What are we looking for?
Companies in the energy sector with strong price momentum.
All Canadian sectors are down year-to-date – except for energy. The oil and gas sector has performed very well because of a supply shortage, which has prompted Goldman Sachs to increase its Brent oil price forecast by US$10 to US$135 a barrel for the second half of 2022 and the first half of 2023.
Record profits are enabling oil producers to pay down debt. This puts them in a much better position to pay sustainable dividends and withstand future oil price volatility. While some companies, such as Baytex Energy Corp., have seen their share price rise by more than 800 per cent since the beginning of 2021, the sector remains significantly cheaper than the S&P/TSX Composite Index, with a forward price-to-earnings of 7.8 compared with 12 for the S&P/TSX. Last week’s 20-per-cent sell-off in the sector has provided a great entry point for momentum stocks.
Today, I use Morningstar CPMS to look for Canadian energy companies of all sizes that have price momentum and are in relatively good financial condition. I used the three-, six- and nine-month price change to capture price momentum as well as the price change from a stock’s 12-month high. We have found that stocks trading close to their previous 12-month high have continued to perform well.
I used the Morningstar Quantitative Financial Health Score to make it easier to determine whether a company is in good financial health. This is a proprietary methodology to determine the likelihood that a company will tumble into financial distress by measuring the firm’s “distance to default.” A score of one means the stock is in very strong financial condition. (As an example, Royal Bank of Canada has a financial health score of 0.9. Unfortunately, oil stocks don’t score that high on financial health at the moment, but this will likely change over the next couple of years.)
The last factor is the market capitalization because I would like a small bias toward larger cap equities.
The investment process started off with all 102 Canadian energy stocks in our CPMS database. Then we ranked our stocks from 1 to 102 according to the three-, six- and nine-month price momentum, Morningstar Quantitative Financial Health Score and market cap.
Next, we applied two screens to create our list of stocks:
- Price change from 12-month high must be ranked in the top third of our list;
- Morningstar Quantitative Financial Health Score must not be in the bottom third of our list (a score of 0.34 or less). We’re avoiding companies that have a high amount of debt such as Gran Tierra Energy Inc.
What we found
I used CPMS to back-test the strategy from January, 2006, to May, 2022. During this process, a maximum of 10 stocks were purchased and equally weighted. The portfolio is rebalanced monthly and the strategy produced an annualized total return of 15 per cent since inception whereas the S&P/TSX Energy Total Return Index advanced 2.7 per cent on the same basis. Today, the top 10 stocks that qualify for purchase into the strategy are listed in the accompanying table.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.