There’s value in these eight energy stocks

Investment Committee, Switzer Dividend Growth Fund
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The energy sector, both globally and domestically, is trading below long run valuations, however there is value in the sector and it should be an important part of any longer term portfolio or self-managed super fund (SMSF).

Valuations discounted

The energy sector in general is trading below traditional long-run valuations. The slower global economic momentum, particularly from the energy intensive emerging economies has resulted in lower energy prices. Combine this with ongoing large capital expenditure (CAPEX) requirements and the aggressive chase for income/dividend paying stocks over the past quarter, and it’s no surprise that there is a discount in the sector.

While the energy sector has become a little out of favour over the past year, it’s ultimately a key sector for investors and there is plenty of value.

In our view, the key is to find companies that have the appropriate discounted valuations because the structural longer-term outlook remains positive. That is, the emerging economies increasingly need to increase per capita consumption of energy, in all its forms. Therefore, despite the recent weakness in the sector, long-term value still remains.

Chart 1 – Domestic energy sector 1-year forward multiple vs. the long run

Chart 1 shows the one-year forward price to earnings ratio (PE) for the domestic energy sector. There is a clear discount when compared with the long run (and recent) average PE ratios. Globally, the discount is even larger.

Defensive utilities

Before we move into the true energy sector, investors need to look at the broader investment universe landscape. Utilities, the traditional defensive sector, exhibit less sensitive earnings through the economic cycle. Utilities need to supply both wholesale and retail networks via a diversified portfolio of energy sources. This sector has been well supported in recent months. Utilities generally have higher gearing given the defensive cash flows with some increasingly moving into larger more capital expenditure (CAPEX) intensive energy investment that require joint ventures.

Stock suggestions

Table 1 shows eight stocks that reflect both utilities and energy exposures. DUET Group (DUE), Spark Infrastructure (SKI) and AGL Energy (AGK) are all in the utilities sector and have featured in the UBS Wealth Management Core Equity Dividend Portfolio.

Moving into the more preferred energy exposures, I would suggest Origin (ORG), Santos (STO), Woodside (WPL) and Oil Search (OSH). They offer investors quality diversification across energy sources, geography and are underpinned by long-term contracts.

Worley Parsons (WOR) is also a key part of the sector even though they are ultimately a large-cap energy/resource service provider. WOR earnings are very much linked to energy prices over a cycle.

The energy sector is effectively a multi-cycle exposure driven by the energy needs for the domestic and emerging economies. The ongoing need for these companies to invest significantly going forward will always remain a challenge and impact valuations. That the sector is underperforming other defensives this year is evidence of that. They are also all trading below consensus analyst forward price estimates.

The bottom line

The energy sector, both domestically and globally, is trading at compelling valuations compared with both long run and recent valuations. The sector offers value and investors should look at the opportunities given many defensive dividend paying sectors have run so hard in recent months.

This note was written on 10 August 2012. George Boubouras is the Head of Investment Strategy & Consulting, UBS Wealth Management, Australia.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should consider the appropriateness of the information in regards to their circumstances.

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