How we recommend investing to find the best energy sector stock

An energy sector stock operates in the commodities business, so it’s hard for any one of them to build a lasting advantage over their rivals. But the ones that do can dominate their markets.

Energy stocks include businesses engaged in the exploration for, extraction and delivery of energy sources such as natural gas, oil, uranium and coal, as well as alternative and renewable energy sources.

How to invest in the best energy sector stock

While selecting energy company stocks, look for well-financed companies with no immediate need to sell shares at low prices. These stocks typically have strong balance sheets with low debt.

We look for an experienced management team with a proven ability to develop energy. We make sure they’re not in any insecure or politically unstable regions such as the Congo and Venezuela, or in countries with little respect for property rights and the rule of law such as Russia or Mongolia.

We avoid any energy stocks that trade “over the counter,” where such things as regulatory reporting are lax. And we don’t invest if the stock is trading at an unsustainably high price, because it’s likely the result of broker hype or investor mania.

We also look at the market cap of energy stocks versus the estimated value of the reserves they have in the ground. Sometimes, a company’s marketing efforts are so successful that they drive the stock up too high in relation to the size of its reserves. We like an energy stock’s market cap to be no more than half the value of those reserves. We assume that the company will be able to expand its reserves through exploration, but if the reserves are double the energy mining stock’s market cap, it provides a margin of safety.

6 tips for investing in a top energy sector stock:

1. Energy sector stocks may serve as an early warning sign of coming inflation. They may well shoot up before it becomes clear that inflation has revived.

2. Energy sector stocks need to make large, high-risk capital investments, in order to keep finding new deposits or sources of oil.

3. Modern energy projects call for a great deal of engineering, financial and political expertise. The top resource companies acquire a lasting competitive advantage by developing their expertise in these areas. This expertise is a type of hidden asset. It doesn’t appear on the balance sheet, but it gives top energy sector stocks an advantage in every project they undertake.

4. Energy sector stocks do sometimes turn out to have hidden environmental liabilities, as do companies in other sectors. But for top energy sector stocks, their hidden assets far outweigh their hidden liabilities. They accumulate rights to promising acreage long before the land rush starts. They have the technical and political skills they need to foresee and deal with environmental and political obstacles.

5. Successful energy sector stocks pioneer technological advances. For instance, recent advances in oil and gas drilling technology helped bring huge new supplies of oil and gas on the market. The new technologies made it possible to vastly increase oil and gas production, even from deposits that were once considered worthless.

6. One thing we’ve noticed about energy sector stocks is when people generally believe the price of a resource is sure to go up, the reverse often happens. That’s because resource producers and those who use their products also read the newspapers, and they both take steps to protect themselves and profit from the situation. The suppliers try to increase supplies, and the users try to become more efficient or find alternative commodities.

Performance in the energy stock sector

Energy stocks were generally below-average performers for some time, and many investors were tempted to get out of the industry altogether. However, the energy segment can play a crucial role in your portfolio as a hedge against inflation. The low inflation rates of the past couple of decades deserve much of the blame for the poor performance of the sector. When they rebound further, energy stocks could grow significantly for years to come.

You can profit over the long term by investing in well-established and well-managed companies that are active in businesses that involve highly volatile commodities like oil and gas. You profit all the more if you buy these companies when they are cheap in relation to earnings, cash flow and assets.

Are you holding energy sector stock in your diversified portfolio? How have these stocks performed for you so far? Please share your experience with us in the comments.