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For the patient investor, a sector packed with value

A huge supply of natural gas has flooded into the market, resulting in a deeply discounted price for the commodity. For the companies that drill wells and perform other necessary services for the industry, those low prices are anything but good news. Their share prices are down in the dumps.

Canadian energy services companies now look cheap on just about any measure you care to examine. By way of demonstrating that, let me point out that there are only 32 companies out of the hundreds on the Toronto Stock Exchange that can pass a stock screen based on three traditional indicators of value:

-- a dividend yield of more than 2 per cent;

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-- a forward price-to-earnings ratio below 10;

-- an enterprise value (market capitalization plus net debt) less than five times its EBITDA, or earnings before interest, taxes, depreciation, and amortization.

Fourteen of these 32 cheapies are energy services companies, according to Standard & Poor's CapitalIQ. That suggests the sector is ripe for value-oriented investors.

Before you get too excited, a warning: These stocks may not have hit bottom yet. However, investors with the stomach to weather what could be a rocky summer may want to consider getting in for the long term.

First, though, let's discuss some risk factors, beginning with those apparently low forward P/E ratios.

Although forward P/Es often offer a better picture than trailing measures of profits, there's an inherent problem in focusing on estimated profits for the year ahead. The forward "E" is a projection, because the next 12 months haven't happened yet.

In this case, share prices have collapsed to the point where many energy services companies have forward P/Es in the mid-single-digits. But if analysts cut their estimates — reducing the future "E" — the P/E will rise and the sector won't look like such a bargain.

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However, there's a case to be made that the market has already anticipated the estimate cutting. Analyst Chad Friess of UBS Investment Research believes this is so because, he says, analysts are "historically too late" in identifying downturns. And, perhaps counterintuitively, a wave of estimate reductions may actually be a positive leading indicator.

Mr. Friess looks to the sharp selloff in the 2008-2009 period as a point of comparison to the current downturn. "Just like last time, forward estimates continued to rise long after the equity prices weakened." And just like four years ago, the primary cause of the recent selloff in energy service stocks has been "multiple compression" – in other words, the tendency for the market to pay less for a dollar of forward earnings as those future earnings become increasingly doubtful.

He says that, following the last downturn, the performance of stocks in the industry "was actually sharply positive" after analysts began to trim their expectations. Stock prices gained 27 per cent in the three months and 62 per cent in the six months after forward estimates started to fall. The reason? As analysts began to factor in the reality of the downturn, the market began to price in some optimism for recovery, resulting in a willingness to pay higher multiples for earnings.

Investors looking for a similar bounce today will have to be patient. Analyst Kevin Lo of Calgary's FirstEnergy Capital believes that "with the summer energy market looking weaker by the day, we suspect the next few months of trading will be choppy at best."

At the same time, however, a number of energy service stocks are trading at close to 10-year lows on a price-to-book value basis, Mr. Lo says. "Much like we can't predict the top of the industry, we would rather not attempt to predict the bottom. We just feel that at this juncture, the odds are in the investors' favour for those who enter into services stocks over the next 12 months."

Mr. Friess of UBS prefers Precision Drilling Corp. and Western Energy Services Corp. , two stocks that didn't quite make the grade on my three-factor screen because they don't pay dividends, but would easily qualify on a valuation basis. He also has "buy" ratings on Calfrac Well Services Ltd. , Ensign Energy Services Ltd. and Trican Well Service Inc.

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Mr. Lo, who believes larger-capitalization companies usually lead the rebound, upgraded Precision Drilling and Ensign Energy Services in late April to "Outperform" from "Market Perform." He also has "Outperform" ratings on Trinidad Drilling Ltd. and CanElson Drilling Inc.

In all, it seems there's plenty to choose from for an investor who — if you'll pardon the pun — looks beneath the surface.

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