Energy Ideas For Contrarians
Many investors won’t touch Energy with a ten-foot pole and that’s understandable. Oil prices are down and we’re constantly hearing reports of too much supply, which is being exacerbated by the activities of politically motivated rather than commercially oriented producers. Still any time a group gets pounded, there are contrarians wondering if and when they should pounce. After all, nothing is forever and trends tend to turn when conventional wisdom least expects.
What’s Ahead for Oil Prices?
Darned if I know. I’m not the one to ask about this. Seriously. I’ve been dead wrong about oil so often, quants might study me and conclude I’m a statistically significant contrary indicator. (But at least I admit it!)
So please, please, please, do not even think of initiating or adding to energy positions because you interpret something I say as being bullish.
But If You Really Want to Play Oil . . .
There’s something I can offer that’s in my wheel house that may help; an approach for picking and choosing among stocks in sector in an effort to find some that can offer better upside and less downside whatever the future of oil prices.
No, I don’t spend my life touring the world’s oilfields checking on who is doing what, who has the best reserves (however that may be defined nowadays), who is adding to reserves most efficiently (Is that still a good thing?), who is in what country, etc. I’m sure, however, that the trade media and high-priced consultants can amply address issues like that.
I’m into good old plain vanilla fundamental and sentiment investment metrics. Financial data! The stuff you see all the time on web sites, ion corporate fillings, in earnings releases, etc. STOP! DON’T CLICK THAT MOUSE!!!
I know you want to exit this post. I know you’re likely muttering “What a ripoff. He dangles an idea and comes up with nothing more than the same old boring nonsense. I want something REAL!”
This is real. I’ll show you. I’ll even reverse the usual sequence give you the good stuff up front, and then explain the approach.
The Bottom Line
Table 1 compares performance (share price change plus dividends) for:
- An equally-weighted ten-stock energy portfolio I created using Portfolio123. It’s refreshed every three months and results include a 0.25% slippage penalty for each trade that establishes or exits a position.
- A equally-weighted benchmark portfolio consisting of all Energy stocks drawn from a Russell 3000-like universe
- A second equally-weighted benchmark portfolio consisting of seven well-known widely traded Energy ETFs: iShares U.S. Oil & Gas Exploration (IEO), iShares U.S. Oil & Gas Equipment (IEZ), iShares U.S. Energy (IYE), SPDR Energy Select (XLE), SPDR S&P Oil & Gas Equipment (XES), SPDR S&P Oil & Gas Exploration (XOP), Vanguard Energy (VDE); the portfolio holds these ETFs in equal weights, but each ETF’s portfolio is market-cap weighted portfolios
What we’re looking for here is a portfolio that has the potential to suffer less than the sector as a whole in bad times while participating, at least fully and hopefully better, during good times. I can’t tell you want Energy will do. But for those who want to make a contrarian play, it makes sense to enhance one’s probabilities by hunting for stocks that have a reasonable probability of outperforming the overall sector.
Table 1: Annualized % Returns (Risk)
| Portfolio | Benchmarks | |||||||||||||||||||||||||||||||||||
| Russell 3000 Energy | Energy ETFs | |||||||||||||||||||||||||||||||||||
| Last 10 years | +7.6 (9.0) | -7.9 (9.8) | -0.2(7.9) | |||||||||||||||||||||||||||||||||
| The Better years* | 32.5 (7.9) | 12.6 (7.0) | 16.9 (7.1) | |||||||||||||||||||||||||||||||||
| The Lesser Years* | 0.4 (9.3) | -13.9 (10.5) | -5.3 (8.1) | |||||||||||||||||||||||||||||||||
| Last 12 mos. | -23.2 (5.8) | -58.5 (9.8) | -23.2 (7.4) | |||||||||||||||||||||||||||||||||
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Better years are 2/23/06 – 8/25/08; lesser years are 8/25/08-2/23/16 Risk is standard deviation of rolling 20-day returns For those who like price charts, here are Figures 1 and 2. Figure 1 – Last 10 Years (Index Values starting at 100)
Figure 2 – Last 12 Months (Index Values starting at 100)
It looks like we’re on to something we see a track record showing less pain on the downside and strong participation in the good times. Table 2 lists the stocks that presently pass muster. Table 2
No, It’s Not Just “Data Mining” Today, many looking at results like this are tempted to brush them off as data mining or curve fitting; excess reliance of 20-20 hindsight. That’s understandable. Testing is a powerful process, but many misuse it, the way drunks misuse automobiles. Still, as with driving and many other situations, one should not judge an endeavor by the misconduct of its worst practitioners. The difference between testing done right and the disreputable kind is that existence of a rational basis, separate and a part from a “what worked” study, for each aspect of the model. For more on this topic, check my post. I believe the one developed here fits the done-right category. And Now, The Recipe The most exotic thing I do here isn’t in the ingredients per se but in the initial decision to apply the basics to what seems to be a very news-driven sector. The portfolio starts with a screen that identifies Energy stocks with market capitalizations of at least $500 million from a universe built on the basis of Russell 3000-like principals. The universe was designed to limit eligibility to legit stocks, those that can be readily traded without excessive bid-ask spreads. A strictly performance-oriented model would have emphasized smaller issues, but I chose to control risk at the outset by imposing a market-cap floor. Smaller companies, however much I love them, do suffer from two handicaps which could be troublesome when one’s sector is going through stormy times; diseconomies of scale (meaning that fixed costs are harder to cover) and lesser or nonexistebnt internal diversification. From that list of stocks passing the screen, the portfolio selects the ten stocks that rank highest under a three-style ranking system I created on Portfolio123. One style is “Quality.” To me, this is a vital measure of fundamental risk. I might look the other way in boom time, but with Energy being pounded as it is, there’s no way anybody should neglect this collection of factors (or another collection similar to it):
The second style is “Value.” That shouldn’t be a hard sell. It uses just two factors:
The final style is “Momentum” (price momentum and analyst sentiment, which often correlates highly with price momentum). Believe it or not, this is actually a very reputable approach – when used properly. It tunes us into qualitative judgments being made within the investment community (which is important since numbers alone can’t tell us everything), but in contrast to monitoring headlines, this sort of data moves us beyond anecdotes selected by news producers based on what will attract eyeballs and gets us to what’s real, and what’s being acted upon. That can be powerful when combined with objective Value and Quality considerations. This component of the ranking system uses the following factors:
Don’t Think Of This As THE Answer This isn’t a secret one-of-kind piece of wisdom known only to a special genius like me. It’s one approach among many along the same lines – a blend of fundamentals and sentiment using standard financial data and ratios – that could be constructed and which would likely produce broadly similar results It’s not about the details. It’s about the general idea – a willingness to stick to basics even under circumstances that exacerbate the usually severe temptations to make decisions based on emotion, hype, news, etc. If you want excitement, forget you ever read this post. If, on the other hand, you want a rationally probability of achieving superior performance, an approach that has the potential to result in a higher-probability contrarian Energy play, give this some thought. Disclosure: None.
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