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Energy windfall highlights the promises and perils of contrarian investing

Lewis Jackson  |  22 Oct 2021Text size  Decrease  Increase  |  
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Contrarian investors should be guided by valuations, constantly revisit their investment thesis and be ready to accept missteps on the way. That’s according to two fund managers whose outsized bets in the unloved energy sector started to bear fruit in the September quarter.

Bronze-rated Allan Gray Australia Equity and Silver-rated Lazard Select Australian are among those funds with the largest holdings of energy producers Woodside Petroleum, Oil Search and Whitehaven Coal.

And those bets have begun to pay off thanks to soaring global energy prices. Allan Gray’s fund is up 5.5% and Lazard’s 10.9% in a quarter where the S&P/ASX 200 TR Index added just 1.7%.

Building big positions against the grain requires nerves and willingness to check and re-check the investment thesis, says Dr Suhas Nayak, a co-portfolio manager at Allan Gray.

"The nature of our investing style is that we're always holding these things that are quite unloved at any point in time. Energy stocks are no exception to that,” he says.

"Because we're always uncomfortable we spend a lot time trying to tear apart the thesis and revaluate.”

Contrarian positions can take time to deliver. Allan Gray has owned Woodside from 2014 and Oil Search since 2017. Morningstar data shows Lazard first bought into Woodside in 2015 and has owned a meaningful chunk of Whitehaven Coal going back to March 2019.

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"Nature of investing is that you get some things wrong over time. Those first investments into some of these companies were clearly at higher points to today,” admits Nayak.

The S&P/ASX 200 Energy index is up 0.34% on a five-year basis, versus 6.38% for the broader index.

Both funds still trail the S&P/ASX 200 TR on an annualised 5-year basis despite the recent boost. Allan Gray’s fund and Lazard’s returned 9.3% and 7.1%, respectively versus 10.4% for the index.

Valuations help inform when to step into the market, says Aaron Binsted, a portfolio manager at Lazard Asset Management. The fund has added to its positions at moments when prices fell, as they did in April and May 2020.

"It's a willingness to back valuation and the view you have. When we saw the prices that were there, they were absolute guineas and we saw a lot of money for our clients,” he says.

Morningstar analysts still see value in the energy sector. Where the broader market is trading at a 7% premium to fair value, energy names such as Woodside or Whitehaven are at double digit discounts.

Backing fossil fuels in a renewable world

Despite the growing adoption of renewable energy, both managers argue that the supply and demand dynamic for transition fuels such as natural gas supports a short to medium term investment case.

Asian demand for natural gas is projected to grow for decades as economies turn off their coal-fired plants and look for reliable alternatives to feed the energy demands of growing middle classes.

Binsted claims natural gas use is set to grow at a 4% compounded annual rate for the next twenty years.

“It’s really about Asia. What the western hemisphere does is not that important,” he says.

That demand will be buttressed by the 1.5 billion people the World Economic Forum forecasts will join the Asian middle class this decade.

Continued demand could butt up against years of underinvestment in supply and keep prices high, says Nayak.

The oil and gas majors have held off expanding supply because of years of low oil prices and pressure from shareholders leery of massive outlays.

“There’s been a cut in capital expenditure in an industry which requires investment just to keep production flat,” he says.

According to a 2021 report by the International Energy Agency, a rich world policy body, upstream oil and gas investment is still well below pre-crisis levels.

Investing in fossil fuels can also contribute positively to the energy transition, says Binsted. Instead of cutting polluters from portfolios, investors should use ownership to persuade boards to cut emissions.

The alternative is letting other investors take these companies private, where there is less scrutiny and transparency.

He says the fund engages with companies such as Woodside and Whitehaven on reducing the emissions they produce directly.

is a reporter and data journalist with Morningstar. Tweet him @lewjackk or get in touch via email

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