Knowing a little about a lot can take an investor a long way. But knowing a lot about a little can, in many cases, take that investor even further. Just ask Rodney Mitchell, the founder and president of The Mitchell Group, a Houston-based registered investment advisory firm which invests exclusively in publicly traded energy securities. Between 1970 and 1989, he was president and chief investment officer for Tallasi Management Co., a New York investment advisory firm then managing $500 million worth of equities across a broad spectrum of industries. "We were generalist equity managers, but I found during that period that it was becoming increasingly difficult to maintain an informed position on everything, and that occasionally, we were getting surprises," says Mitchell. There was a need for specialization. He chose energy. "The liquidity in this sector is gigantic. But more importantly, I felt at the time that Wall Street didn't understand the opportunities in energy. It was my view then-and this has since been validated-that abnormally depressed prices in so vital a commodity as oil or natural gas will encourage consumption and discourage supply, and that this in turn will lead to higher prices for that commodity." In 1989, he founded The Mitchell Group to test this theory. The following year, the upstart boutique energy investment firm-focused on managing the monies of corporate pensions and employee benefit plans, college endowments and foundations, and high net-worth individuals and families-landed its first $200,000 account. Today, the firm manages $450- to $500 million of energy investments for 15 individual accounts-13 of them nonindex-related-including names like General Mills and the University of Richmond (Virginia). More impressive than this growth, however, has been the investment performance of The Mitchell Group. Between December 31, 1991, and year-end 2000, the energy equities manager achieved for its active investors an annual compound rate of return of 18.27% versus 12.31% for the Dow Jones Energy Group, 14.67% for the S&P Energy Composite and 16.09% for the S&P 500. Viewed another way, the Mitchell Group's cumulative return during the same period was 353%, compared with 283% for the S&P 500 and a composite 218% return achieved by five other energy specialty investment funds. Such an above-average rate of return is confirmed by Tom Witt, director of the H.E.B. Savings and Retirement Plan for H.E. Butt Grocery Co., a San Antonio-based grocery chain serving southern Texas, New Mexico and Louisiana. "We invested $25 million with Rod and his group in December 1997, when oil was around $15 and gas $1 to $2," says Witt. "To me, it made sense to hire an energy specialist for the simple reason that conventional equity managers tend to not have a major weighting in energy." The result? "Nothing short of a tape-measure home run. For the three-year period ending April 2001, this investment achieved a compound annual rate of return of nearly 21%. During that same time, the S&P 500 was up only about 5.3%." The obvious question arises: How has The Mitchell Group been able to outperform the S&P indices during the very time the energy industry itself has been underperforming those same indices? Mitchell says, "Superior investment performance requires an advantage, and there is no greater advantage than superior knowledge. That's what we've tried to apply to the energy sector, from an industry and financial management perspective." If resumes mean anything, then The Mitchell Group's investment committee certainly has this knowledge. Its senior vice president of investments, Wayne Nance, was formerly president of Tenneco Oil Co., while its other vice president of investments, Douglas M. Hohertz, was formerly a manager of accounting and finance for the Western Geophysical division of oil-service giant Western Atlas. Also, sitting on The Mitchell Group's senior strategy committee are John E. Swearingen, formerly chairman and chief executive officer of Amoco; John H. Williams, former chairman and chief executive of The Williams Cos.; Henry Groppe, who, before establishing his own consulting firm for petroleum and chemical clients, was with Dow Chemical, Monsanto, Texaco and the Arabian American Oil Co.; and Robert M. Gates, who served nine years on the National Security Council under presidents Nixon, Ford, Carter and George H.W. Bush, and was also director of the Central Intelligence Agency under the lattermost. This impressive roster of industry and financial professionals wasted no time putting their knowledge to work. "We recognized early on why the energy sector-which accounted for 30% of the S&P 500 in the early 1980s and only 6% of it by year-end 1999-was falling out of favor so badly with investors," says Mitchell. First, right after the Gulf War, money managers stopped using energy stocks as an insurance policy against political upheaval in the Middle East, he says. They found out that, even with a war in the region, oil would still be plentiful at fairly normalized prices. Second, whereas energy had historically been considered a hedge against inflation, the 1990s had become a disinflationary period, so many institutional investors were discarding energy stocks from their portfolios. "Third, investors always had owned energy stocks because they had such a low correlation of return to the S&P 500 and hence, would perform well when the overall market did poorly," he says. "But in a market that was going up 25% almost every year, investors weren't interested in diversifying portfolios-they wanted close correlation to the S&P." With this sober recognition, but the borne-out belief that increasing energy demand and declining supplies of oil and natural gas would eventually trigger higher commodity prices, The Mitchell Group has pursued a long-term strategy of investing primarily in the stocks of E&P companies and oil-service companies. "These sectors of the industry are most sensitive to commodity prices, and