Tag Archives: basic-materials

Valuation Dashboard: Energy And Materials – Update

Summary 4 key fundamental factors are reported across industries in Energy and Basic Materials. They give valuation status of an industry relative to its historical average. They give a reference for picking stocks in each industry. This is part of a monthly series of articles giving a valuation dashboard in sectors and industries. The idea is to follow up a certain number of fundamental factors for every sector, to compare them to historical averages. This article covers Energy and Basic Materials. The choice of the fundamental ratios used in this study has been justified here and here . You can find in this article numbers that may be useful in a top-down approach. There is no analysis of individual stocks. You can refine your research reading articles by industry experts here . A link to a list of stocks to consider is provided in the conclusion. Methodology Four industry factors calculated by portfolio123 are extracted from the database: Price/Earnings (P/E), Price to sales (P/S), Price to free cash flow (P/FCF), Return on Equity (ROE). They are compared with their own historical averages “Avg”. The difference is measured in percentage for valuation ratios and in absolute for ROE, and named “D-xxx” if xxx is the factor’s name. For example, D-P/E = (AvgP/E – P/E)/AvgP/E. It can be interpreted as a percentage in under-pricing relative to a historical baseline: the higher, the better. It points to over-pricing when negative. ROE is already a percentage. A relative variation makes little sense. That’s why we take the simple difference: D-ROE = ROE – AvgROE. The industry factors are proprietary data from the platform. The calculation aims at eliminating extreme values and limiting the influence of the largest companies. These factors are not representative of capital-weighted indices. They are useful as reference values for picking stocks in an industry, not for ETF investors. Industry valuation table on 12/21/2015 The next table reports the 4 industry factors. For each factor, the next “Avg” column gives its average between January 1999 and October 2015, taken as an arbitrary reference of fair valuation. The next “D-xxx” column is the difference between the historical average and the current value, in percentage. So there are 3 columns relative to P/E, and also 3 for each ratio. P/E Avg D- P/E P/S Avg D- P/S P/FCF Avg D- P/FCF ROE Avg D-ROE Energy Equipment&Services 20 24.2 17.36% 0.72 1.73 58.38% 8.65 35.34 75.52% -10.91 7.34 -18.25 Oil/Gas/Fuel 14.93 18.53 19.43% 1.65 3.35 50.75% 15.48 29.03 46.68% -15.55 4.47 -20.02 Chemicals 18.3 18.48 0.97% 1.31 1.21 -8.26% 35.82 25.37 -41.19% 8.71 6.74 1.97 Construction Materials 51.27 21.44 -139.13% 1.36 1.16 -17.24% 58.56 40.5 -44.59% 9.34 5.77 3.57 Packaging 21.58 17.96 -20.16% 0.91 0.61 -49.18% 23.15 20.09 -15.23% 18.23 8.34 9.89 Metals&Mining 19 19.83 4.19% 1.2 2.65 54.72% 13.94 25.53 45.40% -19.39 -8.6 -10.79 Paper&Wood 30.98 21.27 -45.65% 0.92 0.72 -27.78% 21.8 22.81 4.43% 8.35 4.99 3.36 The following charts give an idea of the current valuation status of Energy and Materials industries relative to their historical average. In all cases, the higher the better. Price/Earnings : Price/Sales : Price/Free Cash Flow : Quality (ROE) Relative Momentum The next chart compares the price action of the SPDR Select Sector ETF in Materials (NYSEARCA: XLB ) and energy (NYSEARCA: XLE ) with SPY (chart from freestockcharts.com). (click to enlarge) Conclusion In one month, XLE has fallen by 11.3% and XLB by 6.3%, both underperforming SPY by a wide margin. The reason is obvious looking at WTI oil price: it hit last week a level not seen since the second half of 2003. In this meltdown, the five more resilient S&P 500 stocks in Energy and Materials on a 3-month period are Airgas Inc (NYSE: ARG ), Chevron Corp (NYSE: CVX ), E. I. du Pont de Nemours (NYSE: DD ), Tesoro Corp (NYSE: TSO ), Valero Energy Corp (NYSE: VLO ). The two latter are refiners. Oil price is not a major driver of their profitability, and concerns about a possible end of the crude oil export ban seem to disappear. The improvement in valuation ratios for all industries of these sectors since my last update is just a consequence of lower stock prices. The harder the fall, the better the “improvement”. It is not a signal that things are really improving for oil and gas companies. It is even the opposite: the quality measured by the ROE industry factor went down. As a group, energy and metal/mining are looking like a nest of value traps: the 3 valuation ratios point to underpricing, whereas the quality factor (D-ROE) is deep in the red and worsening. This is not true for all the oil industry: we have seen that refiners are doing quite well and several of them have hit an all-time high in November. Some of them are also in the very best of the S&P 500 in my value and quality-based screens. No industry in these two sectors looks globally very attractive. However, comparing individual fundamental factors to the industry factors provided in the table may help find quality stocks at a reasonable price. The next table shows a list of stocks in the Energy and Basics