The BuyChart of the day: XLE

We’re still not excited about investing in Energy companies as a basket, regardless of what oil prices have done recently or what Saudi and Russia plan to do to ruin our thanksgiving (kidding).

With our newfound capability of analyzing ETFs – from the bottom-up, stock by stock – we can finally communicate our view on Oil & Gas with a compelling picture. This is one area where we significantly depart from one of our mentors – Warren Buffett (well he doesn’t know it, but we use his writings as a mentor). He’s heavily invested in Oil & Gas, but it doesn’t bother us – he has different return objectives and business requirements. He’ll be fine. As for us, we like to have a portfolio that allows us to sleep well at night.

The chart says that we’d definitely buy the SPY (S&P 500 Index ETF) over the XLE (S&P Energy ETF). Please bear in mind that this is our perspective as long-term investors with a specific long-term return target. Honestly, when it really comes down to it, even the SPY doesn’t excite us too much.

The BuyTheme of the day: Renewable Energy

If not fossil fuels, then how about investing in Clean Energy companies? We haven’t yet included and Clean Energy ETFs in The Fundcaster. We will soon. But here a few clean energy stocks that we watch. It’s a mixed bag. The main negative about Renewable Energy stocks is thin Gross Margins. Any prolonged dip in electricity prices kills their profit margin. And that factors into their unimpressive Rationality Ratings. 

Enphase Energy is the exception. It’s a competitor to Tesla’s Energy business – Enphase makes home energy solutions like microinverters and batteries. Interestingly, it’s stock is down about 60% over the last 12 months – BUT it’s still up more than 2,000% over the last 5 years! That doesn’t matter in our Rationality Ratings. And we like to dig into stocks with Rationality Scored of 9 and above.

Between the Tickers: Predicting the Past

History doesn’t repeat but it rhymes, they say. Sure, sometimes, kinda, maybe. But in our world of equity investing, this is usually a dangerous assumption. For some important variables in our world, history might rhyme. For most variables, it’s just a footnote.

Relying on historical data has a nice cozy feeling to it. Formulas are comforting. As an analyst, it’s frustrating when we can’t simply extrapolate historical patterns into eternity. But with the tech-infused world changing as fast as it is now, it’s a brave new world every quarter. Analysts feel a bit like Lord Grantham of Downton Abbey (utterly frustrated with the preposterous idea of a classless society).

But that’s what makes an analyst a good analyst – to know when to consider the faint echoes of history and when to ignore them entirely. OK – let’s get a little controversial – some of these notions below may offend the Lord Grantham in you. If not, you’re already a step ahead.

Here are some variables where for which history is useless (or mildly useful, at best).

1. Returns: History may provide some context but it’s dangerous to assume that just because as asset has returned X% on average over the last Y years, it will deliver something similar over the next Y years. This is dangerous to assume for asset classes, individual stocks, commodities, almost anything under the sun. It’s dangerous because we don’t to wake-up decades later only to realize that our portfolio overpromised and underdelivered.
2. Risk: The main definition of Risk (which almost no one should disagree with) is the likelihood of losing money. The likelihood of losing money will change over time, especially in today’s world where a company’s competitive landscape changes like a rotating kaleidoscope. However, most people think Risk = Volatility, which we discuss a minute later (hint: it’s not, for long-term investors).
3. Growth: This is a bit iffy. As we move down the cash flow waterfall, history becomes less relevant. For revenue growth, history may provide some context (we use it as a limiting constraint in The Buycaster). But further down the cash flow waterfall, relying on past data for profit or earnings growth, for example, is…cue in the old, overused quip: “It’s like driving while looking at the rear-view mirror…!”
4. Valuation Ratios: This one really bothers us because it’s so easy to pass off historical valuation ratios as “analysis”. Valuation Ratios inherently have built-in expectations of future profit growth. So, the same crowd that thinks that the history of profit growth is a harbinger of things to come, believes that historical valuation ratios like Price/Earnings to EV/EBITDA can be extrapolated into eternity. This kind of thing falls flat for high growth companies that are bound to slow down as competition catches up with them. Or for slow growth companies that are slow-bleeding into oblivion.

And now, here are some variables for which history may provide some context:

1. Profit Margins: History may provide some context, for some companies that have relatively stagnant cost structures. So, that value of historical profit margins is case-dependent.
2. Cost Structure: The split between fixed and variable costs remains somewhat steady for many companies, especially in Retail or Industrial sectors that sell somewhat commoditized physical products. For others, like software companies, economies of scale and scope throws out the window any predictive value of historical data.
3. Volatility: Ah! Did you think Volatility = Risk? Gotcha. If you did, you’re not alone. Price Volatility of the stock is often used as a measure of Risk on Wall Street because it’s used in Academic Finance. It works for short-term traders, maybe. But for long-term investors volatility isn’t all that relevant. In fact, it presents opportunities to buy great companies at low prices.

If you find that your research report or stock tip relies too much on “predicting the past” – you know what to do. If the report has no numbers and just hyperbole, then it’s just dreamcasting! Both are equally harmful. The balance is, of course, Buycasting – and that’s a little unabashed plug for our flagship equity analysis tool: The Buycaster.

Here’s the main takeaway: Next time anyone pitches you an idea based on the premise that history will repeat or rhyme – especially when it comes to returns, risk (the real risk), growth numbers, and valuation ratios – keep asking “why”, like a 5-year-old, until you get a real answer. “Because that’s how it’s been…” is not a real answer.