Heed the Bible's Word and Don't Forget Your Oil

The energy sector hasn't been this cheap in over a decade. When shining a light on your portfolio, don't forget the oil.

Jan 26, 2014 at 12:33PM

Matthew 25:3 - "They that [were] foolish took their lamps, and took no oil with them."

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During times of extreme relative stock valuations, it can be difficult for value investors like myself -- and most Fools -- to identify attractively priced investments. Based on the chart above, the energy sector is clearly a bargain when you compare it to historical levels dating back to 1996.

With a price-to-book valuation well below 1.0x, you are essentially able to purchase these companies for less than 80 cents on the dollar. Now, do not misconstrue the chart above to mean that all energy companies are undervalued. This chart is a visual depiction of the overall sector according to the MSCI World Energy Index. As with most distributions, there are sure to be some outliers in both directions. 

Bargain hunting in a surging market
After riding 2013 to some lofty returns, companies appear to be fairly expensive by historical standards, both in terms of traditional price-to-earnings metrics and the derivative, Shiller Price-to-Earnings ratio. For the purposes of this article, I will be referencing the traditional P/E multiple, rather than Robert Shiller's alternative calculation which takes historical levels into account.

For simplicity's sake, we will just examine the S&P 500, which is trading around 19.5 times its aggregate earnings level, with many sectors trading much more expensively than this. Take the 17 Real Estate-focused companies with a price tag of 31.4x trailing twelve months earnings. The 10 companies that make up the Communication Services sector can't be forgotten either, as they currently expect investors to pay 27.5x their trailing earnings. 

Examining these numbers makes it difficult to find fault in an investor who's trigger finger begins to shake the closer the mouse gets to the "Submit Order" icon on their brokerage site. However, rather than shirking the entire market and labeling it "overpriced," try doing a little digging in the energy sector which is only requiring that investors dole out 14.7x the previous twelve months' earnings per share. 

Don't be "foolish" and forget your portfolio's oil
It's easy for me, as an energy analyst, to keep my eyes on this sector, but for many investors, it simply doesn't contain the same consumer-facing firepower that the aforementioned, loftily priced sectors do. Currently, some of the strongest names in the business are available at ridiculously cheap valuations. 

Enough is enough, and it's time for a change
The cheapest among them is Hess Corporation (NYSE:HES). By charging investors just 7.7x trailing EPS, Hess appears to be quite a bargain. While I do believe this claim has some solid footing, Hess' future is not exactly crystal clear.

Major changes have been undertaken by management since October 2012, with several more currently being wrapped up and the sale of its Bakken midstream assets planned for 2015. The sole focus of the shift has been to make Hess an adaptive exploration and production company rather than the integrated dinosaur that it had become. All cylinders appear to be clicking, and the only bump in the road I fear would be a broad reduction in global oil and natural gas prices. 

Offshore valuations are drowning
If ranked by trailing P/E ratios, the bottom half of the S&P 500's energy sector would contain five offshore drillers. I have been finding it tough to convey my confusion surrounding this discovery. Perhaps it's because traditional investors haven't yet regained confidence that was shaken to the core by BP plc's Macondo well explosion. Or perhaps, retail investors simply haven't steered their retirement wagons toward the next great oil and natural gas frontier. It is also quite possible that the shale revolution currently going on in the United States has cast its shadow over these companies like a storm cloud hovering over the Gulf of Mexico.

These attempts at justifying this conundrum are all that I can muster when examining the fact that deepwater leaders like Ensco plc (NYSE:ESV) and Transocean (NYSE:RIG) can be had for less than 10.5x some pretty solid earnings over the past 12 months.

In Ensco's case, shares simply haven't kept up with earnings growth over the past three years, as they are up only 5.8% versus earnings that have risen back to 2008 levels thanks to 35% growth in EPS since 2010 wrapped up. Add to this the fact that Ensco's dividend has risen 93% over the same time frame, and my bewilderment regarding its underperformance expands.

The buck doesn't stop here
The list of "undervalued" energy companies is much longer than the trifecta discussed in this article. In closing, I would encourage you to take a look at an oft-overlooked sector for some potential bargains. Don't simply consider P/E ratios in isolation, though.

This metric can serve to whittle down your candidate pool, but a solid understanding of the business, backed by a thesis that can be tested on a recurring basis, must support your decision.

Questions on the Energy sector? Email us at Energy@fool.com.

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Taylor Muckerman owns shares of Ensco. The Motley Fool owns shares of Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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