Performance Review 2008
Jordaan Fouche: "During the 2008 financial crisis equities fell sharply. However, small and mid cap stocks fell even faster, due to higher perceived risk and lack of liquidity. The focus of the fund is on mid and smaller cap companies, many of whom had projects in developing countries. The general flight out of equities and in saver asset classes resulted in a severe drop in the fund performance. As a result the fund underperformed its peer group."
Performance Review 2009
Jordaan Fouche: "After the severe selloff in 2008, which was partly driven by panic selling and not by fundamental valuations, the invested stocks showed historically low valuations. For example, some market caps were below net cash holdings, which emphasised the attractive valuations of the fund. With a return of the market to value investing, the fund could significantly outperform the shown benchmark (+68% vs. 31%).
The positive performance during 2009 emphasised the observation that the Earth Energy Fund UI can outperform its peers in times when the market is driven by fundamental valuations."
Performance Review 2010 - Year-to-Date
Willem de Meyer: "During 2010, the Earth Energy Fund performance reflected the volatile, but generally sideways, trend of global energy markets, with the oil price stuck in a trading range of $70/bbl to $85/bbl. However, careful stock selection and sector allocation (oil vs. natural gas weighted and exposure to coal producers) started to pay dividends at the end of this period when investor sentiment towards the energy sector turned positive. The fund also benefitted from a few corporate acquisitions of companies in its portfolio. The fund reacted sooner than the shown benchmark to these developments and were up YTD 26% vs. the benchmark 10% at the time of making the graph above."
Performance Review since 2008
From inception to September 2010: Jordaan Fouche; from October 2010: Willem de Meyer: "The fund performance graph since inception shows the nature of investing in mid and small cap stocks and exposure to projects in emerging markets: these perform relatively worse during times of strong market corrections (2008). However, the solid bottom-up stock selection approach can result in superior returns when the market is focused on fundamental analysis.
Due to its long-only character (UCITS III) the fund cannot “go short” or take similar protective positions. However, from past experience, it is believed that volatility can be controlled during phases of strong corrections by investing in financially sound companies, shifting the weight towards higher cap companies and increasing the cash holding (to 20%)."
Investment Process and Strategy – How does the Fund Manager Invest?
Willem de Meyer: "The ERIG Funds are “long-only” funds. The management strategy focuses on the active management of the portfolio, i.e. the aim is to provide a portfolio return that exceeds a fixed return (7% per annum). The decision process consists of two parts: macro and micro portfolio construction.
1.1 Macro component
Top-down inputs for commodity prices, currencies and inflation rates will be derived from a centralized database. Commodity price forecasts are divided into two sections: short/medium-term (<5years) and long-term (>5 years). The database is adjusted regularly (on quarterly basis). Information from a wide network of highly ranked brokers and commodity analysts are taken into consideration in the top-down approach.
The macro component of the portfolio compares market capitalizations, outlook and liquidities for the various commodity sub-sectors, aiding the allocation of weightings of these sectors in the portfolio. Further consideration in the weighting process is given to geographical distribution. In the weighting of sub-sectors, special consideration will be given to the correlation of different sub-asset classes (e.g. the correlation between gold price and oil price).
1.2 Micro component and Ranking
The stock selection process within the portfolio construction process focuses on a bottom-up analysis (see below) and the subsequent ranking of stocks. The ranking process is crucial in this regard and will be integrated within the ERIG FUNDS database, taking into account the following valuation parameters:
• Net Asset Value (NAV)
• Expected return
• (2-year) NAV growth
• Balance Sheet strength
• Access to financing
• Liquidity
• Market cap
2 The ERIG value approach
The ERIG Funds invest “away from the benchmark”. Investments will only be guided by the company valuations. Focus will be on “undiscovered”, undervalued companies and projects. The value approach should offer potential for capital gain, regardless of the long term increase of underlying commodity prices. Underlying the capital gain estimate is the “valuation curve” of resources companies.
