Now that oil trades for $40 / barrel and the Saudi government announced dramatic price cuts over the weekend, and…
The energy sector represents just 3.5% of the S&P 500 weighting (a historical low) and…
Many oil related stocks throughout the supply chain are down to 10-15 + year lows, is this a sector investors should be buying?
The short answer is YES…..but investing in energy (and all companies with cyclical economic drivers) requires discipline, patience and a careful study of which companies are best positioned to withstand a downturn while offering decent recovery potential when the industry cycle improves.
Investing In A Low Cost Producer
With that in mind, here are a few points to consider:
- How safe is the current dividend yield? Companies that are on the cusp of a dividend cut typically experience dramatic shareholder turnover in the short-term as yield sensitive investors exit while a new shareholder base takes time to form. A dividend yield cut may present a buying opportunity over the long-term, but wait until the cut is announced before initiating a position.
- Is the company a low cost producer? There are certain “laws” in economics and one specifically related to commodity companies is The Low Cost Producer Ultimately Wins b/c it can make money at price levels that are uneconomical for competitors. With an eye on downside protection, stick with the low cost producer!
- Where are we in the capital cycle, specifically supply? Industry supply drives pricing and an environment where capital investment is on the decline is more favorable than one that is rising. In a declining price environment, supply reduction works to restore future profitability while rapidly expanding supply works to destroy it.
- How competent is management? Do they have a track record of creating value or are they serial mis-allocators of capital?
- How risky is its asset base? Without getting too technical, all sources of production are not created equal. Find companies that have a history of investing in the core and providing an acceptable return to shareholders over the full commodity cycle.
- Is the accounting conservative? Somewhat tied to #4 in that many companies are reluctant to admit mistakes and by extension, aren’t aggressive enough in writing down the assets on its balance sheet b/c it may compromise its debt/equity and/or debt/ebitda ratios……..which in turn could trigger covenant violations. The asset value must reflect a conservative commodity price curve. If it doesn’t, then move on to the next idea (life’s too short).
- Does it make sense to invest in an energy ETF? Maybe……please contact me for more information as it’s much too complicated to sort through by email.
Remember, great buying opportunities aren’t supposed to feel great. To help mitigate some of your own behavioral weaknesses, buy but don’t keep score on your investment for at least 18-24 months. In addition, don’t use leverage which may reduce your ability to remain rational during volatile periods.
All the best,