Materials sectors. They are all cheaper than their respective industry for 3 valuation factors simultaneously: Price/Earnings, Price/Sales, Price/Free Cash Flow. Then they are selected for their higher Return on Equity. This screen updated and rebalanced monthly has an annualized return about 17% and a drawdown about -65% for a 17-year backtest. The corresponding sector ETFs XLE and XLB have an annualized return of respectively 8.32% and 6.79% on the same period. Past performance, real or simulated, is not a guarantee of future return. This list may be considered an entry point for further due diligence, or as a portfolio after adding a few trading rules and market timing. This is not investment advice. Do your own research before buying. ATW Atwood Oceanics Inc. ENERGYEQUIP DOW Dow Chemical Co (The) CHEM EMN Eastman Chemical Co CHEM IOSP Innospec Inc CHEM KS KapStone Paper & Packaging Corp FORESTRY LYB LyondellBasell Industries NV CHEM REX Rex American Resources Corp OILGASFUEL TSO Tesoro Corp OILGASFUEL VLO Valero Energy Corp OILGASFUEL WNR Western Refining Inc OILGASFUEL If you want to stay informed of my updates on this topic and other articles, click the “Follow” tab at the top of this article.

As Producers Get Out, You Should Get In: Why I’m Long XLE

Summary WTI crude in the mid-30s is close to the cash operating cost of many high-cost oil producers. As oil trades in the mid-30s, production will be shut in and supply will fall, in theory creating a floor in the price of oil. Continued low oil prices will likely create an underinvestment in oil production, and could create risk to the upside in future oil prices. Investors should consider buying XLE, as it will likely be able to weather the storm, and avoid XOP, as it contains much smaller producers that may not survive. Investors should avoid USO as it is subject to the decay associated with negative roll yield in WTI futures contracts. On December 15th, West Texas Intermediate Crude traded through $35 a barrel. This is close to the variable operating cash cost of many high-cost producers operating out of North America. At these prices, producers potentially stop pumping crude from their wells because it is more expensive to pull it out of the ground than the oil is worth. North American rig counts have already fallen precipitously; at these levels, they are likely set to fall even more. As rig counts fall, supply lessens from this area, and investment in future productive capacity also likely falls. This may set the oil market up for much higher prices in the future, repeating past energy cycles. Investors should consider buying the Energy Select Sector SPDR ETF (NYSEARCA: XLE ), which contains the larger players in the energy sector, to capitalize on this potential for higher oil prices in the future. Investors should avoid buying the SPDR S&P Oil and Gas Exploration and Production ETF (NYSEARCA: XOP ); however, as many of these producers are smaller and may not be able to ride out the storm. Investors should also avoid the United States Oil ETF (NYSEARCA: USO ), as contango will eat away at profits over time. Cash Operating Costs of the Marginal Shale Producer Below is a chart of the estimated cash operating cost of oil production for oil producers globally. “Cash cost” is the variable operating cost of pulling oil out of the ground. These figures are roughly a year old, but are probably still relevant. Note that Canadian oil sands, U.K. producers, and U.S. producers are on the upper end, within a $25-40 barrel cash cost range. As oil prices dip into these levels, independent producers will begin to shut-in production as it stops making economic sense to continue producing. This, in theory, should create a floor on the price of oil, as the price-determining marginal supply from these producers diminishes. Note that as the price dips as low as $30, almost 30% of producers are operating at levels that don’t make sense to continue. (click to enlarge) Source: Morgan Stanley and Business Insider Falling North American Rig Count Rig counts have fallen dramatically since last year as oil has collapsed and oil producers have cut back CAPEX in the face of a deteriorating credit market in the oil and gas sector. New rigs that would be too expensive to operate at low oil prices are not coming online, and old rigs being phased out are not getting replaced. Per Baker Hughes, North American rig counts have collapsed from a high of 2,300 rigs to 883 today, or a decline of 61% in one year. North American Rig Count through Time (click to enlarge) Source: Baker Hughes and Bloomberg Given that many producers have cash costs of oil in the $30-40 range, rig count is likely to decline further with oil breaching $35 a barrel, in my opinion. As rig count falls, the industry as a whole sets itself up for stronger oil in the future. The effect is twofold; supply of oil falls initially, stabilizing prices, but then the ensuing underinvestment in oil infrastructure creates a situation where oil prices could increase dramatically as underinvested producers are less able to quickly increase production in response to higher oil. We could see a repeat of the underinvestment of the late 1990s that