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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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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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  • James on March 14 2016 said:
    Are any oil & gas stocks worth investing in? With so much disruption in the energy sector, it seems earnings momentum and ROCE cannot be relied upon going forward. The futures market says oil expectations are below $52/b for the next nine years. So any sort of investment based on a belief in oil price recovery above this level is a bet against the futures market. If the futures market is wrong, please explain why?
  • Robert cattle on April 25 2016 said:
    A stock that produces oil/gas that has good gearing and worldwide areas in every increasing amounts, and with increasing success rate in finding gas for many potential nations
    Is
    Woodside petroleum Australia

    Burma Myanmar needs power. WP has found enough to make the country boom at below 50$
    This goes for many other nations from Ireland to Morocco etc.

    At 26AUD per share an annual increase of above 8% per share in AUD,s will occur as
    Australia sorts out its own economy.
    WP uses US$ as its accounts.

    Pity I have no assets to back this and as my age runs out, 9 years is too long?
    However, I would like to know why this theoretical thought is wrong or is that gain too minimal?
  • David Addison on February 23 2017 said:
    Mike,

    I'm curious as how you came up with those metrics. Can you point to any literature to support utilizing those metrics for the energy industry - specifically upstream oil and gas?

    Have you read this paper from S&P Capital IQ?

    http://marketintelligence.spglobal.com/our-thinking/ideas/drilling-for-alpha-in-the-oil-gas-industry

    //dpa

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