Those that seek value in the stock market are having a tough time of late. The big story over the last year or so has been economic improvements and, as we are seeing once again in this earnings season so far, rising corporate profitability. Alongside that, we have also seen stock prices get to the point where average Price to Earnings Ratios (P/Es) are above long-term averages. As long as earnings continue to be strong, that is not a problem, but it does make finding individual stocks that can outperform the market difficult.
There are two approaches to that problem. You can look for stock in companies that are underperforming in their industries, or industries that are underperforming the market. In both cases, the underperformance is almost always there for a reason, but the cyclical nature of the market makes it more likely that sectors and industries will recover than that individual companies that are being beaten by rivals will turn their fortunes around.
That, along with the fact that fundamental changes for a sector or industry can be better predicted than those for one company, is why investors seeking value should first decide where to look in terms of sectors.
Two notable laggards as the market has run up recently have been energy and financials, so it makes sense to start there. The low interest rate and high capital requirements that have limited banks’ profitability are gradually changing but will take time. The low oil prices that have kept energy stocks down, however, are looking more like a thing of the past with every passing day.
Still, after a series of false starts, the market is exhibiting understandable caution in the energy sector.
That caution has been echoed by the industry itself. Even as prices have climbed, most energy companies have maintained a restrained view of the future. Early indications from this earnings season are that that is beginning to change, and that bodes well for an underperforming sub-sector in an underperforming sector: offshore drilling.
Baker Hughes, A GE Company (BHGE) released so-so earnings on Friday, but the weakness was mainly down to integration issues at the new company. Revenue grew and more importantly, management said that they are increasing investment in anticipation of strong demand for oil field services and infrastructure, particularly from offshore operations.
That is a reasonable assumption given that WTI crude oil has been over $60 a barrel for all of 2018 and looks to be stabilizing in a higher range. In addition, the political climate favors offshore drilling, with a White House administration that clearly prioritizes oil extraction over environmental concerns. That may be enough of a concern for you that you don’t want to take advantage of it, but if not, the possibilities are clear.
So, starting with an underperforming industry, then narrowing in on an underperforming sector in that industry, and taking into account improving fundamentals for businesses in that sector, we arrive at offshore specialist oil companies as an area of value. The two obvious plays there are Transocean (RIG) and Diamond Offshore (DO).
Both have been hit hard by the downturn in offshore oil generally, but both currently have positive free cash flow which will enable them to take opportunities as they arrive. Both are still risky plays, but if you are looking to boost portfolio returns by adding value in a market as tight as this, risk is the price you have to pay, and these two stocks offer a good chance of serving that purpose over the next few months.