Energy: The Most Attractive Sector Now

by: Stephen Yu, CFA

After rallying nearly 80% from March 2009 through April 2010, the U.S. stock market looked stretched. But what a difference a month makes. After just last month’s "May"hem, many stocks are looking attractive again. To be certain, there are not as many screaming buys as a year ago. Nonetheless, there are more low-hanging fruits now than at any other time since 2Q09. Where are those fruits, you ask? Well, in investing, reversal to the mean usually ensures that the area with the worst recent performance is the most fertile. Therefore, to find those fruits, follow me to find the area that underperformed.

To start, let’s look at the performance of the sectors in the Dow Jones Industrial Average (DJIA) over different periods.

As you can see from these charts, the energy sector has been the worst in all 4 periods. So the economy has been bad, the energy sector gets hit, but why has it been hit so much harder than basic materials, especially in the YTD and 1-year period? Both energy and basic materials are economically-sensitive. What affects one affects the other. So when energy underperformed materials by a wide margin, does it mean energy is cheap?

Glad you ask, because the above charts really do not do the sectors justice. The charts compare only the absolute sector performance, and that is not right. Let me explain. Some sectors are more volatile than others. Using finance lingos, high volatility is high beta and vice versa. Let’s suppose the DJIA rises 5%, a high beta sector may rise 7%, and a low beta one may only rise 2%. Therefore, if one sector rises more than another, it does not necessarily mean one is over or undervalued. It can be that the sectors are simply rising proportional to their beta.

If, however, a sector rises more than its beta suggests, then that sector may be overvalued. So for my next exercise, I used the performance of the DJIA and each sector’s beta to determine the "expected" performance. The difference between the actual performance and the expected performance of each sector is plotted below. The sector with the largest negative performance difference is the one that underperformed most relative to expectations and therefore is most likely undervalued.

In this second series of charts, the underperformance of energy is even more pronounced. Not only did energy underperformed relative to other sectors on an absolute basis as shown in the first 4 charts, it underperformed relative to its historical pattern. You want more proof? You got it.

Next, I compared each sector’s May 31, 2010 valuation to its fair value. To do this, I used iShares sector ETFs as proxies. For example, I used IYE as a proxy for the Dow Jones Energy sector. I then compared each ETF’s May 31, 2010 closing price against its fair value provided by Morningstar. The chart below plots discount from Morningstar fair value of the sectors. The larger the discount, the more undervalued and attractive a sector is. (Unfortunately, Morningstar does not provide a fair value for IYT, the iShares ETF for Dow Jones Transport sector, and so the sector is excluded.)

In this case, financial is the most undervalued sector; health care is next, followed by energy. OK, energy is not the cheapest according to Morningstar, but it is close.

Finally, I compared the sector ETFs prices against their trading range in the last 3 years. Why the last 3 years? Simply that in these years, stocks have seen both overvaluation and undervaluation. So even if you cannot calculate fair value, you know that you can find it somewhere in the last 3 year. And the closer to the bottom of the range a sector is, the more undervalued it is. To make the comparison easier, I normalized the results so that if a sector is trading at the top of the last 3 years’ price range, it is at 100%. Similarly, if a sector is at the bottom of the price range, it is at 0%.

Again, energy trade closest to its three-year low amont the sectors.

In all the above analyses, energy underperform relative to others and relative to its historic norm. As I wrote in the beginning, energy’s poor performance is understandable given PIIGS, Chinese tightening, and the oil spill, but that does not mean this result is justified. We simply need energy. The demand is growing. It may be falling slightly in developed countries, but it is growing in emerging markets. More cars are sold in the emerging markets than in developed markets now.

When a developed economy enters a recession, its energy demand slows only marginally; but when an emerging market grows, the energy demand grows exponentially because energy consumption in such a market is inefficient. Net-net, demand will grow. Sure, China is tightening. But we are talking about going from 10% annual GDP growth to may be 7-8%, still very high, and certainly China is not going from 2% to 0! According to the latest outlook, the Energy Information Administration projects oil to reach $84 a barrel this year and $87 in 2011. This outlook does not even factor in oil supply disruption caused by the gulf oil spill.

Yet, oil is trading near $70! And speaking of the oil spill, it will only make it more expensive to extract oil in the future! Higher oil prices ultimately benefits the energy sector as a whole.

Of all the driving forces in investing, reversal to the mean is probably the most dependable. Nothing can defy the norm forever. When something is flying too high or too low, Adam Smith's invisible hand will eventually put it where it rightfully belongs. Therefore, energy's present below-normal valuation provides a good entry point for the patient investor. Besides low valuation, energy is attractive also because it provides protection against future inflation. Finally, many companies in the energy sector pay good dividends. So what is not to like?

Disclosure: Author is long energy stocks and energy ETFs