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How FPA Capital Stacks the Odds in Energy Picks

Jason Stipp

Question: What led to the energy overweight in the FPA Capital fund? 

Rikard Ekstrand: We actually started investing in energy back in early '99, when oil prices were $10 and natural gas was about $1 per MCF. At that point, we bought ENSCO International, selling at about 30 cents on the replacement value.

And then fast-forwarding, we got a big... Basically during the period from '99 to the latter point of 2008, we had been investing in energy. We had been trimming when stocks got high and buying when stocks got low.

So for example, the early purchase in '99, we then sold in 2000, and in the fall of 2001, we got the opportunity to really invest a lot more money when we had the September 11 event and the stocks came crashing down.

And then the stocks had a long run; we were trimming heavily in a lot of the stocks. Some of them we exited entirely. And then in the fall of 2008, we started looking at some opportunities coming up.

We didn't deploy cash until the fourth quarter of 2008. At that point we deployed our heaviest purchase program. We were sitting at north of 40% cash at that point. We deployed about two-thirds of the cash we deployed into the energy sector.

We bought companies at about a third of net asset replacement value. We bought five exploration and production companies that we had been looking at over six or seven years, we had just never gotten the prices.

So for example, we bought Cimarex Energy in the teens. And the stock was selling at what we thought was about a third of net asset replacement value, looking at the assets the companies had in oil and natural gas. The same was true for Newfield Exploration and CNX gas, and several others.

We also deployed capital in the oil service area. Two new names we bought were BJ Services, that then later has gotten taken over by Baker Hughes. As well as Pride International, which is in the jack-up rigs, semi-submersibles, and drill ships. That company had a backlog that basically covered the price that we paid for the company. We got the entire jack-up fleet and deepwater fleet for free.

Question: What is your thesis and outlook for energy going forward?

Ekstrand: When we started investing in this sector back in '99, we felt that over the long term, oil in particular had gotten to a point where the decline rates globally were reaching levels that were basically unprecedented.

We were looking at an IEA study about a year ago, and we were looking at it back in '99, and we we were seeing decline rates approaching 9% per year. When you look at those decline rates globally and you factor in the fact that we haven't really found any new areas for exploration except in deep water--and the deep water is really not enough to offset the decline rates to the extent that now we're looking at decline rates of oil where we're consuming about 30 billion barrels a year, and we're only finding about a quarter of that. So in other words, we're consuming about four times what we're finding.

Question: How do you control risk in an energy-heavy portfolio?

Ekstrand: What we like to do is, we like to stack the odds in our favor. So for example when we bought the companies we bought in the fourth quarter of 2008, the companies were selling at such low prices that even if commodity prices had stay depressed for five-plus years--which we thought was very, very unlikely unless you had a global depression for five-plus years, which we didn't see happening--that we actually would have come out about even, probably, if that had happened. Because the prices were so low that they could have just kind of liquidated the inventories, and we would have been OK.

We also look at the balance sheets. We buy companies with very strong balance sheets. Actually the companies that we had been looking at in the exploration and production sector, they got cut in half because the balance sheets just weren't as good. Over the time period they kept getting worse and worse. So we always focus on the balance sheets and the management teams.

Question: Why is the fund's cash stake holding relatively high?

Ekstrand: The cash stake is always a function of the opportunities. So when we look at the opportunities that are out there today, we don't think it's that attractive. And as a result, over the last 12 months, really starting in the fourth quarter of last year, we really started trimming more and more heavily.

As a result, cash has been building. For example, on the exploration and production companies that we bought, they've in a lot of cases tripled and quadrupled from where we bought them. And as a result we've taken off the entire investment we made in the companies and now we're really sitting with basically the gains.

Question: Does the fund operate any differently with Bob Rodriguez being on sabbatical leave?

Dennis Bryan: Our operations have not changed since Bob left earlier this year, and we expect Bob to be back in January of 2011. The operations in terms of what we do for the FPA Capital Fund have been in place for the last couple decades. I've been working with Bob since 1993 and Rik since 1999. So we're well endowed with the efforts in the management of the FPA Capital Fund.

In terms of how we do it, it's really the philosophy and the strategy that are key. And the strategy is really to invest in small/mid cap companies that are absolutely cheap, not on a relative basis. And the strategy is really to look at companies that are market-leading companies, a history of good profitability, and as Rik was saying earlier, with a strong balance sheet and a strong management team.

But the key really is this absolute value approach. It really doesn't matter if it's Bob Rodriguez, Dennis Bryan, or Rik Ekstrand, as long as we and anyone else adhere to that approach, over time that approach has proven to be a winning strategy.