Ariel Investments Nov Letter

During the long 2002-2007 bull market, and especially in its final months, we received many questions and plenty of suggestions regarding our stance on energy stocks. As you know, energy stocks and commodities were red-hot during much of that cyclical, relatively low-quality stock surge, and we had little exposure to the area in our domestic stock portfolios. For a long time, we held a belief that energy companies were largely dependent on natural resource prices—which makes it difficult to build and defend the durable competitive advantage we seek. Besides, with the prices of those commodities and stocks so rich, there was not much value at hand. It is worth noting that as commodities became inflated, we spent an enormous amount of time studying the sector and its effect on our holdings.

Fast forward to 2013 and we have a number of energy companies in our portfolios. This is true because we shifted our perspective as well as our expertise. Indeed, our view on the space evolved as we started to discover potential opportunities that we can describe in two categories. First, we now think some energy companies can overcome their direct exposure to energy commodities through differentiated business models. Second, we believe some energy-related enterprises’ cash flows are far less volatile than natural resource prices. After we began finding opportunities, we also hired Anthony Walker, a research analyst with deep expertise in the energy sector. Now, among our domestic portfolios, we own a dozen energy and energy-related companies.

As above, the first category of holdings in this group are energy companies that have business models that we believe give them an advantage over peers and insulate them from price fluctuations. The most straightforward such example is Contango Oil & Gas Co. (MCF), which we own in our traditional mid-cap, small-to-mid cap, and small-cap portfolios, as well as in our deep value small cap portfolios. When we first purchased it in 2011, it focused exclusively on shallow-water Gulf of Mexico exploration and production, had an amazingly low-cost operation, virtually no debt, and thus very high cash flow. It was also quite disciplined in drilling only high opportunity locations.

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