I’ve been looking at the Vanguard Energy Fund (VGENX) as part of my current studies on sector specific funds, and have been pleasantly surprised by the historical performance of the fund. Since 1984, it has beaten the S&P 500 by about a percentage point and delivered returns slightly north of 10% annually to investors.
This historical outperformance is impressive given the sharp decline in the fund’s performance since June 20, 2014. That was the day it hit a high of $77.38, and the Vanguard Energy Fund (VGENX) has since fallen to $38.32 per share. Even though the fund came in existence back in 1983, total returns still take a sharp hit when the measuring period includes a period towards the bottom of the business cycle. If someone bought at the May launch and sold in June 2014 at the thirty-year mark, the annual returns would be nearly 13%. Instead, you get 10% annual returns including expense ratios from 1984 through 2014.
I bring this point up because, before you contemplate purchasing the Vanguard Energy Fund (VGENX), you should be aware that experiences a significant amount of volatility on a year-to-year basis. If you bought this energy fund at the start of 2006, you would immediately see a $10,000 investment fall to $9,200 before climbing to $16,240 in the early summer days of 2008 before falling hard in value to $7,700 in March of 2009 before gradually marching its way back to $17,300 in the early summer of 2014 before falling hard to $10,080 right now. That is the volatility factor you should be aware of: From January 2006 through January 2016, you built no wealth through this fund. You were patient, steadily waiting, and doing things the old-fashioned way, and ten years later, you had nothing to show for it.
Now, this may give rise to the question: Why would you want to buy something that is capable of not producing wealth over a ten-year period? Because: (1) over long periods of time, the compounding from energy stocks is on par with consumer stocks and only trails the healthcare and tobacco segments of the economy; and (2) if you invest in a basket of stocks near a low, you are set for low. From a low measuring point with energy stocks, you get satisfactory compounding period through the next oil crash and you have outstanding compounding results during the next period when the price of oil is at a high.
To give some concrete examples–shortly after the Vanguard Energy Fund (VGENX) went public, the price of oil fell hard in 1986 and took about 30% off the price of a typical energy investment. Yet, what happened to the people that bought in 1986? They reaped 14.5% annual returns from Vanguard Energy at that low point through 2014, and they reaped about 11.5% annual returns from 1986 through the lows of the February 2016 pricing. The timing doesn’t have to be perfect, just generally correct: Buying oil stocks at the right time is a form of perpetual protection because your returns are extraordinary through the next booms and still quite good through the next busts.
There’s an old Wall Street adage “well bought is well sold” that I usually ignore in the context of noncyclical firms because it is rare to get a screaming good deal on blue chips like Colgate-Palmolive or PepsiCo, especially compared relatively to the other opportunities that exist at the time (e.g. when Colgate sells at $55 per share in 2009, you have firms like Wells Fargo, Aflac, General Electric, and American Express in the $10 range also competing for your investment dollars).
But in the context of industrials and energy companies, there is something to be said about getting a good price. Often, when the business cycle turns, these firms get much cheaper than the fundamentals warrant, and create a great opportunity for long-term investors because they stand to benefit from: (1) rapidly increasing earnings from the lower base; (2) dividend growth that is consistent with the industry turnaround; and (3) expanding valuations that give total returns in excess of business performance growth.
If you buy it now, this is a fund that you almost certainly want to keep in some type of tax-deferred account because the amount of distributions can be significant. As recently as 2014, a combination of dividends, short-term capital gains, and long-term capital gains netted you $4.16 per share in cash. That’s a big deal to keep in mind when the price of oil rises if your starting point is a purchase order at $38 per share. That would give you almost 11% in cash in a single year compared to your purchase price of Vanguard Energy (VGENX) now.
I recently profiled The Vanguard Health Care Fund (VGHCX) where the tax protections of the investment isn’t an issue. The cash is less than 1% in most years, as it invests in biotechs that rapidly grow earnings and then holds them for the long haul (though, when those biotechs are eventually sold, it does create a large long-term capital gain). But the centrality of tax protection is much more important in the case of the Vanguard Energy Fund (VGENX) because almost 40% of your total returns come from the distribution of income. If you want to actually have anything like those 14% annual returns mentioned from a cyclical low measuring period to a cyclical high, then tax deferral becomes a necessity.
It also provides some protection in the event that oil prices stay low for a long while–approximately 42% of the fund’s value derives from its top ten holdings, and its largest holding is Exxon which is doubled the size of the second-largest fund holding (Chevron), and also had Royal Dutch Shell in the fourth spot. Though, BG Group is in the ninth spot, and assuming the fund holds onto the stock after the merger, you’ll have Exxon, Chevron, and Shell constitute the top three holdings. You can’t beat that.
The fund also has significant, but secondary, investments in Schlumberger, EOG, and Occidental Petroleum which provide more capital appreciation during a recovery in the price of oil. The only downside is that these stocks fall harder during price declines, which explains why Vanguard Energy (VGENX) has seen its price decline more than Exxon has seen its price decline from June 2014 through February 2016. But, if you believe that oil will be much higher five years from now than it is today, The Vanguard Energy Fund (VGENX) offers more capital appreciation potential than you would get from Exxon, which frankly, hasn’t fallen all that much given the dramatic plunge in the price of oil.