Bank of America Corp. chief quantitative strategist Savita Subramanian has upgraded the global energy sector to "overweight" using a compelling argument based on valuations and global fund manager positioning. Applied to the Canadian energy sector, the analysis justifies a surprisingly positive view of domestic oil stocks.
In a research report released Friday, Ms. Subramanian writes, "Despite the 10 per cent increase since February, energy's relative price to book ratio remains near all-time lows. The last time we saw such a low multiple was 1986 – another supply-driven oil price shock – at which point buying the sector delivered over 30 [percentage points] of alpha [excess performance relative to the global equity index] over the next 12 months. … Encouragingly, positioning in energy has fallen to a record low … energy has been and remains among the most out-of-favour sectors, but sentiment is beginning to turn."
The first chart shows the importance of price to book value as an indicator of future returns in the energy sector. The clear 10-year trend is for future performance moving in the exact opposite direction of price to the average book-value ratio for the energy sector. (The apparent pattern is confirmed by correlation analysis.)
When the price to book-value ratio declines sharply – as it did between August, 2014, and November, 2014 – the odds of future performance for the next 12 months improving dramatically climb, based on historical data. If the pattern holds, the next few months should see forward 12-month returns in the energy sector rise in proportion to the degree that price to book-value ratios have fallen.
I was surprised that Bank of America used price to book value for the analysis because price to cash-flow ratios are more widely accepted for energy-stock valuation. Thankfully, the same optimistic trends are apparent when applying 12-month trailing price to cash-flow ratios.
As with price to book value, the second chart illustrates that future returns in energy stocks climb as price to cash flow ratios fall. The decline in the price to cash-flow ratio which began late last summer strongly suggests that the performance of the S&P/TSX energy index is set to improve significantly.
Ms. Subramanian's more subjective point about "global portfolio positioning" is also important, and positive, for the energy sector. Bank of America's monthly survey of global portfolio managers found that, on average, funds were 30 per cent underweight energy stocks.
Sentiment is a contrarian indicator: Historically, a high degree of investor optimism in a market sector served as a warning that volatility is approaching. In the case of energy stocks, the pessimism apparent in the huge underweight positioning – the largest since 2008, according to Bank of America – is a positive indicator for future returns.
Follow Scott Barlow on Twitter @SBarlow_ROB.