Baron Energy and Resources Fund (BENIX)

Portfolio Management

JamesH.Stone
James H. Stone

Fund Manager since 2011

View All Commentary by James

Fund Description

Baron Energy and Resources Fund invests in securities of energy and resources companies and related companies of all sizes.
 

    

Portfolio Commentary

Institutional Performance

Review and Outlook (for quarter ended 3/31/2015)

Oil markets faced continued headwinds as the oversupply situation triggered by OPEC’s decision not to rein in production last November materialized. U.S. oil prices fell by 11% in the quarter. While U.S. inventories built to record levels, inventories in Europe and Asia did not build as expected. This divergence suggested that the oversupply problem was 1) constrained to the U.S. market, and 2) not as bad as initially feared. Global demand was stronger than expected, driven by higher demand in the U.S., India, and more recently in China. As the quarter progressed, a number of forces began to exert themselves that we believe have led to a bottom for the oil market and perhaps the U.S. natural gas market, which in turn led to a strong recovery in share prices and a solid start to the year for Baron Energy and Resources Fund.

We believe the Fund did well in part because we did not panic last quarter and materially alter the portfolio or our overall strategy. We felt secure in the belief that we owned good companies with good assets/businesses that were excessively penalized by the downturn and still offered excellent value. We opportunistically added shares in some of our more battered and undervalued names and added some new names at attractive prices. Performance in the quarter was entirely a function of our stock selection within Energy, certain renewable energy stocks classified within Utilities and Information Technology, as well as a Materials holding that supplies the global oil industry. Poor contributions from various Materials and Industrials holdings partially offset the combined contribution of these investments.

We believe demand could increase as quantitative easing improves the economic outlook in key developed economies. When combined with slowing supply growth (if not outright declines), we believe this stronger demand will lead to a more balanced oil market in the quarters ahead and a recovery toward “normalized” prices that, in our view, should range between $70-90 over time. As long-term investors, we believe our patience and our strategy of investing in companies that can grow in a “normalized” or price-neutral environment is likely to be even more rewarded when we have opportunities to invest during a period in which commodity prices are so far below our view of “normalized” prices. This is what we did during the first quarter.

While the Energy sector has always experienced significant short-term volatility, we believe the long-term returns and potential for future gains make investment in energy a worthwhile proposition. We think the current downturn will prove relatively short-lived as the problems are relatively small compared to the massive demand shock faced in 2009, or the massive supply capacity overhang that plagued the industry in the mid-late 1980s. The growth themes and opportunities for value creation that we have highlighted the last several years, such as the development of unconventional resources, the need for increased infrastructure investment, and the role of technology in unlocking the resources needed to meet growing market demand for oil and gas remain intact and are the core of our investment strategy.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 3/31/2015)
  • SM Energy Co. is an independent E&P company with operations primarily focused on the Eagle Ford shale in South Texas and the Bakken shale in North Dakota. While oil prices remained weak in Q1, SM’s shares rose sharply as the company posted improved drilling results in both of its core plays. These results enhanced our conviction in the net asset value of the company and the potential for further upside in the share price over the next several years.

  • Concho Resources, Inc. is an independent E&P company operating in the Permian Basin in West Texas and New Mexico. Shares rebounded from the fourth quarter drubbing even as oil prices remained weak. Concho prudently cut its spending rate, raised additional capital, and positioned itself well, in our view, to survive the downturn and emerge as a stronger company when oil prices recover. Strong results from its Delaware Basin drilling program is enhancing an asset we believe to be undervalued within the current share price.

  • Shares of renewable energy company SunEdison, Inc. rose in Q1 on increased investor confidence in its strategy to develop cash-generating assets and drop them down to its yieldco TerraForm Power. We believe SunEdison’s recent acquisition of First Wind will help accelerate SunEdison’s development pipeline and TerraForm’s portfolio. Over time, we think the yieldco structure will allow SunEdison to monetize the value of its solar assets and raise capital at a low rate, creating a cycle of growth and value creation.

Detractors (for quarter ended 3/31/2015)
  • Flotek Industries, Inc. is a leading supplier of specialized chemicals to the oil & gas industry. Its proprietary citrus oil based products such as the complex nano fluid experienced rapid growth related to the boom in shale oil drilling in the U.S. and Canada in the last several years. Despite this, the sharper-than-expected decline in U.S. drilling and completion activity has taken a toll on its earnings outlook and its share price during the last couple of quarters. We continue to see significant potential for differentiated organic growth and a rebound in long-term earnings power at Flotek.