led to the boom in oil prices in the mid-2000s. Buy XLE, Avoid XOP and USO Investors should consider XLE, as it contains very large producers such as Exxon Mobil (NYSE: XOM ), Chevron (NYSE: CVX ), and Schlumberger (NYSE: SLB ) that have the ability to weather the storm of lower oil prices for a long time. Investors should avoid XOP, as it contains a higher concentration of smaller capitalization companies that may not be able to survive mid-30s oil for a long time. I could imagine a situation where oil remains in the mid-30s, and XOP continues to tank, as smaller producers come under increasing financial pressure. See below for the breakdown of top holdings of XLE and XOP; note that some of the largest concentrations in XOP are in stocks with market caps of less than 4BN: Source: Bloomberg Investors should also avoid USO, as it is long oil futures contracts, and is therefore subject to the negative roll yields associated with contango. Oil contracts trade for future delivery at specified points in time. Currently, the market is in contango, meaning that contracts further into the future are more expensive than contracts expiring closer to the present. Contango in WTI Crude (click to enlarge) Source: Bloomberg USO owns short-dated contracts, and as those contracts expire, it sells them and buys contracts further into the future. With today’s prices, for example, USO would sell the Jan. 16 expiries at 37.11 and buy the Feb. 16 expiries at 38.27, creating a 37.11/38.27-1= -3.03% yield in just one month. A rough annualization of that yield means that USO is currently losing 36.4% annually! It is better to own the producers themselves who sell their production forward in the futures market than to own a fund exposed to the cost of maintaining a long position in futures, as the price performance between XLE and USO over the past five years has shown. Shorting $1 of USO and buying $1 of XLE, price performance over past five years, excluding dividends: Source: Bloomberg Conclusion Oil in the mid-30s is approaching the cash operating costs of many North American oil producers. As oil falls, they will shut in production, theoretically creating a floor in the price of oil in this range. Underinvestment in oil production in the future due to low oil prices today may also one day contribute to strong future oil prices. Investors looking to take advantage of this potential floor should look to buy XLE, as it contains some of the largest oil-producing companies in the world, and should be able to weather the supply glut in oil, and avoid XOP, as it has smaller producers that may not be able to survive lower oil. Investors should avoid USO as it is subject to negative roll yields associated with contango in WTI futures markets.

GDXJ – Limited Downside And Great Upside Potential In A Rising Gold And Silver Price Scenario

A potential long term investment with limited downside and great upside potential. Diversity of holdings mitigates the downside risk. Virtually every component of the index would be on many people’s list of junior precious metals stocks to buy to take advantage of a rising price scenario. There are few sectors which have such a huge potential for massive gains as resource sector juniors, but to achieve these one not only has to pick a company which on its own has enormous potential in what is one of the riskiest sectors for any investor to dabble in, but also any gains may be doubly enhanced should the resource sector in which the chosen company operates also move from being extremely depressed into a strong recovery phase. Pick the right resource, and virtually any surviving junior will serve you well but, as was seen following the 2008 resource market crash, if you pick well gains could be massive – 1,000 percent or more. Arguably, now could be a really good time to buy into resource stocks. They have seldom been more depressed, particularly the precious metals, and industrial metals copper and iron ore. However the writer does not see any kind of sharp recovery ahead for either copper or iron ore in 2016, although looking further ahead one would still have to consider survivors in the industrial metals sector as being potentially very strong investments, but the fallout between now and then could be perhaps a risk too far. That leaves us with precious metals – perhaps the riskiest sector of all. However the collapse in prices has seen precious metals stocks come down dramatically over the past three years, since gold reached its top of around $1920 an ounce in 2012. Gold for example has fallen by 44% since, and has dragged the other precious metals down with it. Is now the time to climb back in? If one reads the mainstream media one could be forgiven for assuming that the gold price fall had been far greater – but a much bigger drop has been suffered by most precious metals mining stocks – and by the junior sector in particular – ‘so here there be bargains galore’ one would think. And so there most definitely are, but the risks in buying junior precious metals stocks can be enormous. Any prolonged continuation of gold’s fall, and that of the other precious metals could yet see some serious casualties in terms of corporate