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The Energy Sector - Dodge & Cox Funds Commentary
Posted by: Holly LaFon (IP Logged)
Date: November 7, 2013 01:50PM
Energy, a critical input to the modern global economy, accounts for approximately 8% of world GDP. Energy prices have a large effect on economic activity, significantly impacting consumers, companies, and countries. We will discuss the application of Dodge & Cox's long-standing investment philosophy in evaluating this vital sector of the global economy, the Energy positioning in the Dodge & Cox Equity Funds, (a) and some broad industry trends that are influencing our individual security selection.
OVERVIEW OF DODGE & COX'S INVESTMENT APPROACH
Dodge & Cox has operated with the same investment philosophy for over 80 years: we seek to identify well-established companies that have attractive long-term earnings and cash flow prospects, which are not reflected in the current valuation. To select investments, we employ a consistent and disciplined approach that focuses on intensive bottom-up research, a long-term investment horizon, and strict price discipline.
Individual company research drives the selection of stocks for each Fund. Through meetings with companies' senior management, competitors, customers, and suppliers, our global industry analysts seek to build an in-depth understanding of individual companies and industry dynamics. On a company by company basis, our analysts develop projections for growth prospects, earnings, and cash flows, to derive a range of potential investment returns over the next three to five years. Our industry analysts work with our fixed income team to evaluate potential downside and access to capital. Furthermore, we assess corporate governance to understand how our interests align with those of key stakeholders.
Each potential investment is evaluated based on a three- to five-year investment horizon. Decades of investing have taught us that investor perceptions fluctuate much more widely than underlying fundamentals. Thus, we believe it is difficult, if not impossible, to predict short-term price movements. At Dodge & Cox, we look beyond readily apparent short-term information and think about how business fundamentals might change over a longer term horizon. We believe our discipline in focusing on long-term company fundamentals helps us to better analyze price disparities and find attractive investment opportunities.
A strong price discipline is an essential characteristic of our investment strategy. Starting valuation matters to long- term investment returns, so we have to weigh what we are buying (the fundamentals) against what it costs (the valuation). Once we evaluate the fundamentals for a company, we determine if the current price is an attractive entry point. When a company's valuation reflects pessimism about its current challenges, its long-term promise may be obscured.
Each Fund's energy positioning is a result of our bottom-up research process. Energy is not a homogeneous sector. It includes diverse sub-industries and companies that have unique growth prospects and challenges (including technological, market, and project-specific issues), as well as differing sensitivities to commodity prices. To evaluate each potential energy investment, we work with scenarios instead of a specific oil or gas price forecast. Our approach tends to be contrarian: we are often more skeptical as other investors become more optimistic, and our interest increases when other investors become more pessimistic. For example, during the late nineties and early 2000s, when oil prices were quite low, our exposure was significantly above the market averages. As optimism improved and oil prices increased, the share prices rose and we reduced our exposure.
Currently, the Dodge & Cox Equity Funds are overweight (b) Energy Equipment & Services (Oil Services) and underweight Oil, Gas & Consumable Fuels (Upstream & Integrated), compared to their respective benchmarks:
Within the Energy sector, the Dodge & Cox Equity Funds were invested in the following companies (c) as of June 30, 2013:
Overweight Oil Services Companies
In our opinion, major oil services companies are appealing due to their strong franchises, attractive growth prospects, and reasonable valuations. We believe that these companies are positioned to benefit from a number of favorable industry dynamics. First, in our view, the industry is consolidating and the major players are getting stronger. Second, technological innovation is creating opportunities for the larger companies and their customers. Third, we believe they are essentially toll-takers in the industry, and resource holders need to utilize their services to extract assets.
Schlumberger (SLB) (the world's leading oil services company) has been a long-term holding in the Dodge & Cox Equity Funds. Roughly two-thirds of Schlumberger's revenues come from outside the United States. The company is the dominant international provider in key markets including the Middle East and Russia. Historically, its international business has had higher margins and faster growth rates than its U.S. operations. Among its peers, Schlumberger has also consistently spent more on technology and research and development. Although a supply or demand shock to oil prices could reduce industry exploration and production budgets, we believe Schlumberger is well positioned to continue to benefit from the long-term relationships it has with international oil companies and producing countries.
Underweight Upstream & Integrated Companies
While the Dodge & Cox Equity Funds have overweight positions in Oil Services, they are meaningfully underweight Upstream & Integrated companies (global energy producers) largely because of the challenges facing many in these segments. Production naturally declines over time, and the vast majority of assets from producing oil and gas fields are being depleted. Energy producers have to invest to offset their fields' natural rate of decline, and a significant amount of their available cash flow is spent to maintain current production levels. Exploration success has declined in many areas, and new discoveries have become harder to find and more expensive to develop. When commodity prices rise, costs increase and producers are not always able to pass along the higher costs.
Global energy producers can also face competition from national oil companies for development of new resources, as well as changing fiscal terms or restricted access by host countries. Despite these challenges, we have identified selected companies that we believe are able to overcome the aforementioned headwinds. For example, Chevron is one of the world's largest integrated energy companies and conducts business in over 100 countries. We believe the company has a more favorable long-term production growth profile than many of its industry peers; long-term growth should be driven by projects in West Africa, the Gulf of Mexico, Kazakhstan, and Australia. Chevron also has a leading refining and marketing position in the Western United States, where margins have historically been higher than in other regions, and a solid presence in the large and growing Asia Pacific markets. The company's management team remains focused on improving returns in all businesses. In addition, the company's shares trade at a below-average valuation relative to its peers, despite a solid long-term outlook. For these reasons, we believe Chevron is an attractive investment opportunity.
