Whenever an industry hits the skids, much in the way energy has during the past year, some contrarian investors will start looking for stocks on sale. If that describes you, there are few better investors worth modeling your investment style around than Benjamin Graham. His writings are a blueprint on value investing.
Let's dust off our copies of Graham's seminal book, The Intelligent Investor, and use some of his investing principles to determine the three best value stocks in energy.
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The Intelligent Investor litmus testOne thing that separated Graham from his peers was his relentless pursuit of value, as he sought out companies that the market had hammered but that still had solid financials. While there are no hard-and-fast rules for finding these sorts of stocks, Graham laid out a few guidelines in The Intelligent Investor that we'll abide by:
1. Strong financial condition. Graham says companies should have strong liquidity and a good balance sheet, which of course sounds like a gimme when looking at stocks in general. For our rule of thumb here, we'll use his suggestion that a company with sufficient liquidity should have a current ratio of at least 2.0 -- in other words, current assets should be twice that of current liabilities.
For financial strength of the balance sheet, Graham recommends that total debt not exceed two times working capital. This is extremely difficult to do in the energy sector, though, because it is such a capital intense business. So instead of using this, let's use a debt to capital ratio of less than 25%, which is pretty conservative for the industry in general. According to a survey by S&P Capital IQ, the average debt to capital ratio of the energy sector is about 43%.
2. Moderate valuation. This was Graham's way of gauging what Mr. Market thought of a company's stock. He suggests looking for a price-to-earnings ratio of 15 or less and a price-to-book value ratio of 1.5 or less. If a stock hovers in that range but misses one of the criteria, however, Graham suggests multiplying these two metrics, if the combined Price to earnings and price to book value are less than 22.5, then it's probably worth considering.
3. Intrinsic value compared with stock price: This is a tricky one that's worth taking with a big grain of salt. In the book, Graham gives a formula for approximating the intrinsic value of a stock based on its earnings growth rate. Here's the formula:
A number greater than 1 from this formula suggests that the company's intrinsic value is greater than the current price of the stock based on this approximation of earnings growth.
The problem is that the formula is based on something we can't measure: future earnings. So let's make a couple assumptions 1) oil and gas demand growth for the next 10 years will be about what it was for the past 10 years--14% growth in oil demand and 28% growth in natural gas demand. and 2) earnings growth rates for the next several years will be about what they were over the past 10 years. 10 years could be a good number to look at here because it ends at the height of a previous commodity cycle and ends today in a lower point in the cycle.
The candidatesIf we use these three criteria as our benchmark for a great company that has a strong financial standing and that the market is probably undervaluing, there aren't many companies that pass the test. Of the ones that do, these three stand out head and shoulders above the rest:
Source: author's calculations. Data from S&P Capital IQ.
After going through more than 100 energy stocks, it's interesting to see that the three on top are all oil services companies. Helmerich & Payne owns and leases land rigs for shale drilling, National Oilwell Varco manufactures just about every piece of equipment imaginable for the oil and gas industry, and Newpark Resources sells specialty drilling fluids and also leases and sells containment mats to prevent ground contamination atdrill sites.
These companies have been hit hard enough in the recent price crash to land them on a value investor's radar. There are, however, two red flags suggesting that these numbers aren't as great as they appear -- and one of them relates to the drop in oil prices.
The vast majority of H&P's rigs are newer, high-specification machines that are used predominantly in U.S.-based shale drilling. Much of National Oilwell Varco's profit derives from building drilling packages and supplying aftermarket parts for deepwater drilling rigs. Newpark's mats are mostly used in U.S. shale drilling, while its drilling fluids are tied to shale and deep offshore drilling. The problem: Both U.S. shale and offshore drilling activity have declined significantly over the past several months because of low oil prices, and they may be some of the slower forms of production to return as prices get better.
The second red flag is that it may be difficult to match the fantastic earnings growth these companies have seen over the past 10 years.
Source: S&P Capital IQ.
On the other hand, even if these companies' achieve growth rates that are half of these figures over the past 10 years, they would still pass the Intelligent Investor litmus test. Considering all three have rock-solid balance sheets, plenty of liquidity to cover any short-term cash issues, and current valuations that seem overly gloomy, these companies could be major value picks in today's energy space.
What a Fool believesThere are no guarantees in investing. Even Benjamin Graham admits as much in his book. However, going through an exercise like this could increase your chances of finding stocks with a decent margin of safety that will minimize your downside risk. These three companies pass Graham's test with flying colors, and perhaps they should be on your radar as new investment possibilities.
The article 3 Energy Stocks That Would Suit the Intelligent Investor originally appeared on Fool.com.
Tyler Crowe owns shares of National Oilwell Varco.You can follow him at Fool.com under the handle TMFDirtyBird, onGoogle+,or on Twitter@TylerCroweFool.The Motley Fool recommends National Oilwell Varco. The Motley Fool owns shares of National Oilwell Varco. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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