Energy sector stocks can round out any well balanced portfolio—and there is a crucial role they can play

Energy sector stocks have generally been below average performers for the decade or so. And for many investors, the plunge since the summer of 2015 in the price of oil and natural gas was the proverbial “last straw”. These investors are now tempted to get out of the sector altogether.

However, energy sector stocks 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.

My view is that inflation will eventually revive. Governments around the world may react fast enough to keep inflation under control. However, it’s also possible that when inflation returns, it will go back to the high levels of the 1970s and 1980s. It could even go higher. That’s why I think it would be a mistake to drop resource stocks from your portfolio altogether.

Far better to maintain some exposure to the energy sector—and you need to accept the fact that a hedge against inflation will only pay off when inflation seems headed upward.

7 tips and thoughts on investing in energy sector stocks

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. Energy sector stocks operate in commodities businesses, so it’s hard for any one of them to build a lasting advantage over their rivals. But the ones that do are dominators of their market.

4. Today’s energy projects call for a great deal of engineering, financial and political expertise. The top resource companies—like Imperial Oil or Encana—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.

5. 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.

6. 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.

7. 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.

Energy sector stocks have a place in most investors’ portfolios

Instead of a portfolio diversification approach like ours, some investors practice “sector rotation.” That’s where you try to predict which sectors will outperform other sectors. But trying to pick winning sectors—and stay out of other sectors—seldom works over long periods. That’s because you need to guess right three times to succeed.

You have to pick the top sectors, then pick the stocks that will rise within those sectors, then sell before the sector stumbles. It’s virtually impossible to consistently succeed at all three over long periods.

Have you invested in some of the energy sector stocks we’ve recommended in the past? Share your experience with us in the comments.