Friday, 3 May 2013

Time to Fill 'er Up on Oil & Gas Stocks?

Many investors will have noticed that the shares of oil and gas companies have been taking a beating in the last few years. It's one of the main reasons the TSX Composite has been lagging the S&P 500 in the USA. From a peak in mid-2008, oil & gas shares first suffered a big decline and then have got stuck in a doldrum. The chart below (using BMO InvestorLine's internal ETF comparison tool) shows this pattern using the benchmark ETF of the TSX, iShares' S&P/TSX 60 Index Fund (TSX: XIU) and the iShares S&P/TSX Capped Energy Index Fund (XEG), which tracks the oil & gas sector.
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We note that the oil & gas stocks, despite the woes of the past five years, have returned slightly better than the overall TSX over the ten year period. A 150% total return for XEG versus 139% for XIU isn't shabby for either. Maybe we shouldn't be too despondent. Nevertheless, where there is a downtrodden industry, perhaps there is an opportunity to pick up good stocks that have been dragged down with the negative sector trend, so we decided to have a look.
Finding the oil & gas stocks
Using the TMX Money stock screener, we extracted a list of candidate stocks by setting the Sector to Energy and imposing a minimum $2 billion market cap to eliminate the multitude of smaller companies and to thereby focus on established successful companies that have a longer track record. With the 34 companies thus located, we eliminated pipelines like Enbridge, TransCanada, Pembina and Inter Pipeline and utilities like AltaGas. The remainder is a mix of integrated companies that do everything from exploration to production, refining, marketing and distribution, to others that exist in one part of the energy chain or who provide services to the industry. Our first table shows the companies and their type. The table also shows which companies are in the ETFs XIU and XEG. All but two are in XEG, shown by the orange cells, and 11 are part of XIU, the light purple cells. Many of these stocks pay a very attractive dividend, much above that of XIU and XEG's average, as we can also see from the first table. A key question is thus whether the payouts are sustainable.
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Past market performance and profitability
It is no surprise that most of the stocks have had significantly negative returns over the past 1 and 5 years and many have suffered declining profits and have cut dividends, as we can see in our second table below. But, encouragingly, there are some notable exceptions that have increased profits and boosted dividends. Most companies are still making profits, as shown by the positive Return on Equity. Using the profitability factors, we have rated each company with an A (best), B (indifferent) or C (poor) grade. Ten companies out of the 26 get an A.
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Riskiness and volatility
Most investors want to avoid future nasty surprises, so we want to assess how stable and reliable are these companies. Are they paying out too much in dividends as a proportion of earnings, as tested by the dividend payout ratio?  One - Keyera Corp - actually paid out more in dividends than it earned in 2012, which may be sustainable in the short term with enough incoming cash flow but cannot be in the long term. Too low a payout ratio can also be bad if management uses profits for empire building on unproductive investments (which we noted in our recent post on Canadian dividend ETFs). Other risk indicators include the actual daily volatility of the stock relative to the market average (measured by beta, with 1.0 being the market average, i.e. the same as XIU, under 1.0 being less volatile and over 1.0 more so); the dispersion of future earnings per share estimates by analysts (the less the better as we noted in this post); insider trading, i.e. what executives and directors of these companies are actually doing with their own money (buying is obviously a good sign, while selling may be bad as we discussed previously here; and several debt burden indicators since too much debt with the fixed interest obligations makes the company more susceptible to downturns. Only seven companies got A on these factors.
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Price Attractiveness
The final set of measures aims to see whether the stock price reflects a good buy relative to earnings, cash flow, sales and book value. In several cases, the ratios don't all tell the same story. Along with that, we have included (and taken the grain of salt we suggested in this post) the average recommendation of stock analysts on each stock, as well as the often differing results of the value assessment tool provided by BMO InvestorLine to its clients. We are looking for patterns and consistency of results. But there seems to be even less consistency in this set of factors, as only six stocks garnered an A.
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The "A List" of overall best looking stocks to buy
Consolidating the ratings across all the above categories leads us to the following five stocks which we think merit an overall A rating:

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Of course, if you aren't sure which are good and which bad, it is always possible to buy XEG (or other energy sector ETFs listed at TMX Money), which holds almost all of these stocks. If you aren't sure whether the sector is worth buying as against any other sector, XIU holds some of everything.

Disclosure: This blogger owns shares in Imperial Oil.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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