My Investment Philosophy

Next week I will present a talk at Investing Daily’s annual Wealth Summit in Alexandria, Virginia. The title of my talk will be “Future Currents: Where the Global Energy Sector Will Flow.” This will be my second Wealth Summit, and as I did last year I will share my personal portfolio with attendees.

Since a small fraction of subscribers will actually attend the event, I want to share it today with subscribers. I will include the date I acquired shares, the percentage of my portfolio they represent, and my rationale for holding the position. In future issues I will drill down deeper into the fundamental story for each company.

First, I want to note my investing philosophy, because it may be very different from your own. These stocks may not be appropriate for you, depending on your outlook and time horizon. I am essentially a fairly conservative, buy-and-hold investor. I attempt to identify long-term uptrends, and position myself accordingly in what I consider the best companies in the sector.

I am a value investor, so I look for out-of-favor companies that I believe the market is unfairly discounting, or is undervaluing on the basis of short-term factors. I have 20 years left until my target retirement date, so I am willing to tolerate a 20 percent loss on a stock if I believe the long-term story remains positive. Investor sentiment can certainly turn against a company with a good-long term story, but over the long term I believe fundamentals will ultimately win out.

My allocation isn’t one that a financial advisor would recommend. Most would say that I am overweight stocks, and overweight the energy and healthcare sectors. Energy investments make up 28.8 percent of my portfolio. Other major sectors are health care mutual funds (20.4 percent) and technology mutual funds (4.9 percent). I also have 6.7 percent invested in international mutual funds, 7.3 percent in Fidelity Low-Priced Stock Fund (FLPSX), 6.5 percent in Vanguard Morgan Growth Fund (VMRGX), and 8.2 percent in Vanguard PRIMECAP Fund (VPMCX).

My energy holdings aren’t in mutual funds, because frankly I have outperformed most of the energy mutual funds over the years. I believe I understand the energy sector better than most of the energy fund managers, so I don’t entrust my money to them.

I hold four energy companies in my portfolio: ConocoPhillips (NYSE: COP) at 15 percent of my overall portfolio, Phillips 66 (NYSE: PSX) at 7.5 percent, Devon Energy (NYSE: DVN) at 3.2 percent, and Cabot Oil and Gas (NYSE: COG) at 3.3 percent. I would still buy all four of these companies at current prices. If I were to add another company today, it would be Chicago Bridge and Iron (NYSE: CBI).

ConocoPhillips

My COP shares trace back to the years I worked for ConocoPhillips. From 2002 to 2008, I worked for ConocoPhillips and participated in its profit sharing and 401k programs. Each year the company would contribute ConocoPhillips stock to my account. I have never sold any of these shares.

There were times that the stock underperformed, particularly after ConocoPhillips acquired Burlington Resources at a very high premium for its natural gas reserves. This took place in December 2005, when it looked like natural gas in the US was going to be in short supply and prices might settle around $15/million British thermal units (MMBtu). Instead, fracking opened up new natural gas reserves, the price of natural gas plummeted and shares of ConocoPhillips languished.

Nevertheless, for the past 10 years I have believed that the future of oil prices would be inevitably higher, and that companies that produce oil would profit handsomely as supplies struggled to meet growing global demand. ConocoPhillips was aggressively investing in new oil exploration, so when I left the company in 2008 I held onto my shares.

Because I acquired these shares at various times between 2002 and 2008, it’s hard to pinpoint my overall return, but over the past five years shares are up 136 percent. If I look back two years, which takes me to just before the Phillips 66 spinoff (more on that below), the value of my ConocoPhillips’ holdings has increased by 70 percent (which includes the subsequent value of Phillips 66 shares following the spin-off).  

When I joined this publication in late 2012, I purposely didn’t put ConocoPhillips in the portfolio because I wasn’t certain I would look at it completely objectively. But the story kept getting better and better, and ultimately became one of those ideal situations: The market was discounting COP based on its history and ignoring the smart moves the company were making. It looked like such a sure thing that I began to recommend the stock to family members, and we added it to the Conservative Portfolio on Feb. 14. COP has since gained 15 percent  and still yields 3.7 percent.

One of the moves ConocoPhillips made to unlock shareholder value was to spin off the refining and chemical business in 2012. Prior to ConocoPhillips, there existed two integrated oil companies, Conoco and Phillips. “Integrated” means they explored for and produced oil, transported it to their refineries, refined it into fuel and petrochemicals, and sold those petrochemicals. The companies merged in 2002 (a few months after I went to work for Conoco) to become the fifth largest publicly traded integrated oil and gas company. But then in May 2012 ConocoPhillips bundled up the refining, petrochemical, and midstream assets (mostly pipelines and storage) and spun them off into Phillips 66.

Phillips 66

Phillips 66 is a very different company than the original Phillips. The spin-off created the world’s largest independent oil and gas exploration & production company in ConocoPhillips, and a major refiner in Phillips 66. In 2013 Phillips 66 was ranked fourth on the Fortune 500 list based on revenue, behind Wal-Mart (NYSE: WMT), ExxonMobil (NYSE: XOM), and Chevron (NYSE: CVX) and ahead of Berkshire Hathaway (NYSE: BRK-B) and  Apple (Nasdaq: AAPL).

PSX has gone on to create shareholder value by forming a master limited partnership, Phillips 66 Partners (NYSE: PSXP), which I discussed in an article this week called No Letup for Last Year’s Top IPO.

