- Investors' Chronicle Alpha momentum screen highlights oil majors
- Instability in energy narratives could cause volatility in share prices going forward
Fighting climate change is supposed to be front and centre of the political agenda at the turn of November when Glasgow hosts the COP 26 climate conference, but the energy crisis has given sharp rise to a conflicting narrative. Shortages of natural gas in Europe and China’s power stations running close to empty has reminded us how dependent on fossil fuels we still are.
Curbing emissions hasn’t become less important, but the disruption of day-to-day life and supply chains exacerbated by the energy crunch should remind governments of the need for a sensible long-term strategy. Goals and regular key performance indicators are important, and fossil fuel producers must be held to account, but arguably the short-term bashing has been counterproductive.
Investors seem to have come to this realisation faster than policy makers with the two classes of Royal Dutch Shell’s London-listed shares (RDSA and RDSB) topping this month’s Investors’ Chronicle Alpha share price and earnings momentum screen. The energy behemoth passes all eight of the screen’s tests (see below) and, out of the FTSE All-Share index, the shares were fifth (and sixth) best ranked on a combination of earnings forecast upgrade momentum (for this financial year and next) and three-month share price momentum.
The UK market’s other oil & gas giant BP (BP.) still comes up short on forecast earnings growth rate for its next full financial year, but it ranks eighth on the FTSE All-Share on the combination of upgrade and share price momentum.
Forecast earnings growth or earnings forecast upgrade momentum?
This terminology can be a bit of a tongue-twister and the distinction between two of the most important screen metrics can be confusing. The forecast earnings growth we look at is the uplift in the median consensus earnings forecast for companies, according to FactSet data, from the end of the last to the end of the current financial year; and then the growth from the end of the current year forecasts to those for the end of the next financial year.
For the forecast earnings upgrade momentum, we look at how median forecasts for earnings recorded in FactSet data for a given period have changed year on year. The forecast for what is now the current and next financial years’ earnings must both be 10 per cent higher than a year ago for a company to pass our screen.
With a focus on the 'Great Expectations' analysts have for companies, as well as share price momentum, the screen has far more to hang its hat on than animal spirits in the market. It’s proven to work, too, at least in the theoretical sense. The brainchild of our stock screen expert, Algy Hall, the Great Expectations screen methodology delivered almost six-fold total returns between the end of 2011 and the beginning of 2021.
In practice there are dealing charges, and, in any case, investors should regard screens as a source of ideas, not as ready-made portfolios or unquestionable buy signals.
Energy crisis but does that mean tailwinds for the big producers?
Quite unusually for our AlphaScreens, one of the largest UK-listed companies came top of the pile. Including the compulsory forecast earnings upgrade momentum test, Shell met all eight of the screen’s criteria (listed in full at the end of this article). Of the nine companies in the FTSE All-Share index that scored 8/8, Shell ranked highest on that combination of upgrade and three-month price momentum.
BP fails our tests for forecast earnings per share (EPS) growth to be above 10 per cent for the current and next financial years. The fact it posted negative EPS for its 2020 full year means there isn’t the base point from which to calculate a percentage growth rate for this year (although of course the absolute number is expected to be back in the black and much better).
Oil above $80 per barrel would be reason to watch out for upgrade potential, but analysts at Bank of America (BoA) sound a note of caution. They believe a number of factors point to the downside for the oil price from current levels including scope for US dollar strength and decelerating US economic growth momentum. They write that “The oil price is 30 per cent above the fair-value levels implied by our analysis, among the largest overshoots observed over the past 15 years”.
In support of this view, the BoA team emphasise global purchasing managers' index (PMI) momentum having just turned negative. They also point to the supply of crude oil being up by 6m barrels per day over the past six months (the sharpest increase over the past decade). Furthermore, they argue the recent price rises will hamper demand and encourage production. In other words, good old fashioned market forces are likely to set a new, lower, price equilibrium. Writing about the broader European energy sector, they project lower oil prices and a 15 per cent underperformance relative to the markets.
Such worries help contextualise valuations. Both UK-listed oil giants rated on a next 12-month forward price/earnings ratio of eight times when the screen was run using FactSet data. Looking at share prices to forecast full-year 2021 earnings, BP and Shell are rated on 8.5 and 9.4 times, respectively.
