Industry Research
Our Investment Team has significant direct experience in the energy industry and in asset management. Our Investment Team’s asset management experience includes areas such as securities analysis, portfolio management, equities, commodities, derivatives, and developed and emerging markets on both the long and short side. We view this experience as invaluable in providing industry-level perspective and context to each company’s situation.
Our industry research, like our company research, is all original. We collect data from original sources and perform our own analyses on the supply, demand and cost economics of the various oil and gas producing regions in North America, as well on trade flows, inter-fuel competition, conservation and components of demand growth. We also conduct our own research on various regulations that directly and indirectly affect the returns on capital our portfolio companies can earn.
Fundamental Company Research
We maintain detailed financial models within an addressable investment universe of about 121 companies. Additionally, we visit these companies when possible at their home offices, in the field, and at industry conferences. This work is done by each of our seven investment professionals. At EIP, we believe that portfolio managers should do their own financial analysis and not relegate this task to a team of analysts lacking the extensive experience and context needed to translate hours of management conversations into a financial forecast.
Since we generally invest in companies that pay out most or all of their free cash flow, we seek to understand the underlying character of these cash flows: specifically, how cyclical they are and how much cushion there is between that free cash flow and the dividend. This is always developed in the context of the service these particular assets are providing as well as the competitive landscape. It is also tempered by consideration for management’s track record for delivering results against past budget targets. How the company manages its balance sheet and capital spending are also critical to our analysis, especially in assessing the company’s prospects for growth versus its ability to sustain and not cut its dividend.
Process Overview
We locate our investment opportunities at the intersection of (i) non-cyclical, publicly traded companies operating monopoly-like infrastructure related businesses in the energy industry and (ii) high payout ratios.
We believe that successful companies operating in mature businesses with slower sales growth stay successful only if they are disciplined in how much profits they reinvest. For example, a company growing earnings 10% that reinvests all of its earnings would grow its capacity 10% per year. If the demand for that industry’s product grows at rates of only 1-2% (as the energy industry does), then that industry will either build too much capacity or drive up the cost of that new capacity. Either way, returns will decline.
RAB businesses have, in our opinion, the characteristics of companies that succeed over the long term. They have high single- to low double-digit returns and low single-digit sales growth. The only way to sustain high returns in an industry with low sales growth is by returning cash to shareholders via dividends or share repurchase. Returning cash to shareholders forces a high-grading of the projects and acquisitions invested in by the company. The more cash that is returned, the higher the capital spending discipline effect. We recognize companies with policies or corporate charters to pay out all or most of their available free cash flow as monthly or quarterly distributions or dividends as having built-in capital spending discipline.
Investment Process
Our investment process has three main phases. The first step of the investment process is identifying a universe with two key characteristics: 1) non-cyclical cash flows based on a monopoly infrastructure and 2) a high payout ratio. While identifying companies by their payout ratio is a fairly simple exercise, understanding the nature of the businesses the companies are engaged in requires an extensive knowledge of the energy industry and its related parts such as oil and gas production, gathering and processing, transportation, refining, fractionation, blending, petrochemicals, shipping, marketing, storage and trading and optimization. We conduct industry research including by means of onsite visits with company management and attending industry conferences.
The second step in our process is to cull the low quality companies. While this process is made up of quantitative elements such as financial leverage, dividend payout ratio, earnings growth and variability, it is ultimately a qualitative assessment. Some of the qualitative elements that we evaluate are the skill of management, the competitiveness of the assets, regulatory environment and relationships, and the history and background of the company’s strategy. Companies that make it past this second step are usually included in our portfolio if their expected internal rate of return is acceptable relative to risk. No level of cheap valuation can overcome this step.
Portfolio Construction
The final step in our process is portfolio construction. The company’s expected returns, which are determined by the company’s current yield, expected growth and expected change in valuation, must be acceptable relative to the risks. The company must also positively contribute to our portfolio’s overall return and risks characteristics by adding diversification across a number of metrics such as business segment exposure, geographic exposure, market cap and asset class. We also seek to manage the risks of individual names in the portfolio by keeping positions sizes relatively small.
At EIP, we believe that balancing attributes such as position size, yield, dividend coverage ratio, interest charges as a percent of EBITDA, growth, valuation, exposure to each industry segment, regulatory framework, and management ownership enhances portfolio construction. We view portfolio construction as just as important as security selection. It is not just a matter of how many “good picks” we have in our portfolio, but also their size and the size of the bad picks as well. What matters is the total return of the overall portfolio, its underlying risk, its volatility, and its covariance with other asset classes (see the “Analysis of Returns” section for a discussion of volatility and covariance of our portfolio). Ultimately, we place greater weight on downside risks than upside potential.
We believe there is a difference between risk and volatility of security prices. When we think of risk, we must consider the underlying business and how that business is formed, its balance sheet, and capital spending behavior. Companies with too much leverage, uncompetitive assets and cyclical cash flows are at risk of going bankrupt regardless of historical share price performance.
Components of Total Return Framework
In a world focused on relative performance and its various benchmarks, we pride ourselves in being total return investors, and as such we always bring everything back to the metrics we see as composing total return—yield, growth and change in valuation. While we cannot predict the returns our portfolio will generate in the future, we can analyze our returns to date and how the composite metrics may be expected to drive returns going forward.
The total return for all investments, in our view, is made up of the yield and the price change, or capital appreciation or depreciation, of the security, whether that security is a stock or a bond. Decades of history suggest, in our view, that equity prices, over the long-term, will generally follow the per share measures of value like earnings, dividends, cash flow, book value, etc. However, in the short-term, equity prices tend to be far more volatile than their earnings, as sentiment swings with the economy in general or a single company’s fortunes in particular. In other words, valuation fluctuates even if earnings and dividends are stable. So, by dis-aggregating changes in a stock’s price into two components: growth and changes in valuation, we get a simple equation: Total Return = Yield + Growth +/- Change in valuation.
Not only is this simple construct useful in explaining total return history and total return expectations, for us, it acts as a constant reminder of what criteria really matter in stock selection and portfolio construction.
While these components may seem obvious to some, we do not see this framework used by most fund managers to describe their returns. Instead, historic returns are compared to various benchmarks or indices and broken down into “alpha” and “beta”. How much of a given return is “alpha” and how much is “beta”? These rhetorical questions cannot be answered because we don’t know how the relevant benchmark or index performed during this hypothetical example. Since EIP is not an index investor, we think about how to maximize returns adjusted for risk focusing on the drivers of that return as discussed above. Our view is that other factors are useful to analyze and understand only to the extent that they affect these extrinsic drivers and the risk of the investment.
Earnings Stability
As a total return investor, EIP focuses its investment approach on the component metrics of total return including yield and growth. We consequently seek to construct a portfolio that compares favorably by these metrics not just with the energy sector or a given index but more broadly against the S&P 500 and the market as whole. While our portfolio companies’ price performance may move in sympathy with the energy sector or the broader market in the short term, our concern, once again, is for competitive returns over a long time horizon, and earnings stability in particular in our view directly affects yield and growth and therefore drives long term returns in a number of ways.
First of all, we believe companies with stable earnings tend to have higher long-term earnings growth due to the fact that earnings cyclicality is disruptive to the business planning process of publicly traded companies and subject to investor pressure favoring acquisition or divestment depending on performance. We also believe that earnings stability can support higher dividend payouts and capital spending discipline because companies would be reluctant to set dividends at a level where earnings variability could compel them to a near-term cut. Finally, earnings stability provides long term protection for how the market values companies as data shows that earnings stability and valuation tend to be correlated over time.
We invite you to take a deeper look at how to invest with us.