Dear Baron Energy and Resources Fund Shareholder:
The only good thing that we can say about the third quarter is that at least it is over. The performance of our Fund was awful on both an absolute and relative basis. The combination of growing global economic unease, especially related to China and other emerging markets, the nuclear agreement between the P5+1 countries and Iran, and rising concerns about a potential interest rate hike in the U.S. took a heavy toll on oil prices and energy related shares during the quarter. Our Fund posted a decline of 30.6% (Institutional Shares) during the quarter and underperformed our principal benchmark (S&P North American Natural Resources Sector Index) by over 11%. While it is of little consolation, despite such awful relative performance, our trailing three-year performance is essentially in line with our benchmark. However, the annualized decline of 7.77% for our Institutional Share class and the 7.73% annualized decline for our benchmark compared to the 12.40% annualized gain for the S&P 500 Index also demonstrates how challenging the last three years have been for investing in energy and resources related companies, and for our strategy overall. That being said, we believe that many of the imbalances that have led to the investment headwinds in recent years are beginning to abate. In particular, we are seeing more positive signs in the oil supply/demand outlook, leading us to believe that a more favorable environment for investing in energy is moving more clearly into our field of vision.
The performance of our Fund suffered from declining share prices for our investments in Oil & Gas Exploration & Production and Oil & Gas Equipment & Services companies as lower oil prices and declining earnings and cash flow expectations created significant selling pressure in these areas. However, for the quarter, the real carnage actually occurred in two areas of investment where the correlation between oil prices and share prices should be relatively low – Renewable Energy and Oil & Gas Storage & Transportation (aka MLP/GP midstream companies). These two areas represented an average weight in the portfolio of about 35.8% during the quarter and contributed to over 50% of the decline in the Fund in the quarter. These two segments’ contribution to return was -16.5% in the quarter, while the remainder of our holdings contributed the other -14.1% of the total decline of 30.6%.
Our investments in Renewable Energy and Midstream MLP/GPs have typically demonstrated a low correlation to the price of oil, generally have dividends and distributions that do not fluctuate materially with changes in oil or natural gas prices, and have yields that are above that of the overall market (S&P 500). Therefore, we expect these investments to act as ballast and be the portion of our Fund that provide a degree of stability when oil prices are volatile, especially compared to our more conventional energy companies. However, this was clearly not what happened in the third quarter. Instead, it is clear that the sharp decline in oil prices of over 20% created a negative feedback loop in which investors began to question the forward growth prospects of many of these companies, which created concern about valuations, and ultimately led to negative fund flows across the spectrum of energy yield oriented mutual funds, ETFs, and ETNs. As valuations compressed and yields expanded, investors worried that a rising cost of capital would make it increasingly difficult for MLPs and “yieldco” vehicles to make the types of accretive acquisitions that have been one of the key elements of the long-term growth strategy for many of these companies, creating even more doubt about future growth. What historically has been a virtuous circle in these stocks turned instead into a vicious cycle.
To put this in perspective, Midstream MLP/GPs are often compared to REITs and Utilities as alternative yield vehicles and historically the valuations of all three sub-industries have tracked one another closely with few exceptions. In the third quarter, REITs, as measured by the MSCI REIT Index, generated a total return (with dividends reinvested) of 1.75%, while Utilities, as measured by the Utilities Select Sector SPDR ETF, delivered a total return of 5.4% (with dividends reinvested). By comparison, the Alerian MLP Index delivered a total return of -22.1% (with dividends reinvested). Although there is no established index for renewable energy “yieldcos,” those stocks fared even worse than most MLPs/GPs in the quarter. While the financial press and analytical community spent considerable time in the third quarter reporting on investor concerns regarding the U.S. Federal Reserve and pending changes in interest rate policy, it appears to us that rate worries were not nearly as significant a driver of stock performance as was the vicious cycle triggered by falling oil prices. This phenomenon appears to have also been compounded by tax loss selling and other portfolio restructuring late in the quarter, causing a sharp decline in our Fund’s returns in just the last seven trading sessions of the quarter.
Because we believe both midstream and renewable energy-oriented businesses have superior long-term growth and return prospects, we have long maintained a higher than average weighting toward midstream companies and more recently boosted our weighting of renewable energy companies relative to our benchmark and peers. We believe that the indiscriminate selling during the quarter, especially at the tail-end of the quarter, has created an interesting buying opportunity, particularly for investors like us who take a long-term view on investing in these companies.