Valuing the oil companies isn’t straightforward, however. The best measures for companies with capital structures that are debt heavy involve multiples of their enterprise value (the sum of equity market capitalisation and net debt) to various measures of business performance. Examples include the EV to Ebitda (see below), EV to debt-adjusted cash flow, and EV to provable/economically viable reserves.
If the numerators of such equations is hard to forecast, the denominators are close to impossible. Earnings before interest, tax, depreciation (which must include depletion of reserves for oil companies) and amortisation is hard enough to predict. Other figures such as debt-adjusted cash flow require estimates of the change in working capital position. Estimating a forward book value for proven and probable reserves is near futile.
In short, the choicest ways to value the sector are best employed as rear-view mirrors, which isn’t helpful when coming back from a pandemic which blind-sided last year’s figures. It means buying shares in oil and gas companies is a leap of faith both economically and, increasingly, ideologically.
Expect a bumpy ride
Supply and demand mismatches as the world transitions to clean energy are likely to be a feature for investors in the sector over the next couple of decades. The International Energy Agency (IEA) forecasts that given the stated policies scenario (STEPS) global oil demand will peak by the mid-2030s.
In a research note put out by Swiss bank UBS, analyst Jon Rigby recounted the IEA assertion that although spending on fossil fuels is aligned with the net zero [carbon] emissions by 2050 objective, demand is not. This suggests potential for further supply shocks as the calibration between long-term climate strategy and short-term needs will remain problematic. In that near-term horizon, UBS write “Underinvestment threatens oil supply security, heightening price volatility risks”.
Such volatility should read through to the share prices of the UK-listed energy majors. Capital gains are possible but so are losses. That’s a reason energy companies must assuage investors with juicy dividends and share buybacks. All well and good, but for companies involved in a tug of war between renewable projects and keeping fossil fuels on supply at a reasonable price, capital expenditure will be enormous.
True, governments must take on the responsibility for saving the planet, even more than rich investors, but for global corporations the investment pressures for the role they too must play limit possibilities for margin growth. That means they aren’t bargains and the re-rate driven momentum flagged in our screens has possibly been missed.
AlphaScreens earnings upgrade momentum screen rules:
- Earnings upgrade momentum: EPS upgrades over the past 12 months of at least 10 per cent for both the current and next financial year.
- Earnings momentum: Forecast EPS growth of at least 10 per cent in the current financial year and next financial year.
- Price momentum: Share price performance over one, three and six months and one year.
2021 great expectations stocks
|Name||TIDM||Mkt Cap||Price||Fwd NTM PE||Av 12mth EPS Upgrade||DY||Fwd EPS grth FY+1||Fwd EPS grth FY+2||3-mth Momentum||Net Cash/Debt (-) in GBP||Tests passed (out of 8)||Test Failed|
|Royal Dutch Shell Plc Class B||RDSB||£133,974m||1,739p||8||71%||3.1%||317.0%||12.5%||22.7%||-30,814m||8||na|
|Royal Dutch Shell Plc Class A||RDSA||£133,974m||1,721p||8||72%||3.1%||319.0%||12.4%||18.9%||-30,814m||8||na|
|Watches of Switzerland Group PLC||WOSG||£2,557m||1,068p||28||39%||0.0%||45.3%||24.9%||12.8%||-113m||8||na|
|Robert Walters Plc||RWA||£616m||804p||17||43%||2.0%||417.1%||24.7%||8.6%||-38m||8||na|
|Marks and Spencer Group plc||MKS||£3,576m||183p||11||13%||0.0%||985.7%||12.1%||23.7%||-1,603m||8||na|
|DWF Group Plc||DWF||£353m||109p||10||14%||4.1%||33.8%||15.9%||2.4%||-126m||8||na|
|Ashtead Group plc||AHT||£25,530m||5,714p||24||29%||0.7%||30.5%||17.5%||0.1%||-738m||8||na|
|BP p.l.c.||BP||£70,941m||355p||8||78%||4.3%||-||7.9%||16.0%||-20,743m||6||/>10% EPSgrth FY+1/>10% EPSgrth FY+2/|
|Source: FactSet, IC|