Lots Of Ugly in Energy ETFs

We recommend investors short Oil Service HLDRS (OIH) and iShares Dow Jones US Oil Equipment & Services (UEZ). We recommend investors avoid all other energy sector ETFs. We also rate the investment merit of the top-9 energy sector ETFs.

Per our first-quarter-2011 review of U.S. Equity Sector ETFs, the energy sector is one of two sectors that gets our “dangerous” rating. Figure 2 shows how the energy sector’s stocks and the market value attributed to them stack up under the microscope of our stock rating system. The energy sector has only 12 stocks that we rate attractive-or-better while it has has 146 stocks that we rank dangerous-or-worse. Some good stocks in the energy sector to buy individually or as part of an ETF are Exxon Mobil (XOM) and Chevron (CVX). Some stocks to avoid, sell or short in the energy sector are Baker Hughes (BHI) and Slumberger (SLB).

Figure 1: Energy Sector – Capital Allocation & Holdings by Risk/Reward Rating

Sources: New Constructs, LLC and company filings

Though 36% of the value of the energy sector goes to attractive-or-better-rated stocks, the sector gets our neutral rating because neutral-or-worse-rated stocks make up 65% of its value.

The key takeaway here is that the energy sector offers both good and poor investment opportunities. The investment value of each ETF is derived from its constituents, so ETFs that overweight attractive-or-better-rated stocks, like XOM and CVX, can be great investment opportunities while ETFs that overweight neutral-or-worse-rated stocks should be avoided.

When analyzing the energy sector ETFs, we started by identifying those ETFs with acceptable structural integrity as measured by XTF, an ETF research firm. We chose the 6 ETFs whose XTF rating was above the sector average XTF rating.

Figure 2: Energy ETFs With Acceptable Structural Integrity

                                                                                                                              # of Holdings excludes cash.

Sources: New Constructs, LLC; XTF and company filings

Figure 2 shows clearly that not all energy ETFs are made the same. Different ETFs have meaningfully different numbers of holdings and, therefore, different allocations to holdings. Given the differences in holdings and allocations, these ETFs will likely perform quite differently.

After determining the structural integrity, we analyzed the investment merit of each ETF based on how it allocated value to each stock it held. Figure 3 shows how the 6 energy sector ETFs stack up versus each other and the overall sector based on their overall risk/reward ratings and the allocation of their holdings by rating.

Figure 3: Investment Merit Based on Holdings and Allocations

Sources: New Constructs, LLC; XTF and company filings

Attractive ETFs:

We find no Attractive-or-better-rated Energy sector ETFs.

Neutral ETFs:

IYE, VDE, and XLE allocate their value in a way that earns them a Neutral Overall Risk/Reward rating. We recommend investors buy the Very Attractive and Attractive stocks in this sector before buying any of the Energy ETFs we cover in this report. Contact us for the full list of the 12 Energy companies that earn an Attractive-or-better Overall Risk/Reward rating.

Dangerous ETFs:

We recommend investors avoid or short RYE, PSCE, XES, XOP, OIH and IEZ because of their Dangerous-or-worse Overall Risk/Reward ratings. Figure 3 contrasts the difference in investment merit between IYE, IEZ and the overall sector.

Benchmark Comparisons

Sector Benchmark

IYE and the overall sector have comparable quality of earnings ratings. Both IYE and the sector earn Very Attractive Economic vs. Reported Earnings ratings because their Economic Earnings are positive and rising.

IYE outperforms the sector in valuation ratings. IYE has a Price-to-EBV of 2.3, earning it a Neutral rating, and a GAP of 28 years compared to the overall sector’s Price-to-EBV of 2.4 and GAP of 33 years.

Figure 4: IYE – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

Figure 5: Energy Sector – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

IYE and the overall Energy sector’s allocation of value are very similar. Per Figure 3 above, IYE allocates 36.7% of its value to Attractive-or-better-rated stocks while the sector allocates 35.9%. IYE also allocates 34.5% of its value toward Dangerous-or-worse-rated stocks compared to the sector’s Dangerous-or-worse weightings of 39.5%.

For explanation and details behind our risk/reward rating system, see one of our Company Valuation reports, which are available for free here.

Market Benchmark

The S&P 500 outperforms IYE in quality of earnings ratings. IYE and the S&P 500 earn Very Attractive Economic vs. Reported Earnings ratings because their Economic Earnings are positive and rising. The S&P 500 earns a Very Attractive ROIC rating with an ROIC of 18.2% compared to IYE’s ROIC of 8.4%.

The S&P 500 also outperforms IYE in valuation ratings. The S&P 500 has a Price-to-EBV of 1.4, earning it an Attractive rating, and a FCF Yield of 2.4% compared to IYE’s Price-to-EBV of 2.3 and FCF Yield of -2.5%.

Figure 6: IYE – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

Figure 7: S&P 500 – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

The S&P 500 allocates value more effectively than IYE. Per Figure 3 above, IYE allocates 36.7% of its value to Attractive-or-better-rated stocks while the S&P 500 allocates 42.3%. IYE also only allocates 34.5% of its value toward Dangerous-or-worse-rated stocks compared to the S&P 500’s Dangerous-or-worse weightings of 23.7%.

Methodology

This report offers recommendations on Energy sector ETFs and benchmarks for (1) investors considering buying Energy sector ETFs and for (2) comparing individual ETFs to the Energy sector and the S&P 500. Our analysis is based on aggregating results from our models on each of the companies included in every ETF and the overall sector (188 companies) based on data as of April 19th, 2011. We aggregate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to analyze ETFs in the same way they analyze individual stocks.

To make an informed ETF investment, investors must consider:

1)    The structural integrity of the ETF and its ability to fulfill its stated objective. We use XTF, an ETF research firm, to find the top 9 ETFs with the best structural integrity rating.

2)    The quality of the ETF’s holdings. We determine and ETF’s quality using our overall risk/reward rating system.

Given the success of our Rating system for individual stocks, we believe its application to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buying decisions. Barron’s regularly features our unique ETF research. The first article is “The Danger Within”.

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