An Energy-Efficient Approach

Dan Rice is king of the hill. The stock mutual fund he manages, the State Street Research Global Resources portfolio, soared 70% in 1996--the biggest gain of any fund.

Rice produced that stunning return by loading his $150-million fund with small oil and gas stocks--just the types of long-neglected companies that were poised for a major rally, as energy prices rose.

Moreover, Rice’s fund has risen 181% over the past five years, nearly double the 92% gain of the average general diversified stock fund, according to fund-tracker Lipper Analytical.

A 45-year-old father of five, Rice stays active by playing or practicing baseball year-round, complementing that with a passion for tennis and fly fishing.

In addition to his fund, Rice oversees $900 million in institutional money earmarked for small energy stocks. He was interviewed by Russ Wiles, a mutual funds columnist for the Times.

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Times: You had the No. 1 mutual fund overall in 1996, and your 70% gain also was twice the return of the average natural resources fund. What went right?

Rice: It’s simple: The sector we specialize in, small energy stocks, gained about 50% [on average] for the year. The distinguishing feature about our fund is that we’re small-stock-oriented. Nearly all other natural resources funds buy large stocks, which gained about 25% to 30% [on average] last year.

On top of that, we benefited from takeovers: Four of our top 10 holdings were bought out during the year. And in the energy sector, offshore drilling companies were the strongest component. We had 15% to 20% of our assets there.

Times: What fueled the takeover action?

Rice: Strong fundamentals. These companies were cheap, selling at prices [of] less than five times their per-share cash flow. Even today, most trade at just five to eight times cash flow, while growing by 20% to 25% a year. By contrast, stocks in the Standard & Poor’s 500 sell at about 10 times cash flow. So you had and still have attractively priced stocks that are posting high growth.

Times: Why focus so much on cash flow? What about bottom-line earnings?

Rice: In the energy industry, stock prices are easier to predict based on cash-flow multiples. Earnings don’t mean as much because there are various accounting treatments that companies can use that make it hard to compare two firms in a meaningful way.

For example, drilling companies can choose either of two methods to account for dry holes. One involves a write-off against income in the year a dry hole occurs, which reduces income. The other allows you to capitalize the dry hole on your balance sheet, which means you add it as an asset, then depreciate that asset over seven to 10 years.

Both are acceptable accounting treatments that will have a different impact on earnings, which is why earnings do not allow for good comparisons among companies. Cash flow tends to make the playing field more level.

Times: How important was the rise in oil and natural gas prices last year in terms of your fund’s performance?

Rice: They were important psychologically, although they didn’t impact the growth rates of companies as significantly. That is, instead of growing 15% for the year, a firm might have increased its cash flow by 20%.

With energy stocks last year, the fear was that oil and gas prices might collapse. In fact, they went up, and that changed the psychology. So instead of trading at, say, 4.5 times cash flow, a stock might have gone up to six times. When the psychology changes completely, the same company might sell at 12 times cash flow.

Times: With your focus on “growth at a reasonable price,” what are some of your favorite stocks now?

Rice: Among our top five holdings, all feature a fairly low cash-flow multiple and a growth rate in excess of 15% a year. For example, I expect KCS Energy will have cash flow of $8 a share this year. I think the cash flow next year will rise to $10 a share, and to $12 in 1999. So I’m looking for a yearly 20% to 25% cash-flow growth rate, yet the stock [at $38.875 currently, on the New York Stock Exchange] trades at a cash-flow multiple of about five times. That’s attractive.

Similarly, Nuevo Energy trades around $52, with cash flow this year around $8.50 a share, for a multiple near six times. My outlook is for Nuevo’s cash flow to expand by at least 15% annually for the next five to seven years.

Nuevo and KCS are “exploitation” companies, where they have an existing asset base and grow by exploiting it. Two other large holdings, Abacan Resource and Trans Texas Gas, are exploration firms that grow through successful exploration drilling. That entails slightly greater risk, with a potential reward that’s also somewhat higher.

Our other large holding is Seagull Energy, a turnaround situation. It’s an oil and gas exploration company that will grow from successful drilling in Egypt.

Times: When you say exploitation, as in the case of Nuevo and KCS Energy, is that for oil or gas?

Rice: As it turns out, it’s primarily oil for both, but just as easily could have been gas. We’re not married to any one commodity, nor do we think one will do better than the other.

That’s the way most energy industry executives look at it. They’re indifferent to whether it’s oil or gas. They’re looking in terms of risk and reward. Sometimes it’s an oil well they’re drilling; at other times it’s gas. They don’t make a concerted effort to go with one over the other.

Times: Do you invest in other natural-resources stocks, such as gold miners or lumber companies?

Rice: We do, but energy is our specialty, and we keep about 80% of our assets there.

Times: Some investors naturally shy away from “sector” funds like yours because their year-to-year swings can be pretty wild.

Rice: The fund is volatile for two reasons. The first is that it’s a sector fund, and most sector funds are volatile because they are not widely diversified. The second reason is that we concentrate our holdings to the extent that maybe our top 15 stocks will represent 50% of the assets in the portfolio.

Because of this volatility, the fund is not suitable as someone’s sole investment.

Times: Would you pitch the fund as more of a portfolio-diversification tool?

Rice: Yes. The smaller energy stocks of the type we focus on don’t correlate much with the general market’s movements, and yet our performance numbers over the past five years indicate that you actually see superior results.

The typical natural resources fund doesn’t provide as much diversification because most of its holdings are in larger stocks, which mimic the market to a greater degree.

Times: How much of your portfolio is made up of foreign stocks?

Rice: In general terms, we have 20% of our portfolio in Canada and 10% outside of North America. The Canadian portion is large because we look at this as a North American energy market and many Canadian companies are inexpensive.

Times: Considering last year’s hefty gains in small energy stocks, why should investors expect more of the same?

Rice: They’re still cheap and growing faster than stocks in the broad market. Also, the demand-supply picture for energy looks pretty good, with demand worldwide increasing rapidly for both oil and natural gas. As the psychology on oil and gas prices continues to change for the better, this portfolio will do well. I think it could return 15% to 20% this year, if not more. [The fund is up 5.6% so far in ’97.]

There’s a huge consolidation wave still occurring among smaller companies in the energy market, akin to consolidation among regional-bank stocks. Many companies remain cheap, and there are benefits to buying out competitors and diversifying. There’s a consolidation wave, and this fund is sitting in the middle of it.

Hear from top money managers at the Los Angeles Times’ first-ever Investment Strategies Conference, Feb. 22-23 at the Westin Bonaventure in downtown Los Angeles. To register, call (888) TIMES97.

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State Street Research Global Resources

Strategy: Seeks long-term appreciation through investing mainly in smaller energy companies, those with a stock-market value or capitalization below $1 billion

VITAL STATISTICS

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State State Avg. Nat. Global Res. Res. Fund 1996 total return: +70.3% +32.4% Three-year return: +99.5 +56.8 Five-year return: +181.3 +97.1

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Five biggest holdings: 1. Nuevo Energy 2. Seagull Energy 3. KCS Energy 4. Abacan Resource 5. Trans Texas Gas

Max. sales charge: 4.5% Assets: $150 million

Min. investment: $2,500 ($2,000 IRA) Phone: (800) 882-0052

Morningstar risk-adjusted performance rating, 1-5: ****

Sources: Lipper Analytical Services, Morningstar Inc.