Beaten Up Energy Stocks Could Offer Inflation Protection

Published June 14, 2012

| TradeKing

Alan Brochstein Sees Value in Energy E&P Companies

Energy stocks seem to be out of energy. The stocks in the S&P 500 have dropped 8% so far in 2012, by far the worst performing and only negative-returning sector in an index whose price has increased 4% this year. Over the past year (through May), the sector has dropped over 16%. For long-term investors, this seems like a potential opportunity to invest, especially for those who are concerned about potential inflationary pressures.

The slowing global economy, especially in recessionary Europe but also in emerging growth economies that are still growing but more slowly, is pressuring the price of oil. Additionally, early-in-the-year tensions in Iran seem to have faded, at least for now. Finally, the plunge in North American natural gas prices has crimped near-term profitability for many companies in the sector. Buying energy-related companies, such as exploration and production companies or integrated companies, is out of favor currently, but they seem to have rock-bottom valuations based on several different metrics.

I decided to screen the sector to identify some of the best potential opportunities. Here is what I did, using Baseline:

·       Russell 3000 member
·       Energy Sector – E&P or Integrated
·       >$500mm market cap
·       Trailing PE < 10X
·       Trailing 1-year EPS growth > 0%
·       Net debt to capital < 35%
·       Price to tangible book value < 2X

Here are the 9 stocks that made the cut:

Please remember that these are not recommendations. You should always do a thorough investigation of any company before investing in it. The source of the data in the table above is Baseline, a product of Thomson Reuters.

I have sorted the companies by YTD return. The first seven are all in the S&P 500, while the last two are in the S&P 600 Small-Cap and Russell 2000 indices. Note that the average return is -16%, which is worse than the sector return. None of the stocks have improved in price this year. Over the past year, the average stock has declined by 25%, while the S&P 500 has improved in price by 3%. Looking further out, the stocks on average have slightly outperformed the market over the past five years.

I have highlighted four of the stocks as having very low net debt to capital, which offers some downside protection in the event energy prices keep declining. On a trailing basis, the average PE is 8X, which is substantially lower than the 13PE on the S&P 500. On a forward basis, the average rises to 9.4X compared to 12.2X on the S&P 500, as a few of the stocks are expected to see earnings decline over the next year. The forward PE is typically 70% of the ten-year median.

Beyond a lower PE ratio, the stocks also show cheapness on other metrics. Looking at the price relative to the tangible book value, I have highlighted four stocks near or below 1X. Looking at Enterprise Value to EBITDA, which accounts for the amount of cash and debt and compares the full company value to the operating cash flow adjusted for depreciation and amortization, six of the names are below 4X. Even the most expensive name, at 5.4X, is quite reasonable, especially in light of its strong balance sheet. Finally, four of the stocks have dividend yields in excess of the 2.1% that the S&P 500 offers (though Conoco (COP) may be incorrect due to the recent spin-off of its refinery business).

Screening is just a starting point in any investment process. The next step is to analyze more carefully any of the ideas that seem worth pursuing for potential investment. In this case, we seem to have found some stocks that aren’t performing very well but that offer low valuations by several measures. The market has lost its concern about inflation in the near-term as Europe struggles with high levels of debt, but the ultimate resolution to strong monetary stimulus around the world could be global inflation. In that case, companies with energy reserves, such as those mentioned above, could provide investors with some protection from rising prices.

Alan Brochstein
Founder, Invest By Model and AB Analytical Services
TradeKing All-Star Commentator

Disclosure:  CVX is in the Conservative Growth/Balanced model portfolio at Invest By Model

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Alan Brochstein maintains a business relationship with TradeKing.

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