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A Cushioned Contrarian Trade In Energy

Oil

Now, according to the prevailing consensus, is a bad time to be considering any stock in a utility. Interest rates are climbing, and as most utilities have high debt loads and relatively high dividends that leaves them vulnerable to a double whammy. Their debt servicing costs look set to rise and their relative value as yield bearing securities fall as interest on Treasuries and other fixed income products rise. Still, despite that obvious logic, I am bullish right now on a small cap utility, Spark Energy (SPKE).

As I said, the consensus view is negative on the sector, but I learned a long time ago that in any financial market, following consensus views, particularly once they are well established, can be hazardous to your wealth. They are, by definition, both logical and obvious and that is true regarding the case against utilities laid out above. Markets, however, are forward discounting mechanisms, and by the time a view becomes a consensus all the possible effects are usually priced in.

That means there is a limited downside to following the herd and a large upside to being contrarian and finding opportunities where the risk/reward ratio skews in your favor is the essence of both trading and investing. SPKE, after losing over sixty percent between the high in June of last year and the low a couple of weeks ago is a case in point.

(Click to enlarge)

As you can see from the chart above, the stock has bounced a little off that low, but as you can also see, it has bounced off lows on seven other occasions on the way down. That makes buying a risky proposition, but at this point the selling looks overdone, if for no other reason than that SPKE now offers a yield of close to seven and a half percent. That provides a decent cushion against further declines from this point.

In many cases with utilities, a high yield in a rising rate environment is not sustainable as higher debt servicing costs eats into already sub-par cash flow. As this article from Kevin Zeng points out, however, Spark Energy looks to have good coverage of liabilities, suggesting that it has been dragged down by weakness in the industry overall rather than by the specific circumstances of the company.

That is not to say that there are not company specific issues that have contributed to the decline. Spark has missed estimates on each of the last three earnings releases for example, leading to an expectation of disappointment when they report for Q4 2017 in a couple of weeks. Once again, though, that is a case of a worst-case scenario being priced in, and even just an average result from the report will, in that situation, spark some buying.

I would reiterate that buying a stock like SPKE that has strong downward momentum and a negative consensus view is inherently risky, so may not be for everybody. That risk exists but can be managed given the recent bounce off the 9.20 low, which provides a logical level below which to place a stop loss order that would limit potential losses to just over ten percent. Compare that to the sixty percent profit that would result from a fifty percent retracement of the decline and the beneficial risk/reward ratio is obvious and makes the risk of buying this particular utility stock one that is worth taking.




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