Now is the time to load up your portfolio with energy stocks. While the slide in oil prices might not give this impression, the simple fact of the matter is that energy businesses goes through commodity cycles all the time. It might or might not have hit what some would call the bottom of the market, but many companies are selling at much lower prices than they did several months ago. When these sorts of situations develop, it's worth asking, "What would Benjamin Graham do?" After all, Warren Buffett has gone on record saying Graham's book, The Intelligent Investor, is the greatest investing book ever written.
So let's look at the biggest players in the energy space -- the integrated oil and gas companies -- and see which would be considered the best investment based on criteria laid out in Graham's seminal work.
What are we looking for?
Investing isn't an exact science, but Graham's book did offer some effective advice on how to better your chances of picking winning stocks. Here are a few things he held paramount.
Strong financial position: This means having a solid balance sheet without a whole lot of debt, along with ample liquidity to handle a cash crunch during tough times. Two of Graham's rules of thumb were having current assets twice the size of current liabilities and having working capital in excess of long-term debt. The Big Oil space, though, is an extremely capital-intensive business that centers around multibillion-dollar capital projects, so the chances of a company having less than than working capital is next to nil. Instead, let's use total debt to capital of less than 25%, which is a pretty conservative balance sheet ratio for the industry as a whole.
Stable earnings: This one is a bit of a no-brainer. Big Oil companies aren't high-growth machines that can be forgiven from time to time if earnings come in lower than expected. Investors buy these companies for stable earnings that can produce a dividend and a return for shareholders. For this we'll consider the company's return on equity.
Value: This is a tricky one. Graham's book offers a formula that can be used to compares the current price of a company's shares and an approximate intrinsic value based on its current and future earnings per share. Here's the formula:
Any number greater than one means that the company in question's intrinsic value is greater than today's current price, and vice versa for values less than one. Take this formula with a big grain of salt, though, because it relies on accurately estimating how the company will do over the next several years. That is tough to predict in a commodity market such as oil and gas. For argument's sake, let's use earnings growth rates over the past 10 years as our estimate for future growth. Overall oil and gas demand for the next decade is projected to be very similar to demand growth over the past 10 years -- 14% and 28% for oil and gas, respectively -- and the price of oil over this time period was relatively flat.
Also, we can play it safe by looking at a second value metric from Graham: price to earnings multiplied by price to book value. If these combined values are less than 22.5, then it is probably worth taking a deeper look at the stock.
Tale of the tape
Based on these metrics, here is how Big Oil companies stack up:
|Company||Current Ratio||Debt to Capital||Return on Equity||Relative Intrinsic Value||P/E x P/BV|
|Royal Dutch Shell (NYSE:RDS-A)||1.16||20.86%||8.27%||0.76||13.97|
Let's start with financial strengths. By Graham's rule of thumb, none of the companies on this list have ample current assets on hand. Those with better current asset ratios have higher levels of debt, so they are exchanging longer-term liabilities for shorter-term flexibility. I guess when you have investment-grade ratings and almost unlimited access to cheap capital you can do that.
In terms of value, Chevron and Royal Dutch Shell stand out. Neither has a desirable relative intrinsic value, but they are the best in the bunch and fall well under that threshold of price to earnings times price to book value. I should note, though, that ExxonMobil's book value is skewed because it has bought back so much of its stock over the years, which lowers book value and increases return on equity.
What a Fool believes
These numbers are by no means a definitive answer for what to buy and what to avoid, but they paint a pretty decent picture of each company's financial strength and valuation.
Looking at all of the numbers here, my guess is that Graham would probably hold off on buying these stocks for another day when perhaps Mr. Market decides to act a little less rationally. If forced to pick one, though, Chevron seems to be the best option today. It has a solid financial position with adequate liquidity, better than average returns, and the best value based on current earnings, current book value, and intrinsic value of future earnings, assuming it can maintain its earnings growth, which has been 1.26% annually over the past decade. If you are looking to add some Big Oil to your portfolio, then your short list of research should probably focus on Chevron, followed by ExxonMobil and Royal Dutch Shell.
The Motley Fool recommends Chevron and Total (ADR). The Motley Fool owns shares of ExxonMobil. 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.