“Omnia bona quoad perfora” (Loosely, All prospects look good until drilled)”
In Energy, Part I, I explored the impressive—but highly volatile—returns of energy stocks. In this part, I’ll explore how to find the best individual energy stocks. As we will see, the secret to success in the energy sector is similar to the secret in the consumer staples sector: focus on high quality, cheap stocks. Value has been the most successful factor for choosing energy stocks, but the value strategy can be enhanced by insisting on high return on capital and a low reliance on external debt & equity financing.
In this sector series, I’ll highlight “factors” that can be quickly calculated and compared across a wide universe of stocks. I’ll cluster these stock selection factors into several key categories: valuation, profitability, momentum, and quality. I’ll also include some factors that do not add value historically, despite their appeal (e.g. return on equity). Many popular metrics for evaluating energy stocks require a higher touch than I’ll use here (such as Enterprise value divided by proven & probably reserves). I'm working on a more detailed project to address the more nuanced measures.
What Matters for Stock Selection
Today, there are just 170 U.S. stocks in the sector with a market cap greater than $200MM. If you include international stocks listed on a U.S. exchange (usually as an American depository receipt (ADR)), there are 329 stocks.
My analysis of factors separates the universe into quintiles (buckets that represent 20% of the market sorted by a factor, or roughly 65 stocks each today). I’ve tried to include as many factors as possible that are available at free screening services like www.finviz.com, but I’ve also included some factors that are not available from the free screening services.
Value
The valuation of energy stocks has varied considerably through time. Look at the thick black line in the chart below. Measured against all stocks, energy stocks are sometimes among the most expensive in the market (late 70’s, early 90’s) and sometimes among the cheapest (early-mid 60’s, 80’s).
While the valuation of the entire sector ebbs and flows, investing only in the cheapest stocks within the sector has led to very impressive results. The panel below breaks the universe of energy stocks into quintiles based on different valuation factors. The analysis is run since 1963, and the quintiles are rebalanced on a rolling annual basis (so if you were to run a similar strategy, you’d want to hold positions for 12 months—this holds true for all other factors referenced below).
Clearly, buying cheaper stocks works. All five value factors can point you to sector-beating stocks, but EBITDA/EV works best. Where do these factors point you within the energy sector? Here is the historical valuation percentile (similar to the one above) for the various sub-industries within the Energy sector (average for the whole period and a time series).
It is no surprise that integrated stocks are the cheapest, on average, because they’ve delivered the strongest long term returns (value and returns are intimately related). Nor is it surprising that upstream, E&P stocks are the most expensive (and have among the worst returns). Bottom line: buying the cheaper energy stocks leads to superior results.
Quality
There are many ways to measure quality, but here are the results for a few factors within the energy sector:
Two key lessons stand out.
· Return on total invested capital (where invested capital=book equity + book debt – current cash) is a great way of differentiating energy stocks based on quality. Companies earning higher returns on their capital have in turn delivered higher future returns for their investors.
· Financing is an extremely important component of the energy business. Especially among upstream exploration and production companies, enormous amounts of capital are often required to acquire land and extract oil & gas. Some companies, like Chesapeake Energy, have historically issued huge amounts of capital to fund expansion. Chesapeake’s “external financing” in the chart below is calculated as the total amount of net capital raised (debt & equity issued minus debt & equity retired/bought back) divided by the average assets of the company. Huge capital issuers like Chesapeake have fared poorly, on average.
Buying stocks with higher yields has been an effective strategy. Companies paying regular dividend (whose yield is high because the stock is out of favor) have been reliable investments. While helpful, yield is not as powerful as value when selecting energy stocks.
Momentum
Finally, the trend can—to some degree—be your friend when choosing energy stocks. Those that have appreciated the most over the prior six months go on to outperform in the following year, on average.
Conclusion
Picking stocks in the energy sector is much more complicated than I have explored here, but this is a good starting point. Higher quality companies which are trading at discounts and are less reliant on outside capital have historically done very well. As always, let me know your thoughts by commenting below or emailing me at patrick.w.oshaughnessy@gmail.com. I am working on a much more detailed exploration of energy which will include history, industry overview, stock selection, and issues for the future. If you have topics that you would consider “must cover” issues for this project PLEASE LET ME KNOW! I really appreciate the feedback.
IMPORTANT DISCLOSURE! These backtests do not include any costs whatsoever and so should be taken with a grain of salt. While a once-per-year trading strategy is fairly easy to trade these days, the costs can still be significant when trading in small cap names. These test also have a fairly small sample size. With just about 300 stocks at any given time, the energy sector is small. The good news is that the factors that work in the energy sector work in the other nine sectors too, as we will see over the course of this series, and also work in international and emerging markets (which are nice out of sample tests).
Calculation Notes: everything, as always, is rebalanced on a rolling annual basis to avoid seasonality in the results. Only stocks with an inflation adjusted market cap above $200MM are included in the sample. Going smaller can improve results, but leads to trading and liquidity concerns. Due to several comments about excluding international stocks in part I, I’ve included non-U.S. stocks that have a U.S. listing in this study. Results are similar if the universe is U.S. stocks only, but are improved for the most part with a larger (global) universe.
[i] Shareholder yield = dividends yield plus buyback yield (% change in shares outstanding in prior year, negative better)
[ii] Dividend yield doesn’t “quintile” cleanly because of a group of stocks with zero yield.