How To Successfully Invest In Energy Stocks

Trying to pick individual stocks is difficult. Most investors struggle in large part because they lack the kind of information and tools that are available to professionals. In addition, an increasing part of the market is made up of computer programs that trade stocks based on mathematical relationships and metrics that have been shown to be reliably correlated with future outperformance in earnings and stock prices.

Building on my last article about picking stocks based on quantitative metrics, this article discusses the second set of three metrics that have been shown in numerous economic studies to be useful for predicting future stock returns. This is true for energy stocks and companies in every other industry out there. Related: Three Stocks Well Positioned For An Oil Price Rebound

The second set of three characteristics that investors need to consider when buying a stock are earnings momentum, quality of profitability and a stock's Short Interest Ratio.

1.) Earnings Momentum: Earnings momentum refers to the economic performance of a firm over the last 12 months. Studies have shown consistently that firms with strong positive earnings growth over the last 12 months outperform other comparable firms. This is the basis for strategies by some of the most successful hedge funds in the world today. Stocks with good earnings growth might seem expensive because their price has usually risen considerably - yet investors should ignore the firms that seem "cheap" and tilt their portfolios to the "expensive" firms with good earnings momentum. Those firms are the ones that will continue beating earnings expectations in the future. In fact, the real power in earnings momentum is with those stocks that have outperformed 6 to 12 months previously. Firms that hit that hurdle will continue to outperform for the next 12 months on average. Related: Exposing The Oil Glut: Where Are The 550 Million Missing Barrels?!

Two good metrics for assessing earnings are operating cash flows and the recycle ratio. Operating cash flows are a cash flow statement term which includes only the cash that a firm generates from its regular operations rather than through financing or investing activities. Operating cash flows consist of non-cash earnings such as depreciation and amortization plus net income.

Recycle ratios are a little more complicated to calculate, so it might be worth consulting a source like Bloomberg or a financial expert for help on that front.

2.) Quality - Value investors should never look at a simple stock price or even a price-to-earnings ratio to decide which stocks to buy. Instead, investors should be screening for high "quality" firms where quality is defined as low debt, and high stable gross profits measured as revenues less COGS. A good measure of quality in energy stocks is return on capital employed (ROCE). ROCE measures a company's profitability and the efficiency based on the amount of capital it is employing. Return on Capital Employed (ROCE) is calculated as follows:

ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed Related: Iran Slowly But Steadily Increasing Oil Market Share

3.) Short Interest Ratio: Finally, investors need to consider the short interest ratio of a firm. Short interest ratios measure the amount of shares in a company which are shorted divided by the number of shares traded per day on average. Firms with a high SIR have abysmal future returns on average. Investors in the energy sector should look for stocks that have low SIR compared to their peers. On average a SIR less than 3.0 is reasonably acceptable, while SIR less than 1.0 is good. Energy firms with a low SIR have outperformed otherwise similar energy firms with a high SIR by an average of about 2 percent per month over the last year!

There are no guarantees in investing of course, but following these metrics will substantially improve the performance of a portfolio over time according to numerous economic researchers.

By Michael McDonald of Oilprice.com

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