What are we looking for?
Small- and mid-cap energy stocks with strong earnings and cash flow. This is a more aggressive strategy for investors interested in energy stocks; larger, more stable names aren’t growing their earnings at these rates.
Energy bulls have been rewarded this year as companies capitalize on oil prices that haven’t been seen since 2014. The energy sector has been reporting exceptional earnings, paying down debt and providing sustainable dividends to shareholders. Investors who can stomach the sector’s cyclicality and who have a long-term focus may further be rewarded as the commodity proves to be an inflationary hedge. Other catalysts such as underinvestment, supply shortages, the possibility of China easing its zero-COVID policy (boosting demand) and global trade disruptions linked to Russia’s war on Ukraine add more fuel to the energy trade.
Today, I used Morningstar CPMS to look for small- and mid-cap Canadian energy companies with earnings momentum and adequate cash flow to pay down debt.
Overall rankings were determined using the following criteria.
We begin our search with two momentum metrics: the change in operating earnings for the latest reported quarter compared with the previous one; and the change in estimated quarterly earnings for the next quarter compared with the current one.
Next, stocks were only included if analyst estimate revisions were positive in the past three months. A positive figure means earnings estimates have been revised upward as analysts believe the outlook has brightened. We also looked at price momentum and ranked stocks that had a positive price change in the past month.
In addition, the health of a company was addressed using two metrics. The Morningstar Quantitative Financial Health Score ranks companies on the likelihood that they will tumble into financial distress. It uses two main indicators of leverage (ratio of enterprise value to market value) and equity volatility (relative to the rest of the Canadian universe), to estimate a firm’s “distance to default.” The highest possible score is 1.0.
The second financial health metric used is the cash-flow-to-long-term-debt ratio relative to the energy sector; here we are looking for companies with a ratio of 1.0 or higher.
In addition to our ranking criteria, only stocks with a market capitalization greater than $250-million and an average monthly trading value of at least $2-million were considered.
For informational purposes, we have also included expected dividend yield and 12-month total price return.
What we found
The strategy has been back-tested from December, 2006, to September, 2022, assuming an equally weighted 15-stock portfolio. On a monthly basis, stocks were sold if they fell below the top 25 per cent in our ranking. Stocks were also sold if the one-month price change fell below minus 10 per cent or if analyst earnings estimates were revised downward by minus 10 per cent or lower. On this basis, the strategy produced an annualized total return of 19.2 per cent, while the S&P/TSX Energy Total Return Index advanced 1.9 per cent.
Stocks qualifying for this model are listed in the accompanying table.
This article does not constitute financial advice. Investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Joshua Farruggio is vice-president of business development at Morningstar Canada.