Investment Universe, Process, Strategy and Benchmark – How does the Fund Manager invest? (ISIN: DE000A0MWKJ7)1.1 The Earth Energy Fund UI is invests in the Energy Industry. The subsectors that are being focused on, comprise conventional oil and gas producers, unconventional oil and gas producers, refineries, coal miners, uranium miners, the oil services industry as well as renewable/sustainable energy. Due to the scope and size of the industry, the portfolio is managed with a top-down approach as a first filter, i.e. defining macro-trends in the industry and then drilling down to companies that are set to perform well under those circumstances. Each and every stock selection is supported by a fundamental bottom-up analysis of the company. Exposure to super-major integrated oil companies is limited, as they are expected to respond mainly to beta trends only. Investments are typically 30% in large-cap companies ($10-100bn), 40% in mid-cap companies (($1-10bn) and 30% in junior companies (less than $1bn).
1.2 Portfolio Management Strategy and Investment Process
The Earth Energy Fund UI is a “long-only” fund. The management strategy focuses on active management of the portfolio. The aim is to maximise absolute return. The aim is not to follow or outperform any particular benchmark.
The decision process consists of two parts: macro and micro portfolio construction.
Top-down inputs for commodity prices, currencies and inflation rates are derived from a centralized database. Commodity price forecasts are divided into two sections: short/medium-term (5 years). The database is adjusted regularly (at a minimum on quarterly basis). A wide network of highly ranked brokers and commodity analysts provide guidance 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 definition 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 is given to the correlation of different sub-asset classes.
Micro component and Ranking
The stock selection process within the portfolio construction process focuses on a bottom-up analysis and the subsequent ranking of stocks. The ranking process is crucial in this regard and will be integrated within the EARTH ENERGY FUND UI database, taking into account the following valuation parameters:
• Net Asset Value (NAV)
• Near-term NAV growth
• Price to cash flow multiples
• Country and management risk
• Market cap
• And, ultimately, the expected return for the stock over a 12 month basis.
1.2.1 NAV This is the most important valuation tool for companies without established earnings and cash flows and projects in prefeasibility, feasibility or under development. These companies are usually seen as potential takeout targets. Hence we employ a similar valuation methodology to that used by the established producers in determining the value of the companies.
For energy companies we use a discount rate of 10% real to discount back future cash flows using our commodity price predictions.
Calculation of the NAV includes sophisticated techno-economic analysis and modelling.
1.2.2 Near term NAV growth This is an important ranking parameter, since high near term NAV growth (measured over the next 2 years) indicates the transition from the exploration to production stage. It takes cognizance of reducing capital expenditures (mine construction, oil field development) and generally coincides with increased market interest, reduced risk and higher share prices.
We have a natural bias towards companies with a high near term NAV growth. This will affect our risk factor that we apply, as well as our ranking relative to companies with similar projected returns.
1.2.3 Cash Flow multiples
In our opinion, cash flow per share projections, especially the change in cash flows, are the most important short-to-medium term drivers of the share prices of the established large and mid-sized companies in our investment universe.
Our 12-month targets for the large and mid capitalization energy companies is determined by considering the company’s operating cash flows and free cash flows based on our outlook for commodity prices and currency exchange rates 12 months out.
1.2.4 Country and Management Risk
The risk to the company achieving its operational and financial projections due to mineral right ownership, permitting, labour disputes, political, fiscal or legislative changes, and management competency. Companies are categorised according to A, B, C or D ratings.
1.2.5 Project Financing
Project financing is an important factor for investment decisions and portfolio construction, particularly with regards to the timing of any investment. Project financing risk is also affected by sentiment towards the sector and the quality of the projects. Hence it introduces a high degree of subjectivity with regards to investment decisions.
Monthly trading volume/shares issued (averaged over a 3 month period). Liquidity is obviously an important factor for investment decisions and portfolio construction. Exploration companies have generally a lower liquidity than more mature producers. Liquidity is used as a filter: only companies which can be liquidated in less 15 days (using average historic trading data) are considered for the portfolio.
1.2.7 Market capitalization
Market cap and liquidity are generally related, since low market cap stocks also have a lower liquidity. However, some mid and large-cap stocks are tightly held, whereas some small cap stocks have good trading volumes. We therefore use both parameters to consider the balance of investments in our Fund. Due to the capital intensive nature of the oil industry, market cap and liquidity are hardly ever a contentious issue.
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
From inception to September 2010: Jordaan Fouche; from October 2010: Willem de Meyer: "The early part of 2010 showed relatively flat performance, following markets recovery in 2009. From September 2010, with the announcement of QE2, equity markets started to perform positively. The EARTH ENERGY FUND UI showed significant outperformance due to its esposure to smaller cap oil producers and a large exposure to international coal producers."
Performance Review 2011
Willem de Meyer: "After the stellar performance of 2010, the early part of 2011 showed a slow decline in equity markets. The EARTH ENERGY FUND UI underperformed markets in general, due to its initial large exposure to coal producers, and its lack of exposure to independent refiners and super major oil companies. The independent refiners outperformed due to the discount that opened up between WTI and Brent.This also benefitted the super major integrated companies. In April, with the natural disaster in Japan and the subsequent nuclear catastrophe, the fund’s exposure to uranium producers contributed slightly to its underperformance. Equity markets then reacted very negatively in August to the US debt debacle and reached a low point in October. Recovery from there, were led by lower risk, large cap companies. The fund gradually moved its weighting more to large cap, senior oil producers and reduced its weighting to coal miners."
Performance 2012 - Year-to-Date
Willem de Meyer: "In spite of ongoing sovereign debt concerns in Europe, equity markets had a strong performance in the early 2 months of the year. The EARTH ENERGY FUND UI also showed good recovery. Given the indications of investor appetite for risk and equities returning, the fund slowly started to increase its exposure to small cap oil producers with exceptional resource upside. Investment in producers of natural gas are limited in light of persistent oversupply and low prices in North America."