A Contrarian’s Guide to Playing Energy Stocks
It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair.
– Charles Dickens, A Tale of Two Cities
This quote from Charles Dickens’ novel set in the time of the French Revolution sums up well investor sentiment in the energy sector in 2020.
The conventional narrative surrounding the energy sector today goes something like this…
We have seen peak oil consumption.
The traditional oil and gas industry is on its last legs.
Big Oil is doomed.
Ditto for legacy automobile companies whose fate has been tied to Big Oil for more than a century.
Meanwhile, the alternative energy sector is just coming of age.
The plan of action for investors could not be more straightforward.
Sell all traditional oil and gas companies.
And pile into the red-hot alternative energy stocks.
Whenever I come across a narrative this one-sided, my contrarian instincts nudge me to consider the opposite point of view.
As the late, great global investor Sir John Templeton observed…
People are always asking me where is the outlook good, but that’s the wrong question… The right question is: Where is the outlook the most miserable?
Traditional energy companies certainly fit that bill.
It turns out that abandoned traditional energy stocks may offer investors even better moneymaking opportunities than today’s darling clean energy stocks.
“It Was the Best of Times…”
The outlook could hardly be better for investors in alternative energy.
After all, electric vehicles (EVs) will supplant gasoline-powered vehicles within the next decade or so.
California plans to ban gasoline-powered vehicles by 2035.
Britain has done something similar this week, moving the date up to 2030.
In many ways, the EV revolution is already here.
Just this past weekend, I noticed the bus I got on in London is made by BYD – the Chinese automaker that technophobe Warren Buffett is betting on.
More importantly, for investors, clean energy stocks have never been hotter.
The First Trust Nasdaq Clean Edge Green Energy Index Fund (Nasdaq: QCLN) has soared 129% this year.
This ETF is a one-stop shop to invest in red-hot EV stocks like Tesla (Nasdaq: TSLA) and Nio (NYSE: NIO) as well as solar plays like SolarEdge Technologies (Nasdaq: SEDG) and Enphase Energy (Nasdaq: ENPH).
“It Was the Worst of Times”
This bullishness stands in stark contrast to the performance of traditional energy stocks.
Energy has been by far the worst-performing stock market sector in the U.S. this year.
Near the market bottom, the combined market cap of companies in the S&P 500 energy sector index almost halved since the start of 2020.
Demand for oil remains far below where it was a year ago. In April, the price of oil even briefly fell below zero.
The incoming Biden administration’s policies on climate change – electrification, limits on methane emissions and opposition to fracking – are also negative for traditional energy companies.
It’s no wonder that, with more than 45% of its holdings in just Exxon (NYSE: XOM) and Chevron (NYSE: CVX), the Energy Select Sector SPDR Fund (NYSE: XLE) is down 39.24% in 2020.
Making Money From Energy Stocks
The chart below compares the performance of the Energy Select Sector Fund with that of the First Trust Clean Edge Fund in 2020.
And for most investors, this chart is all they need to do the obvious: Invest in the First Trust Clean Edge Fund and avoid the Energy Select Sector Fund.
Alas, my contrarian instincts tell me to look in the opposite direction.
Traditional energy stocks are as cheap as they have ever been.
SentimenTrader recently pointed out that 470 out of 663 U.S.-listed stocks in the energy sector have a share price under $5. That’s more than 70% of stocks in the sector!
More than 390 stocks are trading below $2.
In the past 20-plus years, no other energy bust has seen more than 65% of these firms with a share price under $5.
There were only four other times when more than 55% of energy companies were trading below $5.
The Energy Select Sector Fund was up an average of 47% 12 months later. And it was up by 82% and 99.7% within the next 24 and 36 months, respectively.
“They never ring a bell at the top of a market” is an old Wall Street adage.
But the announcement of Tesla’s entering the S&P 500 Index at the end of December might be close enough.
By any conventional measures, Tesla is not an automobile stock.
Nor is it a tech company.
No, Tesla is a religion.
After all, Tesla trades at a price-to-earnings (P/E) ratio of 930!
And the First Trust Clean Edge Fund trades at a P/E of 316!
Meanwhile, the Energy Select Sector Fund has a P/E of negative 5.29!
Such disparities in valuation are unprecedented in my investment career.
Based on my reading of financial history, I expect the plot to unfold as follows…
Investors will embrace clean energy as the future with clarion calls of “This time it’s different!”
(Remember the “China Miracle,” 3D printing and, most recently, cannabis stocks?)
Investors will bid up shares in the chosen sector to absurd levels.
Analysts will justify these off-the-chart valuations with newfangled metrics.
Inevitably, the stocks will come crashing back to earth.
And savvy investors will make money on the way up and on the way down.
The bottom line?
As famed investor Jim Rogers advises, “Buy value… and sell hysteria.”
That’s precisely how I intend to play both clean and traditional energy stocks.
About Nicholas Vardy
An accomplished investment advisor and widely recognized expert on quantitative investing, global investing and exchange-traded funds, Nicholas has been a regular commentator on CNN International and Fox Business Network. He has also been cited in The Wall Street Journal, Financial Times, Newsweek, Fox Business News, CBS, MarketWatch, Yahoo Finance and MSN Money Central. Nicholas holds a bachelor’s and a master’s from Stanford University and a J.D. from Harvard Law School. It’s no wonder his groundbreaking content is published regularly in the free daily e-letter Liberty Through Wealth.