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When picking energy stocks, size really does matter Add to ...

There's nothing wrong with investing in the behemoths of the energy sector. But Craig Porter, portfolio manager at Front Street Capital, prefers to sift through companies that might not be household names.

No doubt, Mr. Porter's CIBC Energy fund has invested in the likes of giants Suncor Energy Inc. and Canadian Natural Resources Ltd. But his top holdings - among them, Petrominerales Ltd. , Pacific Rubiales Energy Corp. and Celtic Exploration Ltd. - are far smaller and lesser-known.

The reason? Mr. Porter argues that big companies tend to grow very slowly, so the only way their earnings increase is if the price of oil goes up or they buy another company.

"On the other hand, what we're looking for is companies that can add value by going out and doing exploration, by growing production," he said.

"We've been investing in mid-cap or even some of the juniors, which are going to perform very well and become the seniors of tomorrow."

It is an approach that has worked well for Mr. Porter. The CIBC Energy fund is among the top-ranked Canadian energy funds by Lipper, with a three-year annualized return of 10.5 per cent.

The fund's average market capitalization is just over $5-billion (U.S.) - less than half the $10.7-billion average among its peers and a fraction of the size of a company like Exxon Mobil.

While smaller companies can translate into higher risk and volatility, Mr. Porter believes that they are a far better way to bet on energy prices, particularly crude oil.

The way he sees it, even if the price of oil remains stuck within a narrow range of $80 (US) to $100 a barrel - which is his forecast for 2011, given that the U.S. economy isn't exactly booming right now - these smaller firms will see their shares move higher because of their better growth profiles.

According to Lipper, the CIBC Energy fund has invested in companies whose three-year revenue growth has averaged an impressive 41 per cent, versus an average of just 17.5 per cent revenue growth among the fund's peers.

Mr. Porter noted that smaller companies also make better takeover candidates, since they are affordable to a wider range of potential acquirers.

To find these companies, though, he's not limiting his view to the Canadian oil sands. Instead, he likes regions that are looking more stable from a political perspective, and whose energy resources are opening up to Canadian companies. About 38 per cent of the companies within his fund have operations outside Canada, in places like Albania, Peru and Colombia.

"Colombia is a country we've been following for a number of years," he said. "Politics has been cleaning up for the past decade. Ten years ago, no one would go near Colombia and that's the reason why these deposits were sitting there."

At the same time, Mr. Porter doesn't like to bet big on any one stock, but prefers to maintain a broad basket of 50 to 60 names. A top holding might exceed 6 per cent of the fund's total assets, but only if the share price has been rising sharply.

He also remains diversified across a number of different industries besides oil exploration and production. For example, 15 per cent of the fund consists of energy services firms, such as oil drillers.

"As drilling picks up, it doesn't matter what happens to the price of oil. Their revenue goes up," he said. "They are a sub-sector that has done very well over the past year."

Another 8 per cent of the fund is in coal producers, and 7 per cent is in uranium producers.

That's right, natural gas is a big omission here. "We're fairly bearish on gas, and have been for the past few years," Mr. Porter said. "So the fund would have had very little exposure."

Industrial demand in the United States is still fairly low and government incentives in some parts of Canada are encouraging companies to keep drilling for gas, even as storage levels remain relatively high. This has created a difficult environment for many natural gas producers.

Sometimes, the stocks you avoid are just as important as the ones you embrace.

 

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