The energy sector is the largest small-cap sector in Canada.
Not only are there many companies to choose from, but “there’s [also] a big dispersion between the best and worst performing energy stocks,” says Gary Baker, leader of the fundamental Canadian equity team at Connor, Clark & Lunn Investment Management. He’s one of three sub-advisors for the Renaissance Canadian Growth Fund.
So when analyzing prospective investments in the space, he focuses on the bottom-up fundamentals of companies. As well, he prefers longer-term views of the direction of oil and natural gas prices to short-term market predictions.
He also grades companies by looking at the following four criteria.
1. Management teams. “We like to see a track record of value creation,” says Baker.
2. Quality of assets. “We like companies with high quality assets that have repeatable growth,” he adds, rather than those that “depend on one-off, high-risk exploration projects.”
3. Balance sheets. Companies should be able to “withstand the stress of low price…environments. We stress test all the companies we invest in [to] see how they would do [if] oil or natural gas prices fell precipitously.”
4. Stock prices. To make sure he’s paying a premium for quality, Baker looks at a company’s production-per-share metric. “Very few companies in western Canada can grow their production per share at a rate of greater than 10% a year,” he notes.
Baker also works with in-house experts who use “historical capital efficiencies to forecast the production growth rates for all the energy companies.”
The results of this type of analysis are different than the guidance provided by the companies he’s assessing, he adds. “Our forecasts tend to be more accurate than the guidance of company management teams, [who] tend to be too optimistic.”