2.1 Bottom-up Approach
The aim is to identify companies which are trading at a significant discount to their NAV. This requires an understanding of the “valuation curve” of exploration companies and projects.
3 Portfolio construction
The portfolio consists of 35-45 stocks. Although stocks with market caps below US$300m will be considered, liquidity constraints will limit the number and weighting of such stocks. Such companies do not present more than 10-20% of the portfolio. Target fund size is expected at €2,000m-€3,000m.
The portfolio is actively managed, i.e. a stock will be sold, if a company’s share price exceeds its determined target price. Target prices will also include a take-over premium (in general 30-40%).
Investment Outlook
Willem de Meyer: "Amid the background of rising demand and falling supply, natural resources and energy in particular are expected to remain an important investment topic over the next years. However, maximising returns of a natural resources portfolio requires a combination of investment and mining and energy industry knowledge. ERIG’s investment team therefore combines solid operational and industry experience as well as a sophisticated fund management experience.
The portfolio management process of the fund is guided by a combination of top-down market analysis and bottom-up stock picking, whereby sector allocations (e.g. oil, coal, uranium and service industries) are based on the macro outlook (e.g. of commodity prices, global demand trends, inflation rates, exchange rates etc.).
The management strategy relies on an active review and management of the portfolio relative to market conditions and the macro outlook, and positions will be selected and monitored by a combination of top-down and bottom-up processes.
The Market for Energy
The extraordinary economic and population growth experienced by China, India and other developing countries will result in an unprecedented competition for energy resources over the next decades. In order for developing countries to sustain their high rates of growth, they will require an increasing amount of oil, coal and uranium. From historic data a strong positive relationship between the per capita demand of energy and the per capita increase in GDP, is observed.
“... for the first eighteen centuries of the Christian (or Common) Era, the two largest economies were China and India. They didn’t experience the Industrial Revolution and therefore ceded leadership to America and Europe. In the first half of this century, the world will revert to normalcy.”
Christopher Patten, Chancellor, University of Oxford and former Governor of Hong Kong
Figure 1: China’s and India’s growth in Perspective
Figure 2 below shows the historical correlation between GDP per capita and oil consumption per capita for developed and developing nations. Using the regression formula deduced from these data and the recent population growth rates for China and India, it can be estimated that China will reach a GDP per capita of $15,000 and an average annual oil consumption of 7bbl/capita by 2023. At the same time India will reach a GDP per capita of $8,000 and an average oil consumption of 4bbl per capita. Multiplying these numbers with the expected populations of 1.4bn (China) and 1.5bn (India), respectively, will result in an oil demand of approximately 43mmbbl/day – that is equivalent to four times the amount of oil these countries use today and at least half of today’s worldwide oil demand!
Figure 2: Oil consumed per person per year as a function of GDP per capita
Source: IEA, ERIG
Concurrently, we see that, globally, the discovery and development of new oil reserves have not been sufficient to replace production on an annual basis. This is illustrated in Figure 3 below.
Figure 3: Oil Reserve Replacement vs. Exploration Expenditure
Source: SEB Enskilda, ERIG
We therefore expect that oil supply may be sustained at current levels, at best, or even decline with diminishing exploration success. Another unmistakable trend is that new oil reserves are found in more remote locations (deeper offshore areas), or are more difficult or costly to extract (e.g. Canadian oil sands). As these new reserves replace the declining cheap reserves of the past, it is clear that the current low oil price of $70-80/bbl is therefore not sustainable and the world has to prepare for permanent oil prices above the $100/bbl level.
Alternative energies will be needed to fill the growing gap between conventional oil supply and demand, but these will only partly be able to substitute natural energy resources over time. In order to allow for the exploration and development of ever deeper and more costly oil deposits (including oil sands), we believe that oil prices must rise in the future (hopefully with low volatility due to speculation activity). Attractively valued oil companies with good exploration upside will benefit from this scenario.
From the above review we remain optimistic regarding the natural resources and energy universe and believe that well researched energy companies can also in future provide superior returns."
