We believe investors’ portfolios can benefit from actively-managed energy investments which have historically exhibited low correlations to broad equity markets but higher correlations to the inflation rate. We believe energy income investments (midstream/MLPs) are generally less correlated to interest rates compared with other income-oriented investments.
We believe energy investors can benefit from a process specifically designed to manage and profit from the cyclicality and volatility inherent in energy investing. We use ratios of market valuations to book values, typically enterprise value to invested capital (EV/IC). We believe that EV/IC ratios reflect the market’s expectation of future company returns. A company whose returns exceed cost of capital should trade at a premium to IC, while a company with returns below cost of capital should trade at a discount.
We believe that EV/IC is a superior metric compared to more common energy valuation metrics such as EV/EBITDA (for more, see HAL example). Metrics like EV/EBITDA, P/E and forward yield, which incorporate pro-cyclical cash flow and earnings estimates, often send “buy” signals at the peak and “sell” signals at the trough. EV/IC incorporates long-term return data to reduce cyclicality, providing a strong discipline that sends clear signals when decision-making is most difficult: at high points and low points in the cycle.
In a highly volatile sector such as energy, we find that big market swings (which often look reasonable on the basis of P/E or EV/EBITDA multiples) can push EV/IC multiples towards levels that imply returns well outside of a company’s historical return range (which we use as a buy/sell signal).
Indeed, energy cycles have shown that while commodity price volatility can be elevated for extended periods of time, company returns are generally mean-reverting: aggressive spending during periods of high commodity prices tends to drive down returns, while aggressive cost cutting during low prices tends to stabilize returns.