  • Shares of leading utility and industrial contractor Primoris Services Corp. fell in Q1. Revenue dropped 9% in Q4 as Primoris took several project write-downs and charges, resulting in a sizable “miss” versus consensus expectations. End markets (pipeline and power plant construction and pipeline integrity work) remain solid, evidenced by record backlog. We believe this work will come through in late 2015 into 2016, and margins will improve with better collection rates and execution.

  • Canyon Services Group Inc. is a Canadian-focused oilfield service company that specializes in hydraulic fracturing of oil and gas wells. While the company is well capitalized and has a strong presence in Canada, the severity of the decline in drilling and completion activity is resulting in a sharper earnings downturn than we had expected when we purchased the shares. As a consequence of a weakening share price and worse-than-expected fundamental deterioration of business conditions, we decided to exit our position.

Quarterly Attribution Analysis (for quarter ended 3/31/2015)

When reviewing performance attribution on our portfolio, please be aware that we construct the portfolio from the bottom up, one stock at a time. Each stock is included in the portfolio if it meets our rigorous investment criteria. To help manage risk, we are aware of our sector and security weights, but we do not include a holding to achieve a target sector allocation or to approximate an index. Our exposure to any given sector is purely a result of our stock selection process.

The Baron Energy and Resources Fund (Institutional Shares) increased 1.73% in the first quarter and outperformed the S&P North American Natural Resources Sector Index by 324 basis points.

The Fund’s small and small to mid–cap energy holdings, which were meaningful detractors in the fourth quarter of 2014, generated modest positive returns this quarter, and contributed positively to relative results. The Fund’s lack of exposure to lagging large-cap energy stocks, such as integrated oil & gas companies, also aided relative performance.

The Fund’s oil & gas exploration & production (E&P), oil & gas storage & transportation, and renewable energy-related investments were the largest contributors to relative results. The Fund’s E&P holdings contributed the most to relative performance after rising 7.0% as a group, with SM Energy Co., Concho Resources, Inc., Newfield Exploration Co., and Laredo Petroleum, Inc. each up double digits. The Fund’s storage & transportation investments, which consist mostly of master limited partnerships (MLPs) and general partnerships (GPs), rose 3.9% as a group and outperformed their counterparts in the index by 279 basis points, led by double-digit gains from Tallgrass Energy Partners, LP and SemGroup Corp. Despite declining oil prices, shares of MLP Tallgrass outperformed after management accelerated its growth plans and outlined an annualized growth rate target of 20% over the next three years. Shares of C-Corp SemGroup outperformed as management moved forward with its MLP strategy of selling assets at an accelerated pace and announced a $500 million greenfield Gulf Coast pipeline project. The Fund’s significantly larger exposure to the outperforming storage & transportation sub-industry also added value. Strength in renewable energy-related holdings was due to the outperformance of SunEdison, Inc., an Information Technology company and one of the Fund’s largest contributors to absolute performance, as well as renewable electricity companies Abengoa Yield plc and TerraForm Power, Inc. Shares of Abengoa Yield benefited as investors reacted positively to the company’s securing financing for its development portfolio, while TerraForm’s shares rose sharply after the company’s deal for First Wind Energy closed.

The Fund’s lower exposure to oil & gas refining & marketing stocks, which rose 17.5% as a group within the index, and underperformance of its oil & gas equipment & services investments detracted the most from relative results. Weakness in equipment & services was mostly attributable to the underperformance of RigNet, Inc., a provider of remote communication systems and services principally to the global oil and gas and maritime industries, and Canyon Services Group, Inc., a Canadian-based oilfield service company that specializes in hydraulic fracturing. RigNet’s shares suffered amid concerns that weakness in demand and utilization from offshore drilling rigs, its biggest customer segment, is causing a slowdown in the company’s business. Canyon Services Group was the Fund’s third largest detractor on an absolute basis and was sold early in the quarter.

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The prospective performance of the companies discussed herein is based on our internal analysis and reflect our opinions only. We cannot promise future returns and our opinions are a reflection of our best judgement at the time of publication. Our views are not intended as recommendations or investment advise to any person and are subject to change at any time based on market and other conditions and Baron has no obligation to update them. Investing in the stock market is always risky. Current and future portfolio holdings in the Fund are subject to risk.

Source: FactSet PA.