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Energy in Cambridge Canadian Dividend Fund - Why and Why Now?

Stephen Groff's picture

  • With the sharp reversal in investor sentiment over the past couple of years, we have been finding a number of attractive risk/reward opportunities in the Canadian energy sector.
  • We don’t own all Canadian energy companies; we own a select group of high-quality, free cash flow–generating businesses trading at attractive prices.
  • Strong companies have the cost structure, balanced sheet and free cash flow–generation profile to enable continued value creation, even under challenging conditions.
  • We avoid low-quality companies and focus our time on management teams who are strong operators and understand the importance of intelligent capital allocation.
  • Two examples of Canadian energy companies that we own in Cambridge Canadian Dividend Fund are Canadian Natural Resources Ltd. and Keyera Corp.

We would like to thank all who shared our recent job posting ad. We received 1,052 applications and are in the process of starting first-round interviews. We look forward to continuing to invest in top-calibre talent.

The purpose of Cambridge Canadian Dividend Fund is to compound capital over time while taking prudent amounts of risk. This is to be achieved by owning high-quality businesses that are returning capital to shareholders in the form of dividends or share repurchases. We aim to own these companies at prices that offer upside potential while managing downside risk.

As many of you know, we are benchmark-agnostic and will go where the opportunities are. Today, Canadian energy is an area we are finding a number of attractive risk/reward opportunities. Not surprisingly, some have been asking about the increased ownership position in energy companies given the energy sector is not often associated with quality companies. 

Before discussing the opportunities we are finding, it is helpful to see how much has changed (or not changed) over the past two and a half years. 

  End of 2016 Today

West Texas Intermediate (US$)

$54/bbl

$53/bbl

Western Canadian Select (US$)

$38/bbl

$39/bbl

Canadian dollar

$0.74 

$0.74

Energy sector vs S&P/TSX Composite

Negative 25% total return since Dec. 31, 2016 versus 
Positive 12% for S&P/TSX Composite (37% underperformance

Energy as % of Cambridge Cdn. Div.

Under 6%

Over 20%

Investor sentiment on energy

Commonly owned

Almost universally hated

Energy management team morale

Confident

Often visibly depressed

​A few years back, the energy sector was perceived much more favourably by both management teams and investors. We found few opportunities at that time, as evidenced by our very minimal weighting in the sector, and we often received questions as to why we were not more heavily invested in the space. Fast forward a couple of years and the situation has dramatically changed, with both investors and many management teams ‘throwing in the towel’ so to speak. While headline prices for crude oil are actually quite comparable, there are obvious challenges for the energy sector, which have impacted business outlooks and valuations. That being said, many weak companies are being financially pressured (which will ultimately improve industry structure for the survivors), greater attention is being placed on the issues at hand and many management teams are finding religion again when it comes to capital allocation. Let’s also not forget that valuations have corrected to a large degree – and what you pay for an investment plays a critical role in both the return and risk profile of any investment.

Another important distinction is that we at Cambridge are not buying Canadian energy. Rather, we are buying select quality and attractively valued businesses that happen to be in the Canadian energy sector. This is a subtle but important difference. There is no shortage of low-quality companies in the energy patch. We will simply sidestep those, preferring to focus our time on company management teams who are strong operators and understand the importance of intelligent capital allocation (with a focus on investing in the areas where they can earn the highest rates of return).

While Canadian energy companies are facing numerous and well-publicized challenges ranging from egress to political uncertainty, strong companies are going to come out the other side in a much stronger position than their weaker peers. Strong companies have the cost structure, balance sheet and free cash flow–generation profile to enable continued value creation, even under challenging conditions. The valuation dislocation witnessed in the market today is also creating meaningful opportunities, not just for investors, but also for the companies themselves.

For example, we recently had a conversation with a management team who was frustrated with its company’s share price. We asked team members how seriously they were considering meaningful share repurchases given their company’s strong balance sheet and excess free cash flow generation. Their response was they were considering it. Our response was that at the current share price, it likely represented the highest return (and lowest risk) investment they could make. We hope they give this use of capital the consideration it deserves.

Fortunately, a number of management teams have figured out the simple but powerful impact of intelligent capital allocation. Having a share price well below a reasonable intrinsic value, while frustrating, is frankly a great opportunity that should be taken advantage of if it is the highest returning use of capital and the business is on sound financial footing.

Some examples include Canadian Natural Resources repurchasing substantial (4% of shares, plus a 4% dividend, plus an additional normal-course issuer bid) amounts of shares at what we believe are highly attractive prices, Keyera continuing to invest in high-returning and low-risk capital projects and Canadian Natural Resources making a well-timed and well-priced acquisition of the Devon Energy Corp.’s assets in Western Canada.

There is no doubt Canadian energy companies are facing challenges, and a number will not survive if conditions do not improve. Fortunately, we don’t own all Canadian energy companies; we own a select group of high-quality, free cash flow–generating businesses trading at attractive prices, which happen to be in the Canadian energy sector.

We remain disciplined in following our bottom-up fundamental approach to investing, and we appreciate your continued support.

Stephen Groff

 

IMPORTANT DISCLAIMERS

Stephen Groff is a Portfolio Manager to certain Cambridge funds. He does not have a material interest in the securities discussed herein; however, he is an investor in certain Cambridge funds that may hold these securities.

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Published June 17, 2019.

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