shutdowns, and/or sales at hugely below potential valuations, even for juniors who, on the face of things, have some really good potential projects, but do not have the wherewithal to progress them. Now we see the fundamentals for gold in particular on a supply/demand basis as being extremely strong, but it may still take time for the investment sector to come to terms with this. Demand for physical metal has been growing – particularly in Asia and the Middle East – and central banks have been net buyers further increasing demand for physical metal. Meanwhile gold inventories in the West have been declining drastically. Sales out of the Precious Metals ETFs, which kept the market well supplied particularly in 2013 when the price began to dive, are dwindling with the weaker holders already having exited. Low gold prices are beginning to see new mined production starting to fall back, while the same low prices keep the incentive for scrap sales low – so these have been dropping too. So here the prospects for junior gold and other precious metals miners look potentially strong. If there is a supply crunch coming ahead – see 2016 a crunch year for physical gold supply as we suggest – then precious metals, and precious metals juniors in particular should be a major beneficiary and we could see some dramatic stock price gains even on comparatively small upwards movements in the metals prices. The high risk investor is poised to climb back in given many feel the gold juniors are bumping along the bottom. So how does one mitigate the very serious risk element here. It’s all very well jumping into a junior stock, however good it seems on paper, but then some external black swan factor comes into play which completely wipes you out. This could be political, geological, financial, weather related, fire, flood, earthquake etc. – any number of things could bring an under- or tightly-funded project (the nature of most juniors) to a grinding halt. There is a way, though, of investing in this sector in a much safer manner, but still with phenomenal growth potential. As we noted above, if the metals prices rise the whole sector will accelerate – except perhaps a few players who get left in the wake. Consider here investing in an ETF which follows a major junior precious metals index. The diversity in the stocks followed helps mitigate the downside risk, but virtually all the individual holdings in the ETF have great upside potential in a rising precious metals market environment. OK, it also will mean that the whole is perhaps not as profitable as some key elements within it, but the overall potential remains massive. Such an investment is the Market Vectors Junior Gold Miners ETF (NYSEARCA: GDXJ ) (listed on the NYSE Arca Exchange) which seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Market Vectors Global Junior Gold Miners Index. It has been bouncing along what many see as the sector bottom of late. It peaked back in November 2010 at around 171.84 and those who invested in it at the time, and stayed with it, would have lost just short of 90 percent of their investment given it is now, at the time of writing at least, at 18.95. Many feel the chances of it falling lower are decidedly limited, while the potential for recovery, if precious metals prices pick up, is very large. If it gets halfway back to its former high that would mean a gain of around 350 percent from its current level. While this might be a tall order in 2016 it is certainly not outside the bounds of possibility should precious metals start to move. Interestingly trading volume has been high over the past year when the price has fluctuated from around 18.30 to 30.10 so it tends to be easily tradeable and there are obviously others out there aware of its potential. The Index on which the ETF is based is also not based on fly-by-night juniors with little or nothing to offer except hope and a prayer, but also includes some significant miners which are probably highly offended that they might even be classified as juniors, like Hecla Mining (NYSE: HL ), Pan American Silver (NASDAQ: PAAS ), Centerra Gold ( OTCPK:CAGDF ), Evolution Mining ( OTCPK:CAHPF ), Oceanagold ( OTCPK:OCANF ), Osisko Gold Royalties ( OTC:OKSKF ) etc. to name but a few. The top 10 companies held, which include all the above, account for 42.75 percent of the total holding. Note also these include some significant silver miners, and history tells us that if gold begins to move, silver moves too – but faster! Indeed running down the full list of holdings all of them would be on many people’s list of potentially strong performing juniors. They include Pretium Resources (NYSE: PVG ) (developing one of the world’s highest grade – underground gold mines), Detour Gold and Lake Shore Gold ( OTCPK:DRGDF ) – both Canadian junior gold high flyers, Silver Standard (NASDAQ: SSRI ), Coeur Mining (NYSE: CDE ), First Majestic (NYSE: AG ) (all three prominent in the silver space). So – do take a look at GDXJ as a long term punt on a turnaround in precious metals prices. It is a junior investment which nowadays offers what we see as very limited downside, but has great upside potential in a more favorable pricing environment.