GLOBAL ENERGY TRENDS
While our investment decisions are based primarily on company-specific factors, we also consider external factors (e.g., industry trends, regulations, geopolitical risk). Companies in the energy business are strongly influenced by broader industry themes that will have a role in shaping their prospects over the long term. As a component of our bottom-up research process, we evaluate key energy trends. We highlight emerging markets growth, alternative energy, and liquefied natural gas and their impact on selected Fund holdings as examples.
Emerging Markets Growth
Energy demand is directly tied to global economic and population growth. The developing world is growing at a faster pace than the developed world; as a result, emerging markets are becoming an even more significant consumer of energy. In the graphs below, OECD (d) and Non-OECD are proxies for the developed world and emerging markets, respectively.
The majority of the Funds' Energy holdings are multinational companies with significant exposure to the developing world. For example, Chevron, Petroleo Brasileiro (Petrobras), Royal Dutch Shell, Schlumberger, and Total all derive more than 40% of their revenues from emerging markets.
Petrobras (PBR), one of Latin America's largest companies, is a world leader in developing advanced technology for deep-water and ultra-deep water oil production. The company has an attractive asset base with above-average, long-term growth opportunities in reserves and production. Petrobras has an advantaged position in world-class resource basins; its oil fields in the Campos Basin account more than 80% of the Brazilian oil production and its "pre-salt" assets are among the world's largest new oil producing developments in decades. The Brazilian government owns over half of the company's voting shares, and has made Petrobras' growth a national priority. While the government's ownership and social objectives may force the company to take non-economic actions, we believe Petrobras' valuation and strong franchise make it an attractive investment opportunity.
Energy is a large, diverse, and dynamic industry. It's not just about oil—consumption around the world is quite varied by source. Over our three- to five-year investment horizon, we believe that the traditional sources of energy (e.g., oil, gas, coal) will continue to be the primary energy inputs for the global economy. Oil and gas comprise roughly 50% of the world's consumption, and, if you include coal, the amount is closer to 90%. Although its market share is currently small, alternative energy has increased its share of the mix.
Alternative energy sources (e.g., solar, wind, bio-fuels, nuclear) are likely to continue to grow faster than traditional energy sources. Yet, it's important to remember that energy changes generally happen gradually because of long investment cycles, the scale and complexity of the industry itself, and changing consumer preferences and behaviors. Through investments in the Oil Services industry and selected holdings in the Industrials sector, the Dodge & Cox Equity Funds seek to participate in the gradual shift to alternative energy. General Electric is one such holding.
Consumers commonly associate General Electric (GE) with light bulbs and refrigerators. However, energy is also a major source of the company's earnings. General Electric is a leading provider of wind power, clean coal, natural gas turbines, solar, and nuclear fuel technologies. In addition, the company provides financing to energy companies around the globe through its GE Capital business segment. We have chosen not to invest in early-stage alternative energy companies that lack established business models and customer franchises, or are very reliant on new or unproven technologies becoming commercially successful in the future. General Electric, by contrast, offers us exposure to these fast growing areas in a diversified portfolio of leading businesses, which can partially offset the risks associated with the adoption of alternative energy technologies. We believe this company has the financial strength to fund new innovations out of existing cash flow, and the brand recognition, established distribution, and staying power that are critical for customer adoption of any long- term energy solutions.
Liquefied Natural Gas (LNG)
LNG is also growing faster than other traditional sources of energy, partly due to growing power generation and industrial usage. In the form of LNG, natural gas can be transported long distances. The Middle East, Africa, and Australia have significant natural gas reserves and are among the largest exporters of LNG; the biggest importers include Asia and Europe. As one of the world's largest producers of natural gas and suppliers of LNG, Royal Dutch Shell (RDS) is well positioned to benefit from increasing LNG demand in our opinion. LNG continues to be a driver of future growth, accounting for nearly one quarter of Shell's new resource production. This well-diversified business segment has grown more than 10% annually over the last few years, and we project similar growth rates over our investment horizon. Shell's LNG growth is much faster than the demand growth for other traditional sources of energy. While we evaluate the geopolitical risks inherent in the Energy sector against company fundamentals, Shell is held in the Dodge & Cox Global Stock Fund and International Stock Fund due to its reasonable valuation and exposure to LNG.
Each Fund's energy positioning is a result of individual security selection. Companies in the energy business are strongly influenced by broader industry themes that will have a role in shaping their prospects over the longer term, and we have incorporated these themes into our bottom-up research framework. We believe we have found attractive opportunities within the Energy sector and expect to maintain a significant research effort in this area given the sector's size and relative importance to the global economy.
(a) The Dodge & Cox Equity Funds include the Stock Fund, International Stock Fund, and Global Stock Fund
(b) Unless otherwise specified, all weightings and characteristics are as of June 30, 2013.
(c) The use of specific examples does not imply that they are more attractive investments than other holdings in the Dodge & Cox Equity Funds.
(d) OECD = Organization for Economic Cooperation and Development.
The above information is not a complete analysis of every material fact concerning any market, industry or investment. Data has been obtained from sources considered reliable, but Dodge & Cox makes no representations as to the completeness or accuracy of such information. Opinions expressed are subject to change without notice. The information provided is historical and does not predict future results or profitability. This is not a recommendation to buy, sell, or hold any security and is not indicative of Dodge & Cox's current or future trading activity. The securities identified are subject to change without notice and may not represent an account's entire holdings. Before investing in any Dodge & Cox Fund, you should carefully consider the Fund's investment objectives, risks, and management fees and other expenses. To obtain a Fund's prospectus and summary prospectus, which contain this and other important information, visit www.dodgeandcox.com or call 800-621-3979. Please read the prospectus and summary prospectus carefully before investing
Guru Discussed: Dodge & Cox: Current Portfolio, Stock Picks
Stocks Discussed: PBR, GE, RDS, SLB,