Back in December 2016, we discussed our expectation for lower longer-term US interest rates, which we used to justify an aversion to financial stocks. This expectation played out. We also discussed our rotation into the resources sector. We suggested that sometimes rotations can be bumpy, and indeed the last six months has been a bumpy rotation, with the energy sector the worst performing sector year-to-date.

We were clearly early and this has negatively impacted recent performance. We try to take a longer-term perspective and position our active strategy for multi-year leadership trends. Coming out of the 2011 lows, we held a very high proportion of our strategy in health care and consumer staples companies. Never before had we seen a bull market driven by what we refer to as growth counter-cyclical stocks. Bull markets like the 1990s or early 2000s tend to be driven by cyclical stocks. Technology drove the 1990s bull market of course, while financials drove the early 2000s bull market. We call these two sectors “hyper-cyclicals” for this very reason.

We find ourselves in a similar situation today—holding an out-of-consensus viewpoint on a certain segment of the equity market. Specifically, we continue to have a bullish disposition toward the resources sector broadly, and the energy sector in particular. We wish to review our bullish thesis on the energy sector in greater detail.

There are roughly 3,200 companies in the top 85% of the market cap of all 46 developed and emerging market economies. We have created a set of market-cap weighted indexes around this global selection universe that we call the Knowledge Leaders Selection Universe (KLSU) Indexes. These indexes, which are similar to the MSCI Global Indexes, are our starting point for selecting equities for our active portfolios. We’ll be referring to these indexes for the duration of this letter. In particular, we’ll be referring to our developed market KLSU energy indexes, including:

  1. KLSU DM Americas Energy Index, which includes the top 85% of all energy companies in the US and Canada. This index contains 60 companies and has a market cap of $1.64 trillion.
  2. KLSU DM EMEA Energy Index, which includes the top 85% of all energy companies in Europe. There are 26 companies with a market cap of $736 billion.
  3. KLSU DM Asia Energy Index which includes the top 85% of all energy companies in Asia. There are 14 companies with a market cap of $95 billion.

The ideal attributes we look for in a stock are:

  1. It is within a group that has been down for at least 7-9 years. This generally indicates a group where valuations have compressed, sentiment is low and stocks can be accumulated at attractive prices.
  2. Companies have slashed capital expenditures. Generally, when capital expenditures industry-wide decline, the result is improved pricing. This is particularly relevant for an extraction industry like energy. We will get into more details on this shortly.
  3. Companies have a cheap multiple to assets and/or sales. When companies experience secular downturns, flow-based measures like earnings or cash flow can be difficult valuation inputs. We prefer asset-based measures.
  4. Companies are out of fashion among investors. Technicals can be helpful here to quantify the extent to which investors are shunning a certain group. Very often, and we’ll argue now is one of those times, investors engage in capitulation, which can give investors a great chance to buy that cheap company at even cheaper prices.
  5. An opportunity for diversification. Stocks in sectors that have experienced a low correlation to the benchmark have tremendous diversification potential.