A Bargain In The Wreckage: Energy Stocks

| About: iShares Global (IXC)

Call #1: Remain overweight on global energy companies

Unfortunately September lived up to its reputation as the worst month of the year.

Despite generally better-than-expected economic numbers, at least in the United States, and some marginal progress in Europe, stocks ended the month with big losses. While I don’t see any immediate turnaround in the economy or markets, it looks like a good time to trawl the wreckage looking for bargains, particularly considering that cash and even long-dated fixed-income are producing no yield.

One sector that has suffered from both recession fears and general risk aversion: Energy. After a strong start to the year, US energy stocks are down roughly 25% from their July peak.

The recent sell-off has left the sector unusually cheap. Currently, US large-cap energy companies are selling for 1.6x book value, close to an all-time low. The stocks also look inexpensive based on earnings metrics, with the sector trading at less than 10x earnings, and barely 9x forward earnings. Finally, the sector also appears underpriced relative to the broader market. Energy stocks currently trade at a 13% discount to the broader market; as recently as March, they were trading at around a 5% premium.

Part of the recent sell-off can be attributed to the cyclical nature of energy companies. As demand for oil and refined products is driven by economic activity, a global economy teetering on the brink of a recession should lower the price that investors are willing to pay for these stocks. That said, even when you control for the anemic pace of the recovery, the sector appears undervalued.

When you also consider that the energy sector has not been performing as poorly as the overall economy, the undervaluation appears even more pronounced. I first favored the energy sector in late December. Since then energy stocks have lost around 12%, performing slightly better than overall market.

In addition, while overall factory use has been stuck at below average levels since 2008, refiners continue to use up spare capacity. In August, the percentage of refining capacity being used rose to more than 87%, the highest level since January of 2008. This is important as tighter capacity typically leads to higher margins for refined products such as gasoline and heating oil.

This is indeed what I’m seeing today. Spreads for refined products are close to record levels, which should lead to strong cash-flow for refiners and integrated oil companies. In fact, with refining margins at these levels, you would typically see energy companies trading at a 10% premium to the broader market, not a near 15% discount.

While energy companies are unlikely to recover until investors gain some visibility into the risks posed by Europe and the broader prospects for the global economy, for patient investors, now appears an opportune time to buy. Energy stocks were arguably cheap late last year; now they look to be particularly compelling. As such, I still view the global energy sector as a good long-term opportunity.

My preferred vehicle is the iShares S&P Global Energy Sector Index Fund (NYSEARCA:IXC). The fund is made up of large, global integrated energy companies with solid balance sheets and strong cash-flows. As of August 31, it offered a 2.01% 30-Day SEC yield, comparable to a US Treasury, so it may potentially offer investors some income while they’re waiting for stabilization in the economy and financial markets. Past performance does not guarantee future results. For standardized IXC performance, please click here.

Source: Bloomberg

Disclosure: Author is long IXC

Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility.

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