that's why we're weighted to each 40% and 25%, respectively," says Nance. In addition, the firm has a 15% weighting in domestic integrateds, a 10% weighting in international integrateds; and another 10% weighting in primarily pipeline stocks. The ideal E&P investment candidate? "Through the 1990s to today, we've placed a great deal of emphasis on net asset value (NAV)-trying to buy more than a dollar's worth of assets for every dollar we've spent on behalf of our clients," says Nance. "Also, because producers are constantly using up their asset bases and need to replenish those bases, we look not only at the quality of their prospects long-term, but also at their cash flows to see whether they're going to have enough money to develop those prospects." In addition, the firm, which has largely invested in the stocks of natural gas producers, studies a company's operating capabilities. If gas is currently $4 per thousand cubic feet (Mcf), it wants to know the amount of lifting costs and G&A expenses burdening each. Says Nance, "Although E&P stocks have recently enjoyed a run up on M&A speculation, those stocks have been selling at near all-time lows-around four times cash flow versus a more normalized six to seven times cash flow." Among the firm's best E&P investments are Devon Energy, Anadarko Petroleum and EOG Resources. Service stocks On the service side, the energy investment specialist focuses on earnings. "Here, we like to see price-earnings ratios below 20, but we're reaching a point where that's pretty hard to find," says Mitchell. "We also look for the application of unique technologies, particularly among the smaller to midsize companies; among the larger-cap names, we tend to zero in on market share. In no case do we pay much attention to net asset value. I learned a long time ago at J.P. Morgan that a service company's source of NAV is its equipment, and that in bad times, that equipment sells for scrap-iron value." The Mitchell Group also uses another approach to gauge the investment-worthiness of a service company. Says Hohertz, "We spend a lot of time talking to our producer friends, asking them, 'Who is your preferred supplier, and why?'" Some of the firm's best investments in the oil-service arena are Noble Drilling, Weatherford International and Cooper Cameron. In the pipeline sector, the energy specialist firm will consider net asset value, but it pays more attention these days to a company's ability to capitalize on nonregulated activities, such as trading operations. "Also, as the energy convergence trend continues, and more pipelines merge with electric utilities, we want to know what's going to be the cost of natural gas for those utilities and how they're going to get that gas," says Mitchell. "Ideally, we like to see these new energy conglomerates have a good piece of gas production that is their own. The recent acquisition by The Williams Cos. of Barrett Resources gives it a cushion of physical gas supply, rather than just trading pieces of paper to get that supply. That's the reason we bought Coastal Corp. some years back-it had a production side to it and its stock was a very good performer before Coastal was acquired by El Paso Energy." This emphasis on gas supply goes to the heart of The Mitchell Group's macro-thinking about energy. "We may have reached a point in natural gas similar to what we reached in crude oil soon after the end of World War II," says Nance. "Around 1948, we were no longer able to cover our domestic oil consumption from internal production and, by the early 1950s, tankers began coming into the Gulf Coast from places like Saudi Arabia. Today, we seem to be in the same situation with respect to natural gas, as we gear up for the importing of LNG into East Coast and Gulf Coast terminals." It's Nance's belief that, even with accelerated production from the Northwest Territories and the Scotian Shelf in Canada, as well as from Alaska and the Rocky Mountain region in the U.S., North American gas output will still fall short of demand-if consumption continues to grow at the better than 2% annual rate it has in the recent past. Hohertz observes that if all the gas-fired electric generation plants that have been proposed throughout the U.S. come onstream during the next few years, they're going to require at least 14 billion cubic feet per day of incremental gas production-and that's a low estimate. "Also, just to cover oil consumption growth and current production decline rates, the world is going to need to bring on 4 million barrels a day of incremental crude output each year. So even maintaining the status quo is going to be one heck of a challenge." Says Mitchell, "We've gone through 15 years of underinvestment in the energy business-and that's not going to be cured quickly nor cheaply. Trillions of dollars are going to have to be poured into the energy industry during the next 10 years. And to finance those capital expenditures, the industry is going to need higher commodity prices than was the case in the 1990s." Given current supply-demand fundamentals, The Mitchell Group believes a higher order of commodity pricing-mid-$20s for oil and $3 to $4 for gas-appears likely for this decade. Indeed, that's the economics upon which most proposed drilling projects are now being based. This naturally bodes well for E&P and service companies-and investors in their stocks. Says Hohertz, "The monthly average for Henry Hub gas prices during the past decade was about $2.02 per Mcf. If we move to $4 per Mcf this decade, the amount of wealth and value this will bestow upon producers and service companies is gigantic." Not gigantic is Mitchell's assessment of his own company's success. "We just tend to our business, work hard to find value, and try not to lose anybody's money." If past is prologue, it's probably a safe bet that investors in the firm's portfolio of 20 to 30 energy companies don't have to worry much about losing money.
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