Overall, it was a challenging quarter that appeared to culminate in a wave of cathartic, almost “throw the baby out with the bath water” type of behavior, and, as noted above and spelled out in more detail below, we think may represent a turning point.
It is a sign of how challenging the investment environment was in the past quarter that there is only one stock in the portfolio which contributed positively to the Fund’s performance. Flotek Industries, Inc. is primarily a supplier of chemical additives to the global oil & gas industry with some other ancillary oilfield service operations. The company has a proprietary product dubbed the “complex nano-fluid (CnF)” that is a patent-protected product that utilizes citrus-based chemical products to enhance the flow of oil & gas from unconventional oil & gas formations such as shales. Through the analysis of publicly available production and completion data, Flotek has been able to isolate the effectiveness of its product and demonstrate the clear economic benefits of using CnF to existing and new clients. Flotek also is pursuing unique business strategies in the marketing and selling of its core product as it pursues a direct to end-user model in addition to its classical distributor-based model. The direct model appears to be gaining traction and, in our view, has the potential to enhance the revenue and margin opportunity in its core business. As a result, it has grown sales in the past two quarters despite the sharp declines in overall U.S. drilling and well completion activity. Following stronger than expected second quarter revenues and earnings, the company’s shares rebounded sharply in the third quarter, generating a total return of 33.3%. We continue to like Flotek shares at current prices.
In the second quarter, SunEdison, Inc. and its “yieldco” (a dividend growthoriented public company, that bundles renewable long-term contracted operating assets to generate predictable cash flows and attractive income) subsidiary TerraForm Power, Inc. were among the top contributors to the Fund’s performance, all of which was wiped away in the third quarter as renewable energy companies accounted for a substantial portion of the Fund’s decline and relative underperformance. Up until this quarter, SunEdison had been successfully executing on its strategy to become the first renewable “supermajor” and had been developing its renewable energy project development engine both organically and through acquisition, ultimately becoming the world’s largest renewable energy developer. SunEdison’s plan was to own these projects and access a lower cost of capital through its “yieldco” subsidiaries, which are dividend-growthoriented companies with stable cash flow streams that would be valued separately from the developer parent. This ownership model results in SunEdison retaining a significantly higher net present value in the assets it develops versus the previous model of selling those assets to third parties upon completion.
SunEdison could either develop renewable power assets and retain the assets on its balance sheet or retain them within “warehouse” financing facilities for future sale to TerraForm Power (developed world assets) or TerraForm Global (emerging market assets), with the “yieldcos” benefiting from visible long-term growth in distributions per share (these retained assets become a source of future dividend growth for the TerraForm entities). A portion of the cash flow from the projects owned by the “yieldcos” is transferred back to the parent company, SunEdison, in the form of dividends and incentive-based distributions (IDRs) through its ownership of the general partnership of the “yieldco,” which completes the virtuous circle. This virtuous circle works as long as the TerraForms or the “yieldcos” can make value enhancing acquisitions, which is a function of having an attractive enough cost of capital and demonstrating to investors the ability to grow distributions per share over a multi-year period. This business model is extremely similar to that which energy MLPs have successfully executed for nearly 30 years, with dividend and IDRs providing a separate valuation lever that can be quite powerful for shareholders.
During the third quarter, equity capital markets for all types of energy companies including MLPs and “yieldcos” were under severe pressure as oil prices slid and fund flows in energy-related yield products turned negative. With limited growth potential expected due to diminished or no access to capital markets, investor estimates of discounted cash flow value of both the “yieldco” and the parent company’s future dividend streams were negatively impacted by assumptions of lower future retained cash flow and a higher assumed cost of capital causing the stock prices to decline. In addition, it now appears in hindsight that the multiple equity offerings from renewable energy companies between late June and early July also overwhelmed investor appetite for these deals, which contributed to a fall in share prices that may have been an additional trigger for the share price declines. This was a time when the virtuous circle turned into a vicious cycle.
