Value In Action: James Cole

Being a value manager does not preclude you from investing in oil stocks with oil trading near $100, as some might think. Few managers are as fervently committed to both the value style and the peak oil theory as James Cole of AIC Ltd. In fact, Cole picked up and moved his family to Calgary last year from AIC’s headquarters in Burlington, Ontario in no small part due to his desire to be closer to the oil industry where he is heavily invested.

Calgary offers “unparalleled access to information on the Canadian energy industry,” says Cole who has been running AIC Canadian Focused Fund since its inception in February 2000. He joined AIC after a three-year stint managing money at Gluskin Sheff and prior to that at Beutel Goodman. Cole learns new things every day about companies and industries, but in terms of his approach to value, he has always been attracted to AIC’s investment style modelled after world renowned investor Warren Buffet. He tries to “adhere” to that style every day.

He aims to buy companies “for significantly less than they are worth.” A company is worth “all the cash it will throw off over the life of its business discounted at some appropriate rate.” So the real challenge is to accurately forecast a company’s cash flows.

Perhaps it is unsurprising that Cole wants every company he invests in “to be financially strong” to garner an “investment grade” rating. That ensures greater predictability of cash flows. Said another way: “It is one of those things that gives those companies the ability to persevere through adversity which every company will inevitably have.”

A company’s financial position in considered in an “all encompassing way.” Its not just balance sheet measures such as leverage ratios but answers to questions of financial strength such as: “are they generating free cash? What’s the schedule of their debt maturities? What’s the state of their fixed assets?” And income statement measures too: “Are they covering interest expense? How many times out of operating income? That sort of thing.”

“You are looking for companies that have some durable competitive advantage,” says Cole “and that is hard to find in some industries, textiles for example.” Textiles are “pretty much a commodity product.” It is also, not coincidentally, the original business of Berkshire Hathaway, the multi-billion dollar holding company controlled by Warren Buffet. In his 1978 letter to shareholders, Buffett had this to say about the textile industry:

“The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.”

That description applies equally well to the commodity industry, and it explains why many value investors have not invested in energy and materials companies over the past few years when commodity prices were making new highs. Many figure that the commodity industry, which has been a cyclical industry, will turn down with prices and earnings reverting to the mean.

Cole sees things differently having studied the fundamentals of the oil industry in great detail in recent years. He sees a fundamental or secular shortage of oil supply going forward that will prevent oil prices from reverting to the long-term average. The additional demand for oil coming from emerging markets, especially China, makes the problem more acute. It is a situation of “tight supply” that Buffet makes exception for in his description of the textile industry, and it explains why Cole, a value manager at heart, is heavily invested in oil companies.

Cole isn’t attracted to just any oil companies though, but those companies that have an “enduring competitive advantage”, the ones that are producing oil in the Canadian oil sands where oil is literally extracted from a tar that is dug out of the ground. Canadian oil sands producers have “50 years of reserves” compared to conventional oil producers that “may have 10 to 12.” They also have “no finding costs and no exploration risks.” Conventional companies are “always spinning their wheels and suffering production declines.” In contrast, oil sands producers have no production declines either says Cole.

Companies such as Suncor have been part of AIC Canadian Focused Fund since inception in 2000, and Cole remains firmly committed to this company and other tar sands producers. Even after more than doubling in price in recent years, Cole still sees value in these companies. He believes higher oil prices are a permanent feature of the economic landscape and that oil sands producers have been offering the best value opportunities in this space.