Should You Buy This Cheap E&P Stock?

I'll bet dollars to doughnuts you've never heard of Lakonishok, Schliefer, and Vishny, unless you're a total investing dweeb like me. But before they founded LSV Asset Management, which now has $51 billion under management, they were obscure academics about to publish a very famous paper. Best of all, the insights they discovered can help you find stocks that will stack the odds of a successful investment in your favor. Read on to see whether it can make you money in E&P stocks.

Turning investing upside-down
In 1994, the trio divided stocks into 10 buckets, according to earnings yield -- E/P, or the inverse of the price-to-earnings ratio, because academics prefer the exotic. LSV found that high-E/P stocks -- also known as low P/E stocks, or value stocks -- beat low-E/P, high P/E glamour stocks by 4 percentage points per year.

LSV next divided stocks into groups using a formula based on sales growth. Amazingly, they found that boring businesses with low sales growth outperformed flashy high-growth companies by 7.3 percentage points per year.

Best of all, LSV found that a portfolio combining the high-E/P and low-sales-growth approaches outperformed its opposite – high-P/E, high-growth stocks – by 11 percentage points per year!

I keep LSV's formula in mind every month when I'm selecting dividend stocks for my Income Investor newsletter. Let's use it right now to dig up a slow, cheap, and potentially outperforming value stock for your own consideration. I used data from Capital IQ (a unit of Standard & Poor's) to unearth companies trading at a P/E less than seven, with sales growth of less than 3% last year. Here's one that came up:

EXCO (NYSE: XCO  )
EXCO is a Dallas-based natural gas exploration and production (E&P) company that went public during 2006 – when the future of natural gas was looking a lot brighter. Current board member T. Boone Pickens and CEO Doug Miller were the key players, and continue to own sizeable portions. E&P is risky, though, and highly subject to natural gas prices – which have been in the dumps recently, thanks to the current glut of American gas.

That brings up an important nuance: EXCO's net income is pretty good this year, but the market isn't rewarding it with a high price just yet, because of the volatile nature of finding gas. In fact, thanks to some writedowns, EXCO lost money in the 2008 and 2009 calendar years.

But EXCO has acreage in the high-potential Marcellus and Haynesville gas shales, so if (and probably when) gas rebounds, this low-P/E stock might rise.

We see EXCO's volatile P/E trend borne out industrywide. For instance, Texas-based Range Resources (NYSE: RRC  ) sports a P/E of 146 because the market expects earnings to rise. Let's see how some of the other industry participants look.

Company

P/E

EXCO

2.3

Forest Oil (NYSE: FST  )

8.8

Petrohawk Energy (NYSE: HK  )

28.8

Ultra Petroleum (NYSE: UPL  )

17.9

Cabot Oil & Gas (NYSE: COG  )

24.5

Bill Barrett (NYSE: BBG  )

11.0

I can't advocate buying EXCO -- or any stock -- blindly. But considered in light of LSV's findings, it has better-than-average odds of outperforming.

If you scan the news articles on value stocks, you'll see plenty of reasons not to invest. But according to LSV's findings, those same reasons have already driven many investors away from stocks like EXCO. Thus, a company facing headwinds can get priced so cheaply that it actually becomes a good investment. Things don't have to go exactly right; they just have to turn out better than the market expects. In short, companies with low expectations can give you the best chance to score a truly great investment.

James Early owns no stocks mentioned in this article. You can investigate his Motley Fool Income Investor newsletter free for 30 days.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool owns shares of Ultra Petroleum and has a disclosure policy.


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