Contrarians see energy stocks as cheap, but many professionals say they may just get cheaper

Energy Associated Press

Bargain hunting can be a thrill, but remember that it can also be dangerous.

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Brave investors are picking through energy stocks, looking to buy those pummeled by the plunging price of oil. Billions of dollars flowed into energy-stock funds last month, a huge leap from the norm, enticed by prices marked down by 25 percent or more since last summer. But many mutual-fund managers and other professional investors have a warning for the bargain hunters: Don't be surprised if it takes years for the prices of energy stocks to fully recover.

Buying low is one of the bedrocks of value investing, and energy stocks are certainly less expensive than a year ago. But many money managers are waiting for them to fall even lower. In the meantime, they've pulled out of the way and are content to rubberneck.

At the center of the debate is the cascading price of oil. After hitting a peak around $107 a barrel in June, the price has dropped by more than half and settled Thursday at $46.25. Supplies are more plentiful due to increased U.S. production, while weak economies in Europe and elsewhere are pulling down on demand.

Cheaper oil means there will be steep cuts in the profits of energy companies. Analysts expect earnings for those in the Standard & Poor's 500 index to plunge about 30 percent in 2015.

SEARCHING THE BARGAIN BIN

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When the price of oil began its slide last summer, investors fled. For three straight months, they pulled money out of mutual funds and exchange-traded funds that specialize in energy stocks. The selling hit a height in September, with a net withdrawal of $2.3 billion, according to Morningstar.

But investors soon tip-toed back into the group, and the buying exploded last month when net investment in energy funds surged ninefold from November to $3.2 billion. On its own, the Energy Select Sector SPDR ETF attracted a net $2.1 billion.

It's not clear yet who is doing the bulk of the buying, but David Mazza has seen interest from private banks and investment advisers who manage money for relatively wealthy individuals, ones willing to make investments they don't intend to touch for years. Mazza is head of ETF research at State Street Global Advisors.

"Oftentimes in times of stress, opportunities arise," Mazza says. "This doesn't mean energy stocks and energy ETFs are right for everyone, but if someone has a longer-term point of view and is trying to move against the tide, investors are beginning to see there might be an opportunity."

WAITING FOR THE THUD

Should I also try to buy low on energy stocks? It's one of the most common questions that Bob Doll, chief equity strategist at Nuveen Asset Management, hears from clients.

He tells them that it's best not to try to catch a falling knife. Let energy stocks hit bottom first, because they're likely to get even cheaper.

Many pros are doing just that. A global survey of fund managers last month found that they had sharply cut the percentage of their portfolios kept in the energy sector, relative to their benchmarks, according to Bank of America Merrill Lynch.

"What the energy-stock sector needs is not just higher oil prices but also stability in oil prices," says James Liu, global market strategist at J.P. Morgan Funds.

Even if oil magically jumped to $80 tomorrow, energy stocks would likely remain unsettled because investors wouldn't believe that price is sustainable. Some oil production would need to shutter in order to get a better balance of supply and demand, and that takes time.

Investors looking to buy energy stocks now should expect to hold them for at least two or three years, Liu says. "Unless you can really commit to that window, I think there's too much volatility in the short term for investors."

This decline for oil is unlike others because it's due more to a glut of supply than a drop-off in demand, says Margie Patel, who manages $1.4 billion in stocks and bonds at Wells Fargo Asset Management. That's why she is skeptical of some analysts' expectations for the price of oil to find a bottom and bounce back in the second half of this year.

Past declines due to an oversupply of oil have been followed by long recovery periods. In 1986 crude oil started the year around $26, before losing more than half its value by the spring. It didn't get back to $26 until more than four years later.

"Over the next few years, the sector may have much more muted growth than we saw a couple years ago," Patel says.

Lamar Villere, a portfolio manager at Villere & Co., which manages $3 billion in assets, has also been selling shares of his energy stocks on the rare days that they've been up.

"We're not leaving the sector," he says, "but there's just this massive, uncontrollable question mark in terms of the price of oil."