Investment management firm Vanguard offers low-cost exchange-traded funds (ETFs) that hold dozens if not hundreds of stocks. A key benefit of these ETFs is their diversification, which can be difficult to replicate through buying individual stocks alone.
But the Vanguard Energy ETF (VDE +0.24%) is highly concentrated in just a handful of companies. It has a 22.8% weighting in ExxonMobil (XOM +0.85%), a 13.3% weighting in Chevron (CVX 0.40%), and a 6.6% weighting in ConocoPhillips (COP +0.35%). Here's why the top-heavy nature of the Vanguard Energy ETF could be a good thing and why the fund is worth buying now.
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Understanding commodity-sensitive sectors
The energy sector is unique because the competition is high, and it is sensitive to changes in oil and gas prices. Commodity-based industries are all about managing costs, staying financially disciplined, and achieving high margins, whereas other sectors have more product differentiation and an importance on brands.
Coca-Cola and PepsiCo are similar businesses, but they sell different products. Adobe and Salesforce offer completely different types of software. Nvidia and Advanced Micro Devices both design chips, but they have different functions and specs.
Buying the Vanguard Information Technology ETF grants exposure to Apple, Microsoft, Nvidia, Salesforce, Adobe, AMD, and plenty of other companies that provide unique products and services.
But in the Vanguard Energy ETF, many companies have identical business models. For example, 26.6% of the fund is invested in oil and gas exploration and production (E&P) companies, like ConocoPhillips, EOG Resources, Diamondback Energy, Occidental Petroleum (OXY +1.28%), and Devon Energy. These companies aim to produce oil and gas for the cheapest price possible and sell it for the highest price possible. And they all have sizable operations in the Permian Basin of eastern New Mexico and West Texas. So, there's a great deal of overlap.
Betting on the best
Leveraged companies with low-quality assets can do very well when oil prices are high. But when oil prices fall, it's the financially healthy companies with a low cost of production that can endure the downturn and even take market share by buying out competitors at low prices.
Many pure-play E&Ps have done an excellent job improving the quality of their assets so that they can thrive even during mediocre price environments. But they don't have the financial flexibility of the bigger players. For example, Occidental Petroleum had a blowout quarter and is raking in high free cash flow thanks to its acquisition of CrownRock, but it still has a ton of debt, which puts pressure on its balance sheet.
By comparison, ExxonMobil, Chevron, and ConocoPhillips have ultra-low debt-to-equity ratios because they have been using profits to pay down debt.
XOM Financial Debt to Equity (Quarterly) data by YCharts
Having sound balance sheets, diversified business models, and highly efficient upstream portfolios allows ExxonMobil and Chevron to grow their dividends steadily. ExxonMobil has raised its dividend for 42 consecutive years compared to 37 consecutive years for Chevron. There are very few companies in the oil patch with that kind of track record for rewarding shareholders with a growing payout.
Other integrated majors, such as Shell, BP, and Equinor, cut their dividends in 2020. ExxonMobil and Chevron were still able to raise their payouts despite reporting significant losses on the year due to the strength of their balance sheets.
Year to date, ExxonMobil and Chevron have handily outperformed their European integrated major peers. And there's reason to believe that could continue.
XOM Total Return Level data by YCharts
ExxonMobil and Chevron have taken a cautious approach to the energy transition, investing within oil and gas rather than branching too far outside the industry. For example, ExxonMobil invests heavily in carbon capture, storage, and low-carbon fuels, whereas many European majors went big into solar and wind energy.
The downturn across the renewable energy industry could continue under the new administration in the U.S., which may have less favorable support for renewable energy project permitting and tax credits. ExxonMobil and Chevron stand to benefit from pro-oil and gas policies.
Quality is a winning formula in the oil patch
You'll find less expensive energy majors than ExxonMobil and Chevron and E&Ps with lower price-to-earnings ratios or price-to-free-cash-flow ratios than ConocoPhillips. But for investors seeking quality over value, these companies stand out as some of the best buys in the industry.
Investing directly in these companies is certainly an idea worth considering. However, some investors may still prefer the Vanguard Energy ETF to get more exposure to the midstream and downstream industries. The ETF includes many high-yield companies like pipeline giants Williams and Kinder Morgan or refiners Valero and Phillips 66.
With a yield of 3.3% and a foundation in ExxonMobil, Chevron, and ConocoPhillips, the Vanguard Energy ETF is a balanced way to invest in the sector while still getting a ton of exposure to the sector's highest-quality companies.
