Cutting Through The Smoke In The Energy Sector: Choose Stocks Over ETFs

by: David Trainer

Two of the three stocks added to our large/mid cap Most Dan­ger­ous stocks list for Novem­ber are from the energy sec­tor. Those stocks are Energy XXI (Bermuda) Ltd. (EXXI) and Supe­rior Energy Ser­vices (NYSE:SPN) – both get my very dan­ger­ous rat­ing as do all of the Most Dan­ger­ous stocks. Notably, Dyn­ergy (NYSE:DYN) also had my very dan­ger­ous rat­ing when it announced bank­ruptcy might be in its future in late June of this year.

There are no energy stocks on our Most Attrac­tive stocks list for Novem­ber but there are 14 attractive-or-better-rated stocks in the energy sec­tor, such as Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX) and Dia­mond Off­shore Drilling (NYSE:DO). Fig­ure 1 shows that nearly 40% of the mar­ket cap of this sec­tor gets an attractive-or-better rating.

So you would think that there are lots of attrac­tive ETFs in the energy sec­tor, right? Wrong.

There are no attractive-or-better rated ETFs despite nearly 40% of the mar­ket cap of the sec­tor get­ting our attractive-or-better rat­ing. In fact, none of the energy sec­tor ETFs is bet­ter than the S&P 500, which pro­vides a decent amount of expo­sure to energy along with addi­tional diversification.

Click to enlarge images

Fig­ure 1: Energy Sec­tor – Allo­ca­tion & Hold­ings by Pre­dic­tive Rating

Sources: New Con­structs, LLC and ETFdb. * # of Hold­ings excludes cash; analy­sis based on data as of Novem­ber 7, 2011

Fig­ure 2 shows how 15 Energy sec­tor ETFs stack up ver­sus each other, the over­all sec­tor and the S&P 500 based on their pre­dic­tive rat­ings and the allo­ca­tion of their hold­ings by rating.

All of the energy sec­tor ETFs get a dan­ger­ous rat­ing, which means you should sell them.

Fig­ure 2: Pre­dic­tive Rat­ing and Allo­ca­tion Com­par­isons – Energy Sector

* % may not add up to 100% due to the exclu­sion of cash and hold­ings not in our cov­er­age universe.

Sources: New Con­structs, LLC and com­pany fil­ings; analy­sis based on data as of Novem­ber 7, 2011

Another impor­tant take­away from the fig­ure above is that investors can­not trust the labels on energy ETFs.

Just because the ETF issuers call it an “energy ETF,” investors can­not trust they are get­ting expo­sure to the best that the energy sec­tor has to offer. I see the same issue in ETFs across all sectors.

My next obser­va­tion is that ETF issuers are doing their best to sell as many ETFs as pos­si­ble and give investors as many choices as pos­si­ble. Fig­ure 3 lists 15 U.S. equity energy sec­tor ETFs that we cover.

Fig­ure 3: Hold­ings Count of Energy Sec­tor ETFs

Sources: New Con­structs, LLC; and com­pany filings

There are major dif­fer­ences in method­olo­gies between ETFs, which results in dras­ti­cally dif­fer­ent hold­ings even within a given sec­tor. And the prob­lem is that the passively-managed ETFs are not doing a good job of allo­cat­ing to the good stocks in the sec­tor. Do not be blinded by the smoke.

My rec­om­men­da­tion is that investors build their own port­fo­lio of energy stocks rather than trust some­one else to do it for them. Oth­er­wise, I think you might get burned.

Dis­clo­sure: I receive no com­pen­sa­tion to write about any spe­cific stock, sec­tor or theme.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.