high, he believes. The whole sector should also start benefiting from infrastructure projects invested in a few years back.
A question of cash flow
At the end of September, the firm’s 30-stock portfolio had roughly 30% of assets allocated to large-cap companies that are under-valued and are likely to generate higher free cash flow than historically, Waghorn said. One example is China’s state-owned CNOOC, which is currently among the portfolio’s top ten holdings.
“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 skeptical. They don’t believe that the energy industry around the world will keep their capital expenditure low and deliver much cash. Therefore, they are 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 cost today is 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.
Oil prices
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
