Seeking Alpha
Long/short equity, value, research analyst, deep value
Profile| Send Message|
( followers)  

We rec­om­mend investors short Oil Ser­vice HLDRS (NYSEARCA:OIH) and iShares Dow Jones U.S. Oil Equip­ment and Ser­vices (NYSEARCA:IEZ). We rec­om­mend investors avoid all other energy sec­tor ETFs. We also rate the invest­ment merit of the top nine energy sec­tor ETFs.

Per our first-quarter 2011 review of U.S. equity sec­tor ETFs, the energy sector is one of two sectors that gets our “dangerous” rating. Fig­ure 2 shows how the energy sector’s stocks and the mar­ket value attrib­uted to them stack up under the micro­scope of our stock rat­ing sys­tem. The energy sec­tor has only 12 stocks that we rate attractive-or-better while it has has 146 stocks that we rank dangerous-or-worse. Some good stocks in the energy sec­tor to buy indi­vid­u­ally or as part of an ETF are Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX). Some stocks to avoid, sell or short in the energy sec­tor are Baker Hughes (NYSE:BHI) and Slum­berger (NYSE:SLB).

Fig­ure 1: Energy Sec­tor – Cap­i­tal Allo­ca­tion and Hold­ings by Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings.

Though 36% of the value of the energy sec­tor goes to attractive-or-better-rated stocks, the sec­tor gets our neu­tral rat­ing because neutral-or-worse-rated stocks make up 65% of its value.

The key take­away here is that the energy sec­tor offers both good and poor invest­ment oppor­tu­ni­ties. The invest­ment value of each ETF is derived from its con­stituents, so ETFs that over­weight attractive-or-better-rated stocks, like XOM and CVX, can be great invest­ment oppor­tu­ni­ties while ETFs that over­weight neutral-or-worse-rated stocks should be avoided.

When ana­lyz­ing energy sec­tor ETFs, we started by iden­ti­fy­ing those ETFs with accept­able struc­tural integrity as mea­sured by XTF, an ETF research firm. We chose the six ETFs with a XTF rat­ing above the sec­tor aver­age XTF rating.

Fig­ure 2: Energy ETFs With Accept­able Struc­tural Integrity

Click to enlarge

# of Hold­ings excludes cash.

Sources: New Con­structs, LLC; XTF and com­pany filings.

Fig­ure 2 shows clearly that not all energy ETFs are made the same. Dif­fer­ent ETFs have mean­ing­fully dif­fer­ent num­bers of hold­ings and, there­fore, dif­fer­ent allo­ca­tions to hold­ings. Given the dif­fer­ences in hold­ings and allo­ca­tions, these ETFs will likely per­form quite differently.

After deter­min­ing the struc­tural integrity, we ana­lyzed the invest­ment merit of each ETF based on how it allo­cated value to each stock it held. Fig­ure 3 shows how the six energy sec­tor ETFs stack up vs. each other and the over­all sec­tor based on over­all risk/reward rat­ings and the allo­ca­tion of hold­ings by rating.

Fig­ure 3: Invest­ment Merit Based on Hold­ings and Allocations

Click to enlarge

Sources: New Con­structs, LLC; XTF and com­pany filings.

Attrac­tive ETFs

We find no attractive-or-better-rated energy sec­tor ETFs.

Neu­tral ETFs

IYE, VDE and XLE allo­cate their value in a way that earns them a Neu­tral Over­all Risk/Reward rat­ing. We rec­om­mend investors buy the Very Attrac­tive and Attrac­tive stocks in this sec­tor before buy­ing any of the Energy ETFs we cover in this report.

Dan­ger­ous ETFs

We rec­om­mend investors avoid or short RYE, PSCE, XES, XOP, OIH and IEZ because of their "Dangerous-or-Worse Over­all Risk/Reward" rat­ings. Fig­ure 3 con­trasts the dif­fer­ence in invest­ment merit between IYE, IEZ and the over­all sector.

