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Expert Roundtable: Looking at Oil Stocks? Buy These Instead

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Renewable energy and water treatment should prove far more resilient investments than oil in the years ahead.

Oil prices have recovered over the past couple of weeks, but are still down more than 60% since early January. As a result, just about every company involved in the oil industry will lose money this year, and many won't survive. That's why, even with the stock market having recovered much of its losses suffered in late February and early March, oil stocks still, as a category, look very cheap. For instance, the SPDR S&P 500 ETF Trust (SPY 1.69%) is down about 15% from the pre-crash high at recent prices, while the Energy Select Sector SPDR ETF (XLE 0.76%) is still down nearly 40%. 

As a result, many investors are looking at oil stocks for bargains. The catch, of course, is that even as we are on the cusp of seeing more of the economy open up in the weeks ahead, oil demand is expected to be below 2019 levels for months to come, resulting in a continued expansion in the oversupply that's pushed prices down. For many oil stocks, this massive glut of oil will push the benefits of the economic recovery even further into the future. 

Blocks with black arrows pointing right with one red arrow pointing left.

Image source: Getty Images.

So before you rush into the oil patch to bargain hunt, it may be time to take a look at other parts of the energy sector, and even beyond. Three of our top energy contributors say NextEra Energy (NEE 1.16%)A.O. Smith Corp (AOS 2.32%), and Atlantica Yield (AY 0.54%) are better buys right now. Keep reading to find out why. 

This energy stock has a bright future

Matt DiLallo (NextEra Energy): The COVID-19 outbreak has had a major impact on the energy sector, especially oil companies. Prices have cratered because demand has fallen off a cliff, which is causing significant financial stress across the industry. Several oil companies have filed for bankruptcy, and many more will likely follow.

While the reopening of the economy has some investors believing oil will bounce back, I'm a bit more skeptical given the glut of oil still searching for storage space. That's why I'm focusing most of my investing dollars elsewhere. One stock I think is a much better option than most in the oil patch is electric utility NextEra Energy.

NEE Dividend Chart

NEE Dividend data by YCharts

For starters, the company's operations are largely immune to the impact of COVID-19. Because of that, NextEra fully expects to deliver financial results at the high end of its guidance range for the next few years.

One of the sources powering NextEra's optimism is its world-leading renewable energy business. The company continues to add new projects to its backlog, which will provide steady cash flow when they come online thanks to the fixed-rate contracts it signed with other utilities and end users to supply them with renewable energy.

That renewable-focused growth should give NextEra the power to continue increasing its dividend at a healthy rate in the coming years. This outlook puts it light-years ahead of most oil companies, which have seen their payouts plunge with crude prices this year.

A steady cash engine no matter the economic cycle

Tyler Crowe (A.O. Smith): The most compelling aspect of water treatment manufacturer A.O. Smith is that it generates an enormous amount of recurring revenue. While water heaters, commercial boilers, and water purification equipment may sound like a highly cyclical business that fluctuates with the construction market, it's actually a very stable business where more than 85% of residential water heaters are replacements of existing systems. Even through the housing collapse a decade ago, the company's replacement water heater business barely missed a beat. 

Prior to the novel coronavirus pandemic, the company was working through some challenges related to U.S.-China trade relations. China was a major growth catalyst for the company and A.O. Smith had established a dominant market share in water heating and water treatment equipment there. As trade tensions kicked into high gear, though, the company's sales there plummeted. That was only made worse when much of the country went into lockdown during the outbreak.

AOS Dividend Chart

AOS Dividend data by YCharts

Fortunately, the company has its steady North American replacement sales as a cash generator and has made some drastic cuts to its overseas business. The company has a net cash position -- that's cash minus debt -- of $261 million as of its most recent earnings report. Management has also done a stellar job of maintaining a high return on invested capital despite the market headwinds. 

With so many unknown variables out there in the oil market and the economy as a whole, buying stocks that have incredibly reliable revenue sources no matter the economic cycle can be great buys. A.O. Smith's slow and steady sales in North America will be a great cash engine to keep it going through tough times and will give it the capital to reinvest in growth markets like China and India when the time comes. 

Three powerful words 

Jason Hall (Atlantica Yield): The two stocks my colleagues offer up above are wonderful choices. I own shares of a NextEra affiliate, and A.O. Smith's track record of growing its dividend is compelling evidence that backs up Tyler's thesis. My pick, Atlantica Yield, has some things in common with both companies. 

First off, its biggest business is renewable energy production and transmission, which it sells to utility customers and industrial users under either regulated rates or long-term contracts. This business proved durable in the first quarter, with revenue coming in about 5% below last year's first quarter with cash available for distribution -- a cash flows measure that helps measure its ability to support its dividend with cash leftover to invest in the business -- up about 5%. 

Atlantica also operates a water segment that, while a relatively small part of its business, does have solid long-term prospects and had its biggest revenue and second-best adjusted EBITDA quarter ever to start 2020. 

Those three words hinted above? Management summed up Atlantica's resilience and strength during the current crisis in the earnings presentation, saying that so far, it had experienced "no material impact" from the COVID-19 pandemic that has shut down so much of the global economy. 

Yet investors still have sold out of this small but strong cash-flow business. At recent prices, shares are down 14% since January and almost 30% below pre-crash highs. As a result of this sell-off, Atlantica's dividend -- which was just reaffirmed at $0.41 per share -- yields more than 7%. 

Instead of taking a risk and hoping you catch a winning investment in the oil patch, consider Atlantica Yield. Not only is it trading for a big discount, but it pays a dividend that should prove very safe, and its business is strong and growing. Few oil companies can offer more than just the discounted stock price right now. 

Jason Hall owns shares of Atlantica Yield. Matthew DiLallo owns shares of Atlantica Yield and NextEra Energy. Tyler Crowe owns shares of A. O. Smith. The Motley Fool recommends NextEra Energy. The Motley Fool has a disclosure policy.

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Stocks Mentioned

NextEra Energy, Inc. Stock Quote
NextEra Energy, Inc.
$90.47 (1.16%) $1.04
SPDR S&P 500 ETF Trust Stock Quote
SPDR S&P 500 ETF Trust
$427.10 (1.69%) $7.11
The Select Sector SPDR Trust - The Energy Select Sector SPDR Fund Stock Quote
The Select Sector SPDR Trust - The Energy Select Sector SPDR Fund
$78.47 (0.76%) $0.59
A. O. Smith Corporation Stock Quote
A. O. Smith Corporation
$63.87 (2.32%) $1.45
Atlantica Sustainable Infrastructure plc Stock Quote
Atlantica Sustainable Infrastructure plc
$35.57 (0.54%) $0.19

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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