I received shares of Phillips 66 in the spinoff, and once again didn’t sell any of them. The refining sector looked pretty promising at the time, and PSX rallied. In less than a year following the spinoff, the share price doubled before pulling back. Presently, shares are up 124 percent since the May 2012 spinoff, and yield 1.9 percent.

Phillips 66 is a bit different than other refiners in that it is more vertically integrated. The company owns substantial midstream assets (which it will probably continue to drop down into PSXP), and has significant chemical manufacturing capabilities. This is likely one that I will continue to hold over the long haul, but I fully recognize that in a down cycle I may see the value of my investment reduced by 25 percent. The refining sector is highly cyclical so I generally urge people to approach it with caution. But over the years, buying when it is out of favor would have been a rewarding strategy.

Devon Energy

As natural gas inventories swelled in the spring of 2012, prices plummeted and the share price of Devon got stuck on a treadmill for nearly two years. The stock languished even as the outlook for natural gas began to look much better. At the same time, Devon was shifting more of its resources into more lucrative oil production.

But the market remembered Devon’s poor performance of recent years, and a disconnect began to develop between Devon’s share price and its outlook. I began to see this as a rare opportunity to add a company that was being unfairly discounted, so we added Devon to the Growth Portfolio on Sept. 25. The share price has risen over 20 percent since, and has set a number of new 52-week highs over the past month.

Right after Devon joined the Growth Portfolio, shares rose nicely but then pulled back along with numerous other energy names in November. I took the opportunity to open a personal position in Devon, acquiring shares at an average price of $59.69 on Nov. 6. As I am writing this Devon is trading near its 52-week high at $72.00, so the gain on my shares is nearly 21 percent.

Because investors had been down on Devon for a couple of years, I realized that it could take six months or a year for the market to recognize the opportunity. And in fact my shares were flat from November through early February. But as natural gas prices began to rise as a result of the cold winter and a broader recognition of a number of other bullish factors, Devon shares finally began to climb, and have now risen more than 16 percent year-to-date.

Five-year performance of Devon Energy

Cabot Oil and Gas

My final addition is a recent one. Cabot Oil and Gas is another company in line to benefit strongly if my outlook on natural gas prices is correct. But the market has punished Cabot for two reasons, both of which I believe will prove to be temporary. Earlier this year Cabot announced that it was transitioning to pad drilling and that production would be flat in the first half of the year as a result. Even though this will benefit the company in the long term, investors didn’t like the sound of that and sent shares down 10 percent on the news.

I had had my eye on the stock for a while, and felt like this was an ideal time to pick up a good company on sale. I bought shares on Feb. 28 at $35, only to see the share price decline below $33 over the next month. But shares have recently rallied and I now have a gain of 9 percent since that late February purchase. (We added COG to the Growth Portfolio on March 13, 2013, and have notched a gain of over 18 percent since as I write this.)

The other factor weighing down Cabot shares is the shortage of infrastructure to get its Marcellus gas production to market. But that’s being built, and realized gas prices should improve as a result. It’s uncertain how long the market will continue to discount Cabot, but I expect a strong move up within the next year or two. I will be very surprised if I don’t see a 20 percent gain in the share price this year, but I will continue to be patient if this one takes longer to move. When you are betting against investor sentiment, sometimes it takes a while for that sentiment to turn around.

Selling Losers

So when do I sell? When I see a downturn in company fundamentals. We have removed a number of companies from the portfolio over the past year as fundamentals shifted, or because management failed to execute. I have little tolerance for companies missing on their own guidance, and if this becomes a pattern I will likely cut my losses. I may sell on the basis of major shifts in the industry, or on the basis of new government regulations that I feel will be overly costly for a company. I might also sell if a company begins to trade at a significant premium to its competitors. Presently all of my holdings trade at a discount to peers, which is a major reason I hold them.

A year ago I held Berry Petroleum and Westport Innovations (Nasdaq: WPRT). Berry was a merger arbitrage situation. I bought the stock when it appeared to be trading at a discount to the price Linn Energy (Nasdaq: LINE) was offering for the company. The share price did ultimately move higher, and I sold at a small profit before Linn completed its acquisition.

Westport Innovations was an atypical purchase for me, as it was a riskier, early-stage company that was not yet profitable. But I felt like they are operating in a niche — production of natural gas engines — that will see strong growth over the next two decades. I bought shares on Oct. 31, 2012 at an average price of $27.86, saw them rally to $35, but held on. The reason I eventually decided to sell my shares is that management demonstrated over several quarters that it could not deliver on its promises.

The final blow came when Westport shares were trading at $28 and management announced a secondary offering at $25.39. Shares immediately plunged, and I couldn’t forgive this very shareholder-unfriendly move. So I sold my position at a 12 percent loss for $24.46 on Oct. 28, 2013 — four days after we removed the company from the Aggressive Portfolio. We were fortunate that we didn’t hold onto this one any longer, as shares have subsequently declined to $13.40.

Conclusions

There you have my energy holdings in a nutshell. I realize my portfolio isn’t as diversified as it ideally should be, and that I am therefore putting myself at somewhat higher risk. But I believe strongly in the companies in my portfolio, and over the years my strategy has paid off. It requires a solid knowledge of a company’s business, a vision for future energy trends, and patience as investors come to realize the value. It also requires me to understand my risk tolerance and personality, the better to avoid chasing investments outside my comfort zone.   

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