What are we looking for?
Companies in the energy sector trading at a discount.
The Screen
Energy stocks had done really well since the beginning of the year because the price for West Texas Intermediate was up almost 80 per cent. However, things changed really quickly when the World Health Organization declared Omicron a variant of concern. Since then, the CBOE Volatility Index has gone up approximately 60 per cent and the WTI price has plunged from US$78 to a low of US$65 per barrel. A lot of energy analysts believe the current selloff is excessive, and Goldman Sachs still has a forecast of approximately US$80 on the price of Brent oil. Although many companies in the Canadian energy sector appear overvalued because of their performance since the beginning of the year, there are many that appear undervalued and may provide a great source of return. Some will continue to benefit from an increase in oil prices and the reopening of the economy.
Today I used Morningstar CPMS to look for Canadian energy companies of all sizes that analysts have a positive forecast for the current year’s earnings per share. I used four different factors to find companies that are trading at a discount to their intrinsic value. The price-to-book ratio compares the market price per share to the book value per share. The forward price-to-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive $1 of that company’s earnings. The price-to-cash flow is an indication of how much an investor is willing to pay for the cash flow per share of the company. The cash flow of a business can be a better representation of the company’s operations because it does not usually involve as much management bias as earnings. Lastly, the price-to-sales metric will help us determine how much we’re willing to pay for the sales per share of the business.
The investment process started off with all 102 Canadian energy stocks in our CPMS database. Then we ranked our stocks from one to 102 according to the quarterly earnings revision, price-to-book and forward price-to-earnings ratios, price-to-sales metric and price-to-cash flow.
Next, we applied three screens to create our list of stocks:
- average monthly volume above 22 million to make sure that there’s enough liquidity
- market index versus its 80-day moving average above -2 per cent so that we hold cash if the S&P/TSX goes through a significant downturn
- one-month price change above -3 per cent.
What we found
I used CPMS to back-test the strategy from January, 2006, to October, 2021. During this process, a maximum of 10 stocks were purchased and equally weighted. The portfolio is rebalanced monthly, and the strategy produced a return of 12.4 per cent since inception, whereas the S&P/TSX Energy Total Return Index returned 0.7 per cent. Today, the top 10 stocks that qualify for purchase into the strategy are listed in the accompanying table.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
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