A Rare Value Play in Today’s Pricey Market

With the S&P 500 now trading at nearly 16 times forward earnings, it's becoming increasingly difficult to find attractively priced stocks. But as BlackRock Chief Investment Strategist Russ Koesterich noted in his latest market commentary, one sector appears reasonably priced both relative to the broad market and to its own long-term average: energy. Let's look at some of the main reasons why the sector looks attractive right now.

Photo credit: Ole Jorgen Bratland/Statoil.

Relative valuation
The first factor working in energy's favor is valuation. Despite the sector's year-to-date outperformance, its price-to-book ratio is about 15% below the broader market, slightly lower than its own 10-year average, and about 40% less than its price-to-book ratio in 2010. And its price-to-earnings multiple, at around 10.5 times, is also below its long-term average and significantly lower than the 14 times recorded in 2010.  

Recent decline in oil prices
The second reason is the recent pullback in oil prices. Since the oil and gas industry is cyclical, with earnings and stock price performance determined largely by fluctuations in commodity prices, the right time to buy upstream companies, generally speaking, is when oil prices are low.

While it's difficult to call a bottom in prices, oil is near the lower end of its five-year average, as Brent crude slipped to a 14-month low last week. Despite escalating conflicts involving key oil-producing countries including Iraq and Russia, oil's near-term outlook is bearish because of weaker than expected demand, robust supply, and minimal perceived threat of an immediate supply disruption.

However, oil's longer-term outlook is laden with upside risk. The situation in Iraq looks increasingly precarious and, given that the country is expected to supply 60% of OPEC's oil supply growth through the end of this decade, could seriously constrain long-term global supply growth. Lower than expected OPEC supply growth could coincide with decelerating shale production in the U.S., resulting in a much tighter than expected market and higher oil prices over the second half of this decade.

Low fund ownership
The third and final reason why now might be the right time to go bargain hunting for high-quality oil companies is low interest from institutional investors. According to a Merrill Lynch survey of top fund managers, as of June 2014 energy was one of the most underowned sectors or asset classes relative to historical ownership, along with emerging markets, bonds, and commodities.

While many investors might ignore this data, it's arguably just as important as a sector's valuation and fundamentals in assessing future returns. As legendary investor Ray Dalio noted, you always want to think about a market in terms of the buyers and sellers. Since hedge funds and other institutional investors are among the biggest players in the stock market, their moves carry a lot of weight.

If hedge funds begin quickly piling into energy stocks, which I suspect they will given the sector's aforementioned attractive characteristics, share prices will rise and valuations will become less compelling, eroding future returns. That's why the time to get in may be now when sentiment is overwhelmingly bearish.

Investor takeaway
Despite every urge to sell your energy holdings as oil prices slip, astute investors would be wise to avoid the pitfalls of following the herd and instead stick with energy stocks. Relatively cheap valuations, a strong case for higher oil prices in the future, and low interest from institutional investors combine to form a compelling case.

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