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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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The Best ETF In These Harsh Oil Markets

One of the most difficult conundrums for many investors is trying to decide whether to go the stock picking route or simply buy and index fund and leave the guessing about individual company earnings to others. Experts differ on which strategy is best with some advocating for picking stocks especially under market conditions at present, and others suggesting a simpler broad-based approach is better for most investors.

The ETF versus stock picking issue has to be especially vexing for many energy sector investors in 2015. The issue is that for all the bottom-up analysis, virtually all energy stocks were down in concert last year. True, some stocks were down more than others, but that’s hardly a consolation to stock pickers as it merely suggests the best energy investment at all last year was none at all. Energy stocks topped, or rather bottomed, the list of worst performing S&P 500 names last year, and thus far 2016 has only brought more misery. Related: Citigroup: Oil Is The “Trade Of The Year”

There is good news though. At this point, energy stocks as a whole are deeply discounted. The entire sector is deep in value territory. While that does not mean that the sector is going to turn around tomorrow, it does mean that energy stocks bought today will likely be higher in five years’ time, perhaps much higher.

The problem that many energy investors today face is that it is not clear which energy stocks are well positioned, and which are not. While the sector as a whole may represent a good value, some companies will likely end up going bankrupt or being sold in a distressed sale before the market turns around. Investors betting on individual stocks in this market run the risk of picking a name that could go bankrupt before the market turns. This is always something of a risk in individual stock picking, but given the current market state, that risk is heavily elevated. Related: Why Surge In Renewables Investment Is Unrelated To Oil Prices

Instead investors are likely to be better off opting for a broad basket ETF that gives them exposure to eventual upside in oil prices with the benefits of diversification to offset any bankruptcies or company specific distress. XLE is a good choice for many investors with a medium term horizon or longer. The ETF offers a broad basket of stable energy companies including a significant weight in many of the biggest names like Exxon Mobil, Chevron, and Schlumberger.

XLE is trading close to its lowest level in more than five years, and carries a price-to-book ratio of just 1.5X. The P/E ratios for the ETF overall and many of its constituent companies appears elevated at roughly 23X, but this is largely a result of current oil prices and one-time goodwill impairments that have pummeled earnings. On a cash flow basis, the ETF is trading at roughly 7X its trailing cash flows, making it among the least expensive sectors of the market overall. Related: Oil Prices Rebound Above $30. Is A Rally Finally Here?

Individual investors on average considerably underperform versus the overall market which many research economists attribute to a propensity to trade too often and a lack of stock picking skill. For the vast majority of individual investors without professional help, an ETF is a much better choice, and in today’s market especially that is particularly true in the energy sector.

Investors should avoid picking stocks without expert help in this market, and for those who want to go it alone, XLE is a solid long-term value.

By Michael McDonald of Oilprice.com

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  • James on January 24 2016 said:
    disinvest in dirty fossil fuels and invest in energy clean renewables. It's the clear choice for our future.
  • ali zafar on January 26 2016 said:
    how does XLE compare with VDE (vanguard oil related ETF)?

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