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Wallack: Finding Value in Energy, One Company at a Time

Katie Rushkewicz Reichart, CFA

Katie Reichart: I'm Katie Reichart with Morningstar. I'm here with David Wallack of T. Rowe Price Mid-Cap Value. David is Morningstar's domestic stock fund manager of the year for 2016. 

Thanks for being here, David.

David Wallack: Thank you, Katie.

Reichart: The fund had not only a great year in 2016 but a superb record dating back to your late-2000 start. What's driven the fund's success?

Wallack: I'd say it's a combination of a few things. First, being at an investment firm that values fundamental research and understands the importance of really getting to know companies well. I'm very fortunate to work at a firm like that, which is T. Rowe Price.

I think it's also taking a long-term focus and being willing to go against the grain sometimes and buy when others are selling and sell when others are buying, which can be harder to do sometimes than you might imagine. When folks are selling stocks aggressively and sentiment is very negative, sometimes it's difficult to step in. But that's the essence of what we try to do is find companies that are trading below what they're worth. When that happens there's usually some sort of uncertainty or question about the business, sometimes due to cyclical factors, sometimes due to things that the company itself may have caused for itself.

We take a long-term time horizon. We try to understand what companies are capable of generating in earnings and cash flow over multiple years. We want to know what a business is worth to a potential acquirer. If you take that kind of approach I think that gives you the opportunity to think long-term, which is what we try to do. The good investment research capabilities that we have at T. Rowe Price, it's getting to understand companies well and what they're worth, and then being willing to own them for the long run.

Reichart: Energy was one area that was successful for the fund in 2016. You boosted the fund's stake in the first quarter. What gave you confidence to add to your position, and how do valuations look now?

Wallack: We began to increase our holdings in energy stocks in 2015. You'll remember that oil prices were $100 a barrel for several years before they began a long descent to around $30 a barrel. The energy sector came under a lot of pressure in 2015 through the year and then into the beginning of 2016. At that point oil prices had fallen to levels which were more or less at the cost of production for the average industry producer in some of the basins around the world. I'll get back to the importance of that in a moment.

What we saw was quite a few companies that had been around for years, that had a history of success, that had proved, developed, producing reserves of oil and gas that were trading in the marketplace for $10 a barrel or less. The average cost to find and develop oil in the industry has been around $15 a barrel for the last 10 years. We looked around and we said to ourselves, "Gee, Hess Corporation and Murphy Oil and Devon, companies like that are trading for $10 a barrel. It's cheaper to drill on Wall Street than it is in the oil field." This was really a perspective on the value that we saw in these individual names. It was not a call on the oil price. The only observation I would make would be when in a commodity business prices fall to cost of production, that often marks the bottom because that's when producers shut in production. They begin to cut back on investment, and prices typically find an equilibrium.

It was not, "Gee, we think that oil prices are going to rocket from the bottom here." I'd say that was somewhat fortuitous. We're prepared to own stocks for a number of years if we have to.

Reichart: You're a very eclectic investor and will often look for value in places some of your peers might avoid, including owning two biotech companies. How do those fit into the context of the portfolio?

Wallack: As you say, we're pretty eclectic, and we're willing to buy companies in just about any industry provided there is something unique about the business, it has good financial stability, it's worth something more than it's trading, and we don't feel we have a tremendous amount of risk owning it. Biotech stocks from time to time more or less fall in our lap. First of all, we have tremendous expertise at T. Rowe in analyzing healthcare companies and biotech stocks. I certainly couldn't do this at home, so to speak.

Last year there were a couple stocks that essentially traded for the value of the cash on the balance sheet and the royalties. One example would be Alkermes, which we own, which had fallen from the 60s to say $30 a share or below, at which point we said, "Gee, they've got drugs that have been commercialized here that are being sold by big companies like J&J. They earn royalties from this. They have cash on the balance sheet and they have multiple shots on goal, so to speak, with a number of drugs in the pipeline and two new drugs which are being commercialized." They specialize in diseases of the central nervous system, which would be depression and schizophrenia and drug abuse, which are areas where there's always a need. We just looked and said, we're not sure how long we're going to have wait here, but we essentially are buying this for the cash value and are getting a number of opportunities to make a lot of money if even one of these drugs proves to be commercially successful.

Reichart: Looking ahead to the rest of 2017 what are you most optimistic and most worried about in regard to the portfolio?

Wallack: I'm most optimistic that the stocks that we own have good prospects over the long run and good risk/reward. I try not to spend a lot of time thinking about the macro economy. It's just not my center of expertise. I try to focus on the individual companies and businesses.

What I worry about is how I missed something. Because we're very risk-conscious and we try to understand how much money we could lose relative to how much we can make. We're looking for a scenario where obviously there's a disproportionate relationship in our favor. I spent a lot of time thinking about how we can lose money in each stock and continually revisit that. To the extent I worry, I save my worrying for the individual stocks. Everyday, is there something I'm missing in this one or this one or this one?

Reichart: David Wallack of T. Rowe Price Mid-Cap Value, thanks for being here and sharing your insights.

Wallack: Thank you, Katie. I very much appreciate Morningstar's vote for me and your support over the years.

Reichart: For Morningstar, I'm Katie Reichart.