Look at the Relative Valuations Before Buying Energy Stocks

Oil prices have dropped by about 40% over the past six months. Not surprisingly, the decline has led to weakness in oil-related stocks. This weakness intensified last week when shares of many energy companies were assigned Black Friday discounts.

Following the big drop, there have been some calls for investors to start buying these stocks. These calls are based on the assumption that oil prices will rebound in the months to come. Having started my finance career in Houston analyzing energy-related companies, I fully realize the potential profits that can be made from taking a contrarian stance. Being greedy when others are fearful does work in the energy sector.  (It also works well in all other sectors too). The challenge is knowing when a discount is a true bargain. A very big secondary challenge is ensuring the longer-term reward is large enough to justify the short-term opportunity cost of a continued drop in the stock price and/or a period of underperformance.

Fortunately, meeting these challenges does not require forecasting where oil prices will be six or 12 months from now. I don’t know where crude prices will be next year and neither does anybody else. A combination of supply, demand and the strength or weakness of the U.S. dollar all influence the price of crude. There are simply too many underlying variables and wildcard events to make a reliable forecast. There are some basic assumptions we can use, however: the global economy remains highly dependent on oil, the amount of oil in the ground is decreasing, it will become more difficult and expensive to extract it in the future and whenever oil stays below certain price levels, various companies have less economic incentive to continue pumping from certain wells.

There is also one other assumption we can use: valuations are mean-reverting. To the extent that valuations have contracted too much, prices on energy-related stocks should rise. This assumption is at the heart of contrarian investing. Contrarian investors look for situations where the prevailing valuation has priced in most of the bad news but little of the potential for upside. Contrarian strategies work because what ultimately matters is how a stock performs after purchase. As an investor, you want to maximize your potential reward relative to the level of risk you are taking.

How do you know if valuations have priced in enough bad news? Look at the relative valuations. Over a period of time, valuations will fluctuate within a range. Valuations below their historical average are attractive (the stock is cheap) while valuations above their historical average are pricey (the stock is expensive). Be sure to do additional research to ensure that nothing has significantly changed to warrant a reduced valuation. Also, look at the absolute valuation. If a stock has traditionally traded at a price-earnings ratio of 100 and now it trades at 50, it is technically cheap on a relative basis but still darn expensive on an absolute basis. You want the stock to be attractively valued both on a relative and on an absolute basis.

The following tables put the current relative valuations of energy-related stocks into perspective. The first table shows the median sector and industry group median price-earnings (P/E) ratios as of the end of November 2014 (last week’s closing price) and how they compare to three-, five- and seven-year average medians. The second table shows the median P/E ratios at four different key dates: the end of last month, June 2014 (just before oil started its recent drop), February 2009 (the end of the last bear market) and June 2008 (near the last record high for oil prices).

The data is from our Stock Investor Pro database and screening program. I used the statistical summary report function (click on “Print” under the “File” menu in Stock Investor Pro) to gather the data.

Table 1. Current and Historical Median Price-Earnings Ratios

Table 2. Month-End Median Price-Earnings Ratios

 Source: AAII Stock Investor Pro. Data as of 11/28/2014.