It is one thing to understand what circumstances or events led to the performance that so badly hurt the Fund in the quarter, but it is another to figure out what the future might hold and what to do about it. As painful as this experience has been across all of the renewable energy holdings in the portfolio, we are not giving up on the sector or our investments in it. We believe that the biggest problem this quarter was a short-term lack of investor appetite and not a near-term fundamental change in the expected underlying economics surrounding renewable energy projects at either the utility or residential distributed generation scale. During the quarter, we met extensively with a number of companies and talked to other experts and performed extensive analysis to more fully understand the unit economics, returns, financing options, and growth potential for renewable energy projects in the U.S. and around the globe. Our research has led us to the following conclusions:
- There has been little change in the underlying economics of projects;
- The demand for solar and wind electricity generation facilities is robust and strengthening, particularly in emerging markets;
- While public market access to capital slowed in the quarter, public financing through “yieldcos” is a small percentage of the capital that funds the growth in Renewable Energy;
- Project financing availability and costs, as well as equity financing from more traditional sources such as infrastructure funds, pension funds, insurance companies etc…has neither changed nor gotten more expensive in recent months; and
- While investors have made a connection between oil prices and renewable energy demand, it is a specious connection as oil prices are rarely ever considered to be a factor in renewable energy project development discussions and electricity prices are rarely set by the price of oil.
These conclusions lead us to believe there is still a significant opportunity for long-term investors like ourselves to benefit as companies such as SunEdison and its subsidiaries create value from the substantial growth in renewable energy demand that we foresee over the next 5-10 years. We are always skeptical when we are told something abnormal or illogical will persist forever, and, in this case, we doubt that capital markets will forever be closed to these companies. Our confidence stems from the fact that we have seen this movie a few times in the last 25 years in the MLP sector. Considering the high quality and predictable nature of the cash flows that renewable energy facilities produce, their attractive internal rates of return, and the options for these facilities to generate additional value over the long term, it is hard to believe that equity investors will not want to underwrite the ownership of these projects and correct the valuation anomalies that we currently see in these stocks.
Portfolio Structure
At the end of the quarter, the portfolio was broken down into the following sub-industries or categories:
Oil & Gas Exploration & Production – The E&P sub-industry represented 36.2% of the Fund at the end of the quarter and continued to be mostly focused on U.S.-based producers that operate in a number of different unconventional resource plays in the U.S. While we have exposure to a number of the key shale plays in the U.S., the Fund had its biggest allocations to the Permian and Appalachian Basins, which represented over 50% of our investments in E&P and which we believe will be the premier, low cost and high return sources for U.S. oil and natural gas production growth over the next 5 to 10 years.
Oil & Gas Storage & Transportation – This sub-industry, which is largely composed of MLPs and publicly traded general partnerships, is the second largest sub-industry for the Fund and represented 26.1% of its assets at the end of the quarter. As noted, this sub-industry accounted for a meaningful portion of this quarter’s underperformance. However, we continue to view these stocks as having excellent long-term risk/reward characteristics.
Oil & Gas Equipment, Services & Drilling – Our exposure to this subindustry fell again in the third quarter to 11.1% due largely to relative performance differences with other parts of the portfolio. The earnings outlook for this sub-industry remains quite poor amid low rig counts and intense pricing competition, which should continue at least through yearend and perhaps into early 2016 before bottoming and beginning to recover.
Renewable Energy – Renewable or Alternative Energy is not a specific GICS sub-industry, but we think this is really the appropriate classification for our investments in the Utilities and Information Technology industries, since our investments in these two areas are primarily companies involved in the construction and operation of solar and wind electricity generation assets. As detailed above, this segment of the Energy sector was a big drag on performance during the third quarter and its weighting fell to 6.4% from 9.8% by the end of the period.
Industrials, Materials & Other – About 14.7% of the portfolio is invested in these areas, but most of our investments are in businesses that are closely related to the Energy sector and we believe will benefit from our long-term view on key growth trends affecting various parts of the Energy sector.
As valuations became more attractive across a number of companies that we track, including those already in the portfolio, we were fortunate to have had positive net inflows into the Fund, enabling us to add to 22 existing positions, the largest investments being in SunEdison and Targa Resources Corp.
In addition, we initiated a new position in Aspen Technology, Inc. after the shares pulled back on what we believe were misplaced concerns related to oil price weakness. Aspen is the leading provider of engineering, design, operations and supply chain management software to the energy and process industries. Its software is used globally by engineering & construction companies, oil & gas companies and chemical companies among others. Aspen recently completed transitioning its business model from selling one off “perpetual” licenses to a “term” license model where customers must pay an annual subscription fee to use the software. The new model also introduced the concept of “tokens” as a means to encourage wider adoption of its 70+ proprietary software modules. Aspen’s customers increase their token consumption when they use additional modules or allow more users to adopt the suite. Both innovations, coupled with a robust innovation pipeline, have helped to create a business with extremely high levels of recurring revenue, high retention rates, and a visible growth trajectory. The company has demonstrated strong margin expansion over the past six years as it has transitioned to a recurring revenue model. We expect to see margins continue to expand towards 50% over the next several years due to high incremental margins and low selling costs, which we think should help earnings grow faster than revenue.
