The best energy sector stocks have experienced management, a reasonable market cap, and more

The resource sector—including energy sector stocks—is subject to wide and unpredictable swings in the prices it gets for its products. In the rising phase of the business cycle, when business is booming, resource demand expands faster than resource supply, so resource prices shoot up. This balloons profits at resource companies. When the economy slumps, resource prices fall, and this drags down resource profits and stock prices.

Many investors on the look for energy sector stocks would likely think of oil and gas first. But energy sector stocks also include green energy, power from renewable resources like solar power, wind power, geothermal power, nuclear power, and electricity from ocean waves.

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How to find the best energy sector stocks for your portfolio

While selecting energy sector 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 also look for an experienced management team with a proven ability to develop energy. Likewise, we make sure they don’t have significant operations in any insecure or politically unstable regions.

It’s best to 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.

Even the best energy sector stocks are subject to the whims of commodity pricing

A crucial rule for commodity investing: if people generally believe the price of a commodity is sure to go up, the reverse often happens because both suppliers and users of the commodity also read the newspapers. 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.

Our thoughts on investing in renewable energy sector stocks

A renewable energy investment is a form of “theme” investing. Theme investing can pay off—but it can also turn out badly for investors, especially those who get in late or forget about investment quality.

When you indulge in theme investing, you may let a theme or concept take a central place in your investing decisions. Usually the theme or concept includes some prediction about the future that has some truth in it, and will make noticeable changes in society. You may assume that if you can just get aboard that theme or find an investment whose future is tied up with it, you are bound to make money.

In other words, you may be buying what you might call a “Big Idea” without making certain that a particular investment has a workable business concept, or the management strength and financing it needs to overcome competition and profit from it.

Energy sector stocks: Investing in oil companies

Politics, weather and market sentiment will determine whether oil users stock up on oil, or cut down on new buying while they use up existing inventory. This can have a big impact on oil-price trends.

Investors refer to buying at a time like this as “trying to catch the bottom.” Another way to think of it is “trying to catch a falling knife.” Oil has indeed come down a long way from its peak, but even though it has rebounded somewhat from its bottom, it could drop further again. When it hits bottom, it may turn around and shoot back up again, as it has a number of times in the past. Or it may instead go sideways for months or years.

Overall, now is a particularly good time to stick to our three-part Successful Investor approach: Invest mainly in well-established, mainly dividend-paying stocks; spread your money out across most if not all of the five main economic sectors; downplay or avoid stocks in the broker/media limelight.

Then put perhaps just a portion of the money you intend to invest in the Resources sector into energy stocks. But only buy the best of those stocks.

What evolutions in the energy sector do you think will lead to greater stability in stock prices?

There’s more to energy sector stocks than oil and gas. What energy stocks do you find to be good investments?