Production and properties are two of the three "P's" professionals want to see before investing.
(Originally published in the StockHouse Natural Resource Supplement on March 7, 2006)
Production growth is nice. Properties filled with proven or likely reserves of resources are also important. But if there's one thing that professional investment managers want to know most about a resource company they are considering, it's the people running it.
"People are the king. Production is what they're looking for," said Glenn MacNeill, Vice-President, Investments at Sentry Select Capital Corp, and manager of two of that company's resource-based mutual funds. "I would rather invest in really good people I know with a lack of properties. The good people have access to properties and to financing, through who they know. They can access those other things."
He added that "people" extends beyond one or two key principals. "You want good teams. You want an engineer, a geologist, a land man, a financial person, a geophysicist. You need to see the complete set of skills."
Most investment managers have to consider all kinds of resource companies for their portfolios. They need larger companies, both for the stability they provide the fund, but also for the liquidity. But stocks like EnCana and PetroCanada are well covered by analysts and don't offer home run potential. Most investment managers enjoy the thrill of investing in a little company that nobody knows much about, and watching that company succeed.
Bruce Jackson is a managing director and manager at Barrantagh Investment Management, portfolio manager of GGOF Resource Fund. He said the most important factor in their evaluation of a company is the credibility and track record of management.
"People think credibility is subjective, not objective. Our objective approach is based on ranking management teams in five different silos," Jackson said. "We don't invest in a management team if we aren't able to measure and verify their credibility. By credibility, we mean consistently doing what they saying they're going to do."
It's not just a matter of investing in people you know; for the investment managers, it's committing capital based on what the company's managers know. The cyclicality of the resource industry means that experienced management teams often build new companies by developing properties where they already have had success.
"We love to follow a management team who leave a major producer to start their own company and go back and exploit a property," Jackson said, citing the First Quantum Minerals (TSX: T.FM, BullBoards) / Rio Tinto example. "They knew what was going on in Zambia before they started the company."
Jackson added that priorities can be different in the mining industry, where evaluating the assets is much more critical. "We like to see an ore body or potential ore body that is world class in its operating metrics or is in some way a strategic asset."
After people, the most important factor in MacNeill's evaluations is production growth.
"I like to have exposure to the high-growth mid-caps and juniors. I want them to create value for each share by increasing production on a per-share basis," he said. "For a mid-size or junior producer, you might expect anywhere from 25 to 100% annual growth. For a larger company, you might only expect eight to 15% growth. Every firm has to fight that annual depletion, well decline rates and grow their production. It's not an easy thing to do."
For Jackson, management is the most important of three items. They must also have a defensible business plan with assets. And third, the stock's valuation must be attractive based on cash flow. To get a more complete picture of a company, Jackson uses what he the "12-call rule," something he learned 20 years ago as a researcher.
"Even someone with a liberal arts degree can get a good idea of what a company is like by making four calls to competitors, four to suppliers and four to customers," he said. "You tend to get a very consistent message."
For a professional money manager, knowing when to sell a stock is just as important as knowing when to buy. If management hasn't changed, portfolio managers need a different trigger.
Jim Parsons, Managing Director of Middlefield Group, said that in his company's resource portfolios, the sell decision is primarily the result of failure to meet expectations.
"We meet with these companies very regularly. If they're forecasting exit rates of x, and they have one or two bad quarters, if there's no really good explanation, yes, we'll sell," Parsons said. "If it's weather related, or a universal issue for the industry, clearly we'll accept that. We sell if they are consistently underperforming what they say they're going to do."
Missed numbers often lead McNeill to sell as well. "You'd look at it from 'Why did you miss it? Is it going to happen again? If so, why, and what are you doing to prevent it?' If their story is matching up with the results, then ok. If not, goodbye."
For Jackson to sell, one of the three conditions that led him to buy the stock must have changed, either a change in management or a determination that their strategy is no longer viable.
"For us to sell a good management team with a good business model based on valuation, the valuations have to be stretched," Jackson said. "There are a lot of momentum players in the resource sector. We're paying a lot more attention to marginal buyers, those people who are setting the prices. If we see an excess of momentum money going in, we may sell, because we know they all get out at the same time."
Many of the largest oil and gas investments are in the form of income trusts, not corporations. For those trusts, a fourth "P" - payout ratio - can be as important as the people, production and properties.
In a trust structure, the free cash flow - earnings after expenses - is delivered to investors through monthly distributions. But distributing every penny led to fluctuations in monthly amounts. This lack of predictability led many investors to sour on the trusts, and pushed unit prices lower.
More recently, trusts are trying to establish payout ratios - distributing, say 75% of their cash flow - and holding the other 25% back to either cover for weaker periods, or using it to finance additional exploration, development or acquisitions. Fund managers value a trust on many dimensions similar to a conventional operating company - production trends, per barrel costs, exploration and drilling successes and failures - but also what to know what percentage of free cash flow is distributed. Too high a payout level increases the likelihood that distributions would be cut if commodity prices dropped. Too low a payout provides a less attractive yield.