TER: I understand you started investing in some larger caps this year. What prompted that?
BH: As part of that diversification, and because there was heightened volatility coming into the year, we were trying to find value in stocks that paid a dividend and offered lower volatility.
In a new energy cycle, the stocks that typically move first out of the trough are the larger caps. We made investments in some major integrated oil stocks, some of which were paying dividend yields as high as 6%, which really helped buffer the portfolio from excess volatility. We were able to pick up some income in the meantime. Historically, when you can buy large companies with high dividend yields, that's a signal of the value to be had.
One of the companies we added to the portfolio is Royal Dutch Shell Plc. When we purchased the stock, it was yielding over a 6% dividend, and the acquisition of BG Group Plc was a nice bonus. We're very encouraged by that acquisition. We feel it strategically places the company very well. BG Group puts Shell in regions of the world that look interesting from a growth standpoint, namely in Brazil and Australia. We feel like that's going to be a good platform for Shell, and for a company of its size, to get more growth.
TER: Are you expecting more merger and acquisition (M&A) activity as we move through this phase of the cycle?
BH: I think we are going to see the cream rise to the top, and companies that have high quality assets or are strapped with excess debt will become targets. In many cases, at this time in the cycle, you can buy oil reserves in the ground for less than the price of drilling for new reserves. Many market upswings begin with an M&A cycle, similar to the late '90s, when Exxon's $80 billion acquisition of Mobil Oil marked a bottom in the energy cycle.
We recently saw Noble Energy Inc. buy Rosetta Resources Inc. That gives Noble exposure to new, prolific oil and gas basins of the Eagle Ford Shale and the Permian Basin. I think this is a trend that will continue, as companies look to reduce costs and for strategic bargains. I think we'll see more M&A activity into the summer—perhaps a takeout of a larger independent by a major oil company—which would highlight the long-term value embedded in energy shares at this point in the cycle.
TER: Your fund's sweet spot has always been the juniors. Are you finding bargains in the junior space? What are you adding to the portfolio right now?
BH: That has been our core historically. The junior names that look interesting to us are those that, despite cutting capex, are still managing to grow through the drill bit. Other names look attractive simply because their assets are burdened by debt or undercapitalized. On the whole, we're seeing very attractive valuations on a full-cycle basis, which make us quite optimistic.
TER: Can you name some of the companies that you're optimistic about?
BH: They are primarily in Canada. The first name is Legacy Oil + Gas Inc. This company has significant value. It's not a name that most folks are looking at because it has excessive debt on the balance sheet and is actively trying to manage that debt and still grow production. But it has high-quality oil assets, and a lot of operational and financial leverage to the price of crude oil.
We think, on a sum-of-the-parts basis, Legacy looks very interesting at current prices. If you look at the proven reserves in the ground and you discount them over the reserve life, and then net out the value of long-term debt, the stock could double from current levels based on a normal full-cycle oil price.
In addition, it looks as though there are some large institutional shareholders that are trying to unlock more immediate value by breaking up the company, divesting assets or perhaps even replacing management. That could offer additional catalysts.