Morgan Stanley made headlines earlier this week with a complete about-face on the energy sector, abruptly moving from bullish to bearish on the sector. The timing is interesting for Canadian investors – the domestic energy sector is finally looking attractive on valuations. Did Morgan Stanley's capitulation signal the bottom?
When last we checked (in December) on valuation levels in the domestic oil patch, the sector was still expensively valued despite the carnage in stock prices. That has changed dramatically, as previous performance patterns now suggest a significant rally for the S&P/TSX energy index.
The accompanying chart compares the price-to-forward-cash-flow ratio (based on analyst estimates of cash flow for the next 12 months – the orange line) with forward returns for the S&P/TSX energy index. (Please note that the price to cash flow ratio is plotted inversely to better show the trend. A rising line indicates lower valuation levels – the sector is getting more attractively valued.)
For instance, the first data points on the orange line in the chart show that on Aug. 29, 2012, the forward price-to-cash-flow ratio for the energy index was 6.3 times. For performance, the S&P/TSX energy index dropped 1.3 per cent in the period between Aug. 29, 2012, and Feb. 28, 2013.
The chart highlights the extreme changes in valuation levels since Dec. 10, 2014. At that point, oil stocks were trading at 3.6 times cash flow. That measure was attractive relative to the three-year average of 5.9 times but, and this is a huge but, the attractiveness was a mirage. Estimated earnings were far too high – analysts had yet to slash cash-flow growth assumptions to adjust to lower oil prices.
From Dec. 15, 2014, to April 16, 2015, cash-flow projections were reduced by large amounts and the price to cash-flow ratio climbed to a prohibitively expensive 8.1 times (reminder: The orange line is plotted inversely, so when it falls, this indicates rising valuation levels and more expensive stocks). The performance of oil stocks fell as valuations climbed. Between Feb. 23 to Aug. 23, for instance, the S&P/TSX energy index dropped 40.4 per cent.
Then came the happy news. Since April, a combination of lower stock prices and more realistic cash-flow forecasts has seen valuations become much more attractive. From April's 8.1 times, the current price to forward cash-flow ratio is 4.9 times, below the three-year average.
The relationship between forward cash-flow multiples and forward returns on energy stocks is not foolproof. I'm presenting it as a rule of thumb. That said, the chart does suggest an inflection point as energy stocks are now more attractively valued than at any point in 2015. The implied return for the index is approaching positive.
In addition, valuations are not the only risk factor for energy investors. Morgan Stanley's mea culpa and new pessimism on the sector noted that oversupply concerns are likely to remain a problem for the commodity price despite the falling number of active oil rigs south of the border. Still, we've come a long way and the improved price-to-cash-flow ratio should make patient investors far more confident in investments in the sector.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online.