It’s not easy being an energy stock investor these days – or a stock market investor of any kind for that matter – despite the recent minor rebound in oil and stock prices of late. For about 6 years, the general direction of the stock market has been straight up, which in large part reflected the virtually unprecedented (and in large part unwarranted) drop in stocks around the Great Recession as well as the massive monetary stimulus from the Federal Reserve.
Today with valuations back to normal and even somewhat elevated, it is harder to find good stock investments. This article will cover the first three of six characteristics investors should look for in good stock investments.
Many market pundits like to cite current valuations as evidence for another precipitous coming drop in stocks. No one can predict the future of course, but a drop anything like the 2008 collapse is unlikely. Valuations simply are not that rich, and regardless of periodic lamentations about the economy, the U.S. is not doing badly. There is little evidence another recession is on the way unless it is precipitated by inept government interference either from the Fed raising rates too fast or political meddling from Washington. That is cold comfort to energy investors who have little to be excited about beyond a $5 rebound in prices which still leaves oil more than $50 below its peak of a couple years ago.
In these circumstances investors need to hone in on a select few stocks – those that have the characteristics which are hallmarks of long-term winners. Energy investors can benefit from this type of focus especially. There are six major factors energy investors should look for when considering stock investments. All six of these are based on numerous studies by dozens of financial economists including myself.
Some of these factors were even part of the basis for the 2013 Nobel Prize in Economics. To be clear, buying stocks that exhibit these factors does not mean that the company will go up in value today or tomorrow – it just means that on average, over time, firms displaying these characteristics have vastly outperformed other firms.
1.) Small Size – Past research studies have shown that investors should be looking for small companies to invest in rather than large companies if their goal is to maximize returns. This makes sense intuitively since smaller companies have a lot more room to grow than large companies do. Smaller companies are riskier on average than larger companies, but if the investor buys a reasonable portfolio of small firms, they can benefit from the extra return associated with small firms while mitigating the risk. This factor is especially powerful in the energy space. Right now small energy firms are considered to be among the most risky investments, and they are very risky. But these are also the firms with the highest growth potential.
2.) Low Valuation – A lot of investors like to think of themselves as value investors. Unfortunately, most of these investors are assessing value ineffectively. Popular metrics like the P/E ratio or even the PEG ratio are not very effective ways to measure the relative value of a firm. That’s especially true in the energy sector where special metrics need to be used to measure firm value. If investors measure value incorrectly, they often end up being “tricked” by accounting gimmicks used by companies which distort characteristics and leave investors holding the “wrong” stocks. Those investors who do use the right measures of value hold stocks that, on average, perform much better than other stocks.
3.) Low Volatility – It seems intuitive that companies with the highest level of risk, should also have the highest level of return. Unfortunately, that’s not the case, at least based on the common measure of risk used in the financial industry. Risk is usually measured based on the volatility of a stock. Stock pickers often cite their Sharpe Ratios – the ratio of return divided by standard deviation of a stock pick. Energy companies of late are very volatile and also have miserable returns. In fact, research has shown that the most volatile companies are often the worst investments. Higher risk (as measured by higher volatility) equals lower returns. A portfolio invested in the least volatile stocks starting in 1980 would today be worth 19 times as much as a portfolio of the most volatile stocks. Investors need to understand and try to capture returns built on this “vol anomaly”. Capturing extra return based on that anomaly is harder than it sounds
In a future article, I’ll cover the second set of three characteristics investors should look for in stocks, which are related to earnings momentum, quality of profitability and a stock’s Short Interest Ratio.
By Michael McDonald of Oilprice.com
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