We generally don’t write too much about our portfolio sales during the quarter. However, in the case of Flotek, it is unusual for a company to be a “top net sale” and still be a top five position. Our conviction on the longterm growth and return case for Flotek has not changed. In fact, based on the company’s differentiated financial performance over the past couple of quarters, it might actually have strengthened. However, we trimmed our position late in the quarter in order to keep the position at a size that seemed in our opinion more prudent and more comfortable in the context of the rest of the portfolio.
Outlook
Despite the magnitude of the share price declines in the third quarter, or perhaps because of them, we are increasingly constructive on the investment outlook for energy companies over the next 12-36 months for the following reasons:
- There is an increasing volume of data points that lead us to believe that a more imminent tightening of the oil supply/demand balance could happen that will drive oil prices higher than what is currently priced into the oil futures curve. We think the factors that are particularly underestimated by the investor community are the robustness of Chinese product demand, particularly for gasoline and jet fuel, as well as the magnitude of non-OPEC supply declines, especially in the U.S. onshore and international offshore fields;
- Investor sentiment toward commodities, including oil, and equities related to commodities is very negative. In addition, the degree to which investors are underweight energy stocks in their portfolios is at or below the lowest levels we have seen in at least 10-15 years; and
- The decline in share prices has resulted in much more attractive valuations, particularly on a normalized cash flow or net asset value basis.
Throughout the year, we have maintained the view that the imbalance in the oil market that has been the primary driver of lower oil prices has been overstated in its magnitude, and would slowly shift direction from oversupply to balance to deficit. It remains our view that prices are simply too low for the industry to generate enough cash flow and adequate returns to fund and justify the capital investments needed to offset ongoing reservoir depletion and grow production to meet future demand growth. Even as costs in the industry are reduced cyclically and secularly, it remains our opinion that the ongoing capital intensity of the business still mandates a higher long-term oil price.
Based on the data that we track, we feel even stronger that oil markets have passed the point of maximum oversupply and that the gap between supply and demand has consistently been narrowing since late in the first quarter. We have seen significant evidence that lower oil and refined product prices have more than offset diminished global economic growth expectations to drive 2015 oil and refined product demand substantially higher than it was forecast to be at the beginning of the year. This is particularly true in the U.S. and China, where gasoline and jet fuel consumption have made significant gains this year. While the rate of change is likely to slow heading into 2016, the absolute change in barrels per day for 2016 is already looking to be greater than consensus forecasts from earlier this year.
At the same time that global oil demand is looking more robust, it is also increasingly clear that non-OPEC supply growth is not only dwindling but is now expected to decline over the next three to six months. This is particularly true in the U.S., where production appears to have peaked in the first quarter. According to our analysis and that of the U.S. Department of Energy, the ongoing collapse in drilling and well completion activity is expected to result in further declines in supply through at least the majority of 2016. In addition, a recent report from a well-respected, European energy consultant concludes that production from mature offshore oil fields around the world could decline by over 10% in 2016 due to sharp cutbacks in capital investment. These fields represent over 15% of global production. The expected declines in production from the U.S. and perhaps from mature offshore fields around the globe, in the face of rising demand, will likely leave a widening gap between supply and demand. This gap could result in OPEC straining to or being unable to satisfy demand (even after the easing of Iranian sanctions in early 2016) implying inventory drawdowns in contrast to this year’s inventory builds. We believe that a reversal of inventory trends will be a key catalyst for investors to begin returning to the Energy sector.
As noted, investor sentiment toward the Energy sector of the market remains quite poor. We have referenced the BofA Merrill Lynch Global Fund Manager Survey in prior letters as a good proxy for investor sentiment and portfolio manager positioning. The most recent survey showed that fund manager weightings toward this sector at or near 10 year historical lows. The fact that the relative weightings have weakened further throughout the year, puts us deeper into the contrarian camp. We think the fact that investors are so apathetic toward this sector, combined with an improving outlook for oil and oil-related entities, could result in a more favorable environment for investing in Energy and related industries than has been the case for at least the last year. We continue to focus on taking a longterm approach, focusing our research efforts on companies that we think can grow in a profitable manner over the next several years, and positioning the Fund to best capitalize on the opportunities that we see coming down the pipe.
