2 To Buy and 2 To Sell In The Oil Industry

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

To make money in the stock market you have to be willing to buy when stocks go down. Peter Lynch once said that the direction of a stock's price many times has nothing to do with the company's performance. In fact, he said if you are an investor who looks for the market to validate your investment decisions in the short-term, you are likely going to be disappointed. However, in today's market many investors want to know what has a company done for them lately, rather than looking at the long-term. This is why on a regular basis I run a screen on the Fool.com CAPS Screener for stocks that are down 20% from their 52 week high. It's not a fool-proof method, but sometimes there is opportunity in the panic selling of others. 

Investing For The Future Does No Good If You Don't Survive Long Enough To See It:

One thing that many oil and gas related companies have in common is they spend millions or even billions of dollars on projects with the hope that they will pay off in the future. This makes perfect sense if the company survives long enough to prosper. However, negative cash flow can't happen forever, and when a company's balance sheet gets weaker, the future becomes less bright. Two companies that came up on my screen as being down 20% or more were Devon Energy (NYSE: DVN) and Hess (NYSE: HES). Unfortunately for investors, what they both have in common is their stocks are down 20% or more for good reason.

Devon Energy's business is the exploration, development, and production of oil and natural gas. Usually companies that are spending a lot of money on projects for the future should have a high expected growth rate. After all, why would investors wait around for a company that is going to grow slowly anyway? Investors in Devon need to reassess their investment thesis. Analysts are calling for anemic 3.3% growth in EPS over the next few years, and the company's yield of 1.51% is just okay. There are two big problems that I have with the company. First, Devon is spending money like it grows on trees. In the last four quarters, the company's average free cash flow has been negative over $600 million per quarter. Second, Devon's balance sheet has taken a serious hit in the last year. The company's cash balance has stayed relatively flat, but long-term debt has jumped by 41.65% from under $6 billion to almost $8.5 billion. Negative free cash flow, slow future growth, and a weakening balance sheet make this one a sell.

Hess Corporation is another one that makes my sell list. Hess is an integrated oil company, but you could basically copy the Devon story and put Hess' name at the top and call it a day. The company is expected to grow slightly faster than Devon at 6.17% versus 3.3%, but Hess' yield is lower at 0.81%. Hess also has a problem with negative free cash flow, showing a negative $725 million on average over the last four quarters. While Hess' balance sheet decline isn't quite as bad, long-term debt has increased by $1.2 billion, while cash is only up $177 million. Hess really comes down to a case of there are better opportunities. If you want to own an integrated oil company, either Exxon or Chevron seem like good alternatives. Both Exxon and Chevron offer higher yields, but with similar growth rates, and much better cash flow.

Pick And Shovel Sales Are More Predicable Than Mining For Gold:

In the days of the gold rush, it was said that the people selling picks and shovels probably did better than those looking for the gold itself. You could say the same thing about the oil and gas industry. If you want exposure to the natural growth in this industry, buy the companies that provide the tools. Two companies that also are down 20% or more from their 52 week highs are National Oilwell Varco (NYSE: NOV) and Transocean (NYSE: RIG).

National Oilwell Varco does have some of the same challenges that the “2 to sell” companies share. Admittedly, the company has reported negative free cash flow on average in the last four quarters. However, while Devon and Hess are reporting negative free cash flow in the $600 and $700 million range, National Oilwell Varco's free cash flow has been negative by just $26 million on average. In addition, the company's balance sheet has gotten weaker over the last year, with cash and investments down and long-term debt increasing. National Oilwell Varco also shares the affinity for a relatively low yield at just 0.76%. However, there is one big difference that argues for National Oilwell Varco versus the others, their future growth rate supports the idea that they should be investing. Analysts are calling for 16.4% EPS growth from the company in the next few years. With the stock selling for just over 10 times next year's earnings the shares look relatively cheap.

Transocean seems to be the best option of the bunch. While the stock pays no yield, I'm okay with that for three reasons. First, Transocean is expected to grow earnings by over 24% in the next five years. Second, while the company's future growth is significant, Transocean is reporting good free cash flow today. In the last four quarters, the company shows almost $320 million in average positive free cash flow. Third, Transocean is putting this free cash flow toward improving their balance sheet. In the last year, the company's cash and equivalents are up $2 billion, and long-term debt is down slightly.

Don't Buy Because A Stock Is Down, Buy Because Short-Term Investors Are Wrong:

As you can see, there is a big difference between the four companies we have looked at. While the CAPS Screener will tell you each is down 20% from its high, some additional research suggests that Transocean in particular is being punished unfairly. If you want to keep up with developments at Transocean or any of the other companies, add them to your free personalized Watchlist today.

MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Devon Energy and Transocean. Motley Fool newsletter services recommend National Oilwell Varco. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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