Bench­mark Comparisons

Sec­tor Benchmark

IYE and the over­all sec­tor have com­pa­ra­ble qual­ity of earn­ings rat­ings. Both IYE and the sec­tor earn Very Attrac­tive Eco­nomic vs. Reported Earn­ings rat­ings because their Eco­nomic Earn­ings are pos­i­tive and rising.

IYE out­per­forms the sec­tor in val­u­a­tion rat­ings. IYE has a Price-to-EBV of 2.3, earn­ing it a Neu­tral rat­ing, and a GAP of 28 years com­pared to the over­all sector’s Price-to-EBV of 2.4 and GAP of 33 years.

Fig­ure 4: IYE – Risk/Reward Rating

Click to enlarge charts

Sources: New Con­structs, LLC and com­pany filings

Fig­ure 5: Energy Sec­tor – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings.

IYE and the over­all energy sector’s allo­ca­tion of value are very sim­i­lar. Per Fig­ure 3 above, IYE allo­cates 36.7% of its value to Attractive-or-Better-rated stocks while the sec­tor allo­cates 35.9%. IYE also allo­cates 34.5% of its value toward Dangerous-or-Worse-rated stocks com­pared to the sector’s Dangerous-or-Worse weight­ings of 39.5%.

For expla­na­tion and details behind our risk/reward rat­ing sys­tem, see one of our Com­pany Val­u­a­tion reports, which are avail­able here.

Mar­ket Benchmark

The S&P 500 out­per­forms IYE in qual­ity of earn­ings rat­ings. IYE and the S&P 500 earn Very Attrac­tive Eco­nomic vs. Reported Earn­ings rat­ings because their Eco­nomic Earn­ings are pos­i­tive and ris­ing. The S&P 500 earns a Very Attrac­tive ROIC rat­ing with an ROIC of 18.2% com­pared to IYE’s ROIC of 8.4%.

The S&P 500 also out­per­forms IYE in val­u­a­tion rat­ings. The S&P 500 has a Price-to-EBV of 1.4, earn­ing it an Attrac­tive rat­ing, and a FCF Yield of 2.4% com­pared to IYE’s Price-to-EBV of 2.3 and FCF Yield of –2.5%.

Fig­ure 6: IYE – Risk/Reward Rating

Click to enlarge charts

Sources: New Con­structs, LLC and com­pany filings.

Fig­ure 7: S&P 500 – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings.

The S&P 500 allo­cates value more effec­tively than IYE. Per Fig­ure 3 above, IYE allo­cates 36.7% of its value to Attractive-or-Better-rated stocks while the S&P 500 allo­cates 42.3%. IYE also only allo­cates 34.5% of its value toward Dangerous-or-Worse-rated stocks com­pared to the S&P 500’s Dangerous-or-Worse weight­ings of 23.7%.

Method­ol­ogy

This report offers rec­om­men­da­tions on energy sec­tor ETFs and bench­marks for (1) investors con­sid­er­ing buy­ing energy sec­tor ETFs and for (2) com­par­ing indi­vid­ual ETFs to the energy sec­tor and the S&P 500. Our analy­sis is based on aggre­gat­ing results from our mod­els on each of the com­pa­nies included in every ETF and the over­all sec­tor (188 com­pa­nies) based on data as of April 19, 2011. We aggre­gate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to ana­lyze ETFs in the same way they ana­lyze indi­vid­ual stocks.

To make an informed ETF invest­ment, investors must consider:

1) The struc­tural integrity of the ETF and its abil­ity to ful­fill its stated objec­tive. We use XTF, an ETF research firm, to find the top nine ETFs with the best struc­tural integrity rating.

2) The qual­ity of the ETF’s hold­ings. We deter­mine an ETFs qual­ity using our over­all risk/reward rat­ing system.

Given the suc­cess of our rat­ing sys­tem for indi­vid­ual stocks, we believe its appli­ca­tion to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buy­ing deci­sions.

Source: Scrutinizing 'Ugly' Energy Sector ETFs