How a value investor might approach the red-hot energy sector

WHAT ARE WE LOOKING FOR?

North American-listed energy companies with above-average value characteristics and upside price momentum.

Energy remains the S&P 500’s top performing sector. The Energy Select Sector SPDR Fund (XLE), a good proxy, has returned an astonishing 71 per cent over the past 12 months. XLE is also the only Select Sector SPDR Fund with a positive return over the past month, with a gain of 15.8 per cent.

THE SCREEN

We will be using Trading Central’s Strategy Builder stock screener to search for North American-listed energy stocks that have fundamental characteristics that are attractive to a value investor as well as short-term upside price momentum. We begin by setting a minimum market capitalization threshold of US$1-billion to screen out the smaller, more junior companies in the sector that tend to have above-average volatility.

Next, we screen for energy stocks that have a price-to-cashflow ratio below nine. This ratio measures how much a share costs versus the cash flow being generated by the company. It is often a more reliable measure than price-to-earnings, as it is harder for a company to manipulate its cash flow numbers than its earnings-per-share figures.

In order to avoid companies that are highly leveraged, we focused on companies in the energy sector that are indicating a debt-to-equity ratio of less than 0.85. The higher the ratio, the more leveraged the company is.

It is also important to analyze the company’s return on equity, which measures how effectively management has used invested capital to generate income.

We set a minimum of 5-percent ROE.

We are interested in energy companies indicating an operating margin of 10 per cent or greater. Operating margin is a measure of how much profit the company makes on each dollar of revenue. Higher operating margins are preferred.

Finally, for positive short-term price momentum, we screened for stocks in the energy sector that have returned 5 per cent or more over the past four weeks.

We have also included dividend yield, P/E ratio, year-to-date and one-year percentage return for your reference.

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WHAT WE FOUND

Our screener ranks the list based on all performance and revenue criteria.

Topping our list is Parex Resources Ltd., headquartered in Calgary with operations in Colombia. Earlier this month the Colombian government signed 30 contracts with oil and gas companies, including Parex. Some US$4.4-billion of investment is expected to be made in the country’s hydrocarbons sector this year, according to the Colombian Petroleum Association. Parex has the lowest debt-to-equity ratio on our list, near zero (0.001); the industry average is 0.79. Looking at operating margin, the company has the secondhighest margin on our list at 46.6. Its P/E ratio is the lowest on our list at 9.8.

Magnolia Oil & Gas Corp., a Houston-based independent operating in South Texas, has the highest return on equity on our list at 47.8 per cent. The stock price is within 4 per cent of its alltime high this week despite the recent broad market sell-off. Calgary-based Canadian Natu

ral Resources Ltd., operating mainly in Western Canada and the British sector of the North Sea, has the best four-week and year-to-date price performance on our list at 19.7 and 20 per cent, respectively.

Over all, valuations in the oil and gas sector are looking quite attractive as we head into earnings season despite the impressive price performance. All the companies on our list are expected to report earnings in February and March.

The investment ideas presented here are for information only. They do not constitute advice or a recommendation by Trading Central in respect of the investment in financial instruments. Investors should conduct further research before investing.