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Best Energy Stocks To Buy Now – Seeking Alpha

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When discussing investments in energy stocks, most analysts and investors tend to focus their attention on the outlook for energy prices. This is understandable, since energy prices have a huge impact on all stocks in the sector. Unfortunately, this much important variable is notoriously hard to predict.

But that’s no reason to despair. Using quantitative methods to select the best stocks in the sector, while also protecting the portfolio when the energy sector as a whole is in a downtrend, we can build a solid and effective system for making investing decisions in energy stocks.

System Design

The PowerFactors System is a quantitative system exclusively available to members in my research service: The Data Driven Investor. The system ranks companies in a particular universe according to a combination of four key quantitative attributes: financial quality, valuation, momentum, and relative strength.

Some brief explanations about these factors:

  • Financial quality: This factor includes variables such as long-term growth expectations, profit margins on sales, and return on capital. All else the same, a more profitable business with superior growth rates should generate higher returns for investors over time.
  • Valuation: A high-quality business deserves an above-average valuation. However, overpaying for high-quality stocks is a very common mistake, and even the best companies can turn out to be mediocre investments when the stock price is excessively high. For this reason, the PowerFactors system includes valuation ratios such as price to earnings, price to earnings growth, and price to free cash flow.
  • Momentum: Stock prices don’t just reflect fundamentals, but expectations about those fundamentals can be even more important. Strong business momentum means that the company is reporting earnings numbers above Wall Street expectations and driving increasing expectations about future performance.
  • Relative Strength: Winners tend to keep on winning in the market, when a stock is outperforming its benchmark, chances are that it will continue doing so in the middle term. For this reason, the PowerFactor system looks for stocks delivering above-average returns in the market.

The PowerFactors system basically considers multiple ratios and quantitative indicators across these four dimensions, quality, value, momentum, and relative strength. Then it incorporates those numbers into a final PowerFactors ranking for each stock in the investable universe.

Leaving the numerical considerations aside, the main rationale behind the system is actually quite simple. The algorithm is basically looking to buy solid companies (quality) at a reasonable price (value), when the business is doing well (momentum) and the stock is outperforming (relative strength)

Backtested Performance And Recommended Portfolio

The following backtest excludes over the counter stocks from the universe, and it considers only companies with a market capitalization value above $300 million in the energy sector. This size filter reduces potential returns, since smaller stocks generally produce superior gains over the long term.

On the other hand, many investors are unwilling to invest in companies that are too small, since they also tend to be more risky and volatile. For this reason, the minimum size requirement makes the system more realistic and easy to implement in real life.

Among the energy stocks that meet the size requirements, the system picks the 30 stocks with the highest PowerFactors ranking, and it builds an equally weighted portfolio with those names. The portfolio is rebalanced monthly, and it has an assumed annual expense ratio of 1% to account for trading expenses and similar considerations. The benchmark is the Energy Select Sector SPDR ETF (XLE).

Data from S&P Global via Portfolio123

Since January of 1999, the system produced an annual average return of 16.15% per year, far surpassing the 8.37% annual return produced by the Energy Select Sector SPDR ETF in the same period.

In cumulative terms, the system gained 1,714.33% versus 374.19% for the benchmark. This means that a $100,000 investment in the portfolio recommended by the system in January of 1999 would currently be worth nearly $1.8 million, while the same amount of capital allocated to the benchmark would be worth around $474,200.

However, the portfolio recommended by the system is quite volatile, and it has maximum drawdown – meaning the maximum loss from a peak to a trough of a portfolio – of 72.8% versus a maximum drawdown of 56.93% for the benchmark.

In order to reduce downside volatility, we can implement a hedging mechanism that protects the portfolio when the energy sector is considered to be in a downtrend. In a nutshell, if the Energy Select Sector SPDR ETF is below its 200-day moving average, the system goes short the ETF to protect the long positions in the portfolio.

This version of the quantitative system does a great job at reducing downside risk while at the same time outperforming the benchmark by a wide margin. Annual return is 16.33% versus 8.37% for the benchmark, and maximum drawdown is 47.4% versus 56.93% for the benchmark.

Data from S&P Global via Portfolio123

Past performance does not guarantee future returns, and backtested numbers should always be interpreted with caution. That acknowledged, investment decisions based on cold-hard quantified data tend to produce superior returns in comparison to buying and selling stocks based on subjective opinions and speculations about the future of energy prices.

For your information, the table below lists the 30 stocks currently selected by the system, ordered by market capitalization.

Name

Mkt. Cap ($Millions)

Statoil ASA (STO)

88059.37

CNOOC Ltd. (CEO)

80387.83

EOG Resources Inc. (EOG)

68693.53

Phillips 66 (PSX)

55103.86

Valero Energy Corp. (VLO)

49931.63

Pioneer Natural Resources (PXD)

34359.88

Continental Resources Inc. (CLR)

25303.6

Andeavor (ANDV)

21474.38

Encana Corp. (ECA)

12741.81

HollyFrontier Corp. (HFC)

12248.25

Diamondback Energy Inc. (FANG)

12196.27

Energen Corp. (EGN)

6452.11

PBF Energy (PBF)

4645.98

Delek US Holdings Inc. (DK)

4211.25

Peabody Energy Corp. (BTU)

4199.58

Matador Resources (MTDR)

3694.15

CVR Energy (CVI)

3613.04

Viper Energy Partners (VNOM)

3373.19

SRC energy (SRCI)

2893.16

CVR Refining (CVRR)

2878.2

Callon Petroleum (CPE)

2796.98

Carrizo Oil & Gas (CRZO)

2117.3

ProPetro Holding (PUMP)

1624.87

Denbury Resources (DNR)

1523.93

Fairmount Santrol Holdings (FMSA)

1381.63

CONSOL Energy (CEIX)

1228.29

Penn Virginia (PVAC)

924.42

Abraxas Petroleum (AXAS)

471.1

Seadrill Partners (SDLP)

311.28

Solaris Oilfield Infrastructure (SOI)

309.88

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.