After looking at different industries and comparing average return on equity to average price-to-book multiples, independent oil & gas stocks appear overvalued in aggregate. As a whole, these stocks appear promising for constructing net-short positions because they produce below-trend average ROE for their average price-to-book ratio. Using this top-down approach to choose industries for a net-short position, attractively-priced stocks and overpriced stocks were identified among independent oil & gas stocks.
Why create a fully or partially hedged position?
Alpha hunters might consider net short positions in industries trading at indefensible multiples, market neutral positions for fairly valued industries, and net long positions in industries with attractive valuations. If they are willing to hedge their positions, they can find more investment opportunities than they would by just hoping to find the best industries or stocks to buy today. Instead, they can use fully or partially hedged positions to bet on the mean reversion of different stocks in an industry while minimizing or reducing exposure to industry and market volatility.
Independent Oil & Gas Stocks
Plots of these companies reveal how some stocks are much more attractively priced than others:
In each of these graphs a measure of quality or growth is plotted on the y-axis as a function of a measure of cheapness on the x-axis. Historical price-to-earnings multiples, price-to-book multiples, and price-to-sales multiples were used as measures of cheapness. Analyst estimates for earnings growth, historical return on equity, and historical sales growth were plotted as measures of growth or quality. More attractive stocks are found up and to the left while less attractive stocks are found down and to the right.
In the context of history, many of these valuations are simply indefensible. Historically, a price-to-earnings multiple near 15 is considered reasonable, yet there are several independent oil & gas stocks which exceed this rule of thumb.
Two above-trend stocks are presented in bold and three below-trend short picks are listed in red:
Canadian Natural Resources
Enterprise Products Partners
Pioneer Natural Resources
Data from finviz.com
Apache and Chesapeake were found to lie among stocks in the upper left of these plots (higher quality, undervalued stocks) while Nexen, Pioneer Natural Resources, and Range Resources were found to lie at the lower right of these plots (lower quality, overvalued stocks). Based on this work, a net short position for independent oil & gas stocks can be constructed by buying APA and CHK shares while hedging with a larger total short position in NXY, PXD, and RRC shares.
Please read the article disclaimer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.