Friday, September 2, 2022

The best bet in Energy

Active investing is tough. 

Many more mutual funds (proxy for active investors) have shut than started since 2016:

Passive investing, which typically mimics entire markets using ETFs, appear to be the future.

This is because most active investors (think 90%) fail to beat returns from passive ETFs in a long enough timeframe.

It also argues against the existence of this blog and my fund.

To exist is to not only be different, but also right.

What I do different is that I own the most discarded, cheapest, and smallest companies. These companies are too small to move the performance needle for large asset bases.

Consider a $1B fund. If it sets an ownership limit to 10% of a company, it would need to invest in a thousand $10m companies (typical size in my world), which requires more resources than analyzing twenty billion-dollar companies.

I am also never too confident in my positions. I can never predict anything for sure, even for my largest positions.

This means that I can never over-concentrate by having just 5 positions.

But I can also avoid over-diversifying, common in passive investing, by screening out companies with obvious bad fundamentals. 

This philosophy led me to 30 positions for now, and I hope to find more without lowering my hurdles.

I know that I'm different enough. Time will tell whether I am right.

One of my larger positions is Energy And Environmental Services Inc (OTC: EESE). EESE manufactures chemicals mostly for oilfield drilling, completion, and production.

EESE has the best fundamentals among the small companies I've seen. The latest quarter saw 50% revenue growth with 66% gross margins, 20% net margins, just 1x run-rate leverage, and a clean capital structure without warrants or preferreds.

Look at the properties it owns. All these valued at $6m on the balance sheet seem cheap.

"Our research and development lab and organic fertilizer plant is a 7,000 square foot building located at 6300 Boucher Drive, Edmond, Oklahoma. Our oilfield chemical plant is housed in a 27,500-square foot building located at 6701 Boucher Drive, Edmond, Oklahoma. Our Enduro-Bond® coating operations are mostly done in a 30,000-square foot facility located at 1728 Frisco Avenue in Chickasha, Oklahoma. We own these buildings as well as an 80,000-square foot chemical warehouse in Snyder, Texas, and a 2-acre lot on Boucher Drive, Edmond, Oklahoma. We also own land and building in Abilene, Texas, which is used for our production chemicals and services."

EESE uses little debt to own all that and generate monster earnings. Debt was $3.6m against run-rate EBITDA of a similar amount. 

You can own all that at only 4x run-rate PE!

Why is a well-run company available at a cheap price? The low valuation may imply that high earnings are temporary. If real earnings are lower, the PE would be higher and more in-line with the market.

Is EESE over-earning? It all comes down to oilfield drilling activity and oil prices. The stock is saying that those would eventually slow down or decline.

I am bullish on oil prices and drilling activity. Chronic under-investment in global oil exploration is the key ingredient in the recipe for higher energy prices. 

Shale oil producers in the US have also limited oil supply by refusing to drill more, despite higher oil prices. The scars of the previous shale bust are still fresh.

The demand picture also seems supportive of higher energy prices, despite recessionary concerns.

While rising inflation supports higher oil prices, that can be offset by higher costs that reduces profits. This appears not to be a problem for EESE for now. The company reported passing higher prices to customers in the latest quarter.

If inflation and oil prices remain where they are, EESE can easily be a 10x PE story. If both go higher, the stock may be a home-run.

Energy is a cyclical industry. Over-investment can quickly follow periods of under-investment. Before the capital spigots are turned on again, I remain bullish on EESE.