Fidelity's Fruhan: Still Value in Energy

Andrew Daniels: Hello, I'm Andrew Daniels at the Morningstar Investment Conference. Today, I'm joined by Matt Fruhan of Fidelity Large Cap Stock.

Matt, thanks for being here today.

Matt Fruhan: Thanks for having me.

Daniels: You've been on the fund since 2005, and in that time the fund has posted very solid results. Could you talk a little bit about the investment approach and what you're looking for in different companies?

Fruhan: Sure. My investment philosophy and process has been the exact same since I started managing the Food and Agriculture Fund, now the Consumer Staples Fund, back in 1999. The investment philosophy is basically based on my belief that stock prices are driven by changes in long-term earnings and yield expectations. The further out in time one looks, the less accurate the market's earnings and yield estimates are. In an increasingly short-term focused market that values companies on short-term fundamentals, that creates a mispricing between a stock's long-term true intrinsic value. By combining deep-dive research with investment patience, we can exploit that inefficiency in the market. That's the investment philosophy. That has never changed. It won't ever change. That's my true north.

The investment process is very geared on working with our analysts, going deep into the models, and trying to find areas where we really see this three- to five-year earnings and yield delta versus first call. I really don't look at quarterly results other than to make sure that the investment thesis is on track to that three- to five-year earnings and yield power view. There are times when the market goes against what my view is on a stock's value, and having the investment patience to really ride through that often yields to fruitful results.

Daniels: It's been a tough couple of years for active management, but you've still managed to post very solid returns through that stretch. What's been the difference for you and your team?

Fruhan: I think actually as passive continues to take more market share, it's creating an environment where a lot of money is being managed in a reactionary way. Passive investing is by definition reactive investing. It does sometimes create momentum around certain industries or stocks. I actually think that creates an opportunity where if you look out longer term you can exploit that. 2016 was an environment where a lot of cyclical out-of-favor industries, energy and the financial sector, were at multiples in valuations that were not pricing in a lot of optionality that earnings and yield power would improve looking out one, two, three years. It got to such an extreme point where I think we saw a nice snap-back in the valuation around those industries and those sectors combined with a fundamental improving backdrop.

As the market started to get more comfortable in the financial sector, that we were potentially entering an environment of wage inflation and more global inflationary pressures, a lot of angst over the bank's net interest margin or the spread that they earn when they lend started to go away. We started to see earnings estimates for the banks ratchet up very nicely. And you had to be ahead of that. If you waited for First Call earnings estimates to start to move higher, the banks had already had a substantial move. That's why I think you have to be ahead of the game and think perspectively one, two, three years out in the future as to what the potential earnings power could be.

The energy sector was going through a similar period of angst in the market where with oil prices dropping, people were very concerned about what the long-term return and cash flow dynamics of the sector would be. I think the energy sector was a classic, and it's still in the mist of a classic cyclical cycle. A couple of years ago when oil was $100 a barrel or more, that led to higher returns on investment and that incented capital coming into the market. Capital coming into the market and more supply killed the energy cycle. That led to an imbalance, and prices corrected and fell quite dramatically.

That's a healing process. What you see when prices come down is that returns on investment come down, as well. As ROICs come down below the cost of capital, supply starts to exit the market. We started to see a lot of long-dated capital projects not being sanctioned, and so the seeds were being sown for an imbalanced period over a one-, two-, three-year period.

This was not really a demand problem. Demand kept on growing every year. It was a supply problem, and that tends to self-correct and self-heal. Last year, I think we started to see some of the global supply dynamic start to shake out. You started to see oil prices come back sharply, and some of the oil companies that were better capital allocators, that had clean balance sheets, do quite well in that environment.

Those two sectors really helped the fund last year.

Daniels: Where are you finding opportunities now?

Fruhan: The energy sector is still an area where I think there's a lot of opportunities. There's I think more of a debate in the market in the energy sector than some of the other sectors right now. The debate is really I think centered around supply, and it has to do with the markets focus on U.S. shale. U.S. shale is a short cycle supply. It's about somewhere between 5 to 7% of global supply. During the down cycle in oil, U.S. short cycle shale went through a big cost curve work down and technology really helped there, as well. U.S. shale's cost curve has come down quite a bit in the last two or three years. At $50 oil, you're starting to see rig counts come back in the U.S. market.

There's starting to be fears about U.S. production growth tipping the supply demand imbalance back out of whack. But it is a small percentage of global supply. Most of the rest of the world where we have conventional oil has had such a big cutback in capital that we're going to start to see in my mind that production start to fall off. You have the normal growth in global demand for oil basically offsetting most U.S. short cycle supply that's coming off the market, and the rest of the 93% to 95% of the market is not growing or shrinking. I think we're going to start to see over the next couple quarters to years a real rebalancing of the market which hopefully will lead to higher oil prices.

The stocks that I try to invest in in the energy complex, in general, are companies with really strong balance sheets. If I'm wrong on my view of how the global commodity cycle plays out, there's balance sheet strength to withstand lower oil prices but that also have a lot of capital that's already been spent with capex coming down and where the valuations are not demanding right now. If we get into even a slightly higher oil price environment, the ROICs and the free cash-flow of this company should be really significant. I just think in that scenario these are potentially mispriced cashflow streams.

Daniels: Matt, thanks for joining me today.

Fruhan: Thanks, Andrew. I appreciate it.

Daniels: From Morningstar, I'm Andrew Daniels. Thanks for watching.