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2006-05-24 :: Volatility Continues

As I look at my screen to see where the day ended, I see a lot of red.  A number of companies that were up early in the day ended down, and the traditional defensive stocks all seem to be up.

From an intuitive standpoint, the traders in New York all seem to be saying that we’ll never need any additional oil exploration as people have found religion in terms of gasoline usage or that we have plenty of copper, zinc, and nikel on hand for the future.   It makes no sense.  The fundamentals are still in place that started the bull market in commodities, particularly for the energy companies.  Most energy companies share prices reflect earnings estimates based upon $45 or $50 oil, not $60 or $70 oil.  When earnings are posted, they will inevitably be higher than estimates.  But no one ever said a market selloff was a rational thing.

 Monday, I provided a chart of the VIX-Volatility Index, saying that the market has hit the most oversold position since 911.  We did get a bounce yesterday, but it weakend as the day wore on.  Bird flu news and inflation expectations took the buyers to the sidelines and the market ended down for the day.  The chart today looks even more oversold and indicates that a rally is coming.  What we need to see, though, is that the market ends at its highs for the day to give Asia and Europe some momentum overnight.

The chart above is an is a two-year graph of the CBOE Oil Index.  Oil and metals have been hammered hard by the selling.  The value in these stocks now is truly compelling:  Apache with a P/E of 7.15 and a PEG of 0.71; Consol Energy with a P/E of 12.19; Helix Energy Solutions with a P/E of 9.04 and a PEG of 0.29; Nabors with a  P/E of 14.59 and a PEG of 0.23. 

If you are not familiar with PEG as a valuation ratio, it is (in my opinion) a much more relavant tool than simply using the P/E .  PEG includes earnings growth in the calculation and tells you, for example that Nabors earnings growth for neighbos is significantly higher than the P/E Ratio.  A PEG of 1 means that the earnings growth rate and the P/E Ratio are exactly the same.  A PEG of less than 1 means the earnings growth rate is higher than the P/E Ratio (this is a really good thing because it means you are buying a company with very strong earnings and you are paying below fair value for that company).  In Nabors case, their earnings growth rate is estimated to be 63.43% for the coming year, which when divided by the P/E of 14.59, gives you the PEG of 0.23.  Anytime you can buy (or own) a company that has earnings growth of 63.43% and only pay 14.59 times earnings for it, you are getting/owning a bargain that should increase in value.

Comparing Nabors to Google, Google has a forward P/E of 30.53 and a PEG of 1.31.  This means that you are buying a company with an earnings growth rate less than its P/E Ratio.   In a balanced portfolio, there is room for both of these companies.  The deep value in a Nabors along with the growth propects for a Google complement each other. 

Unfortunately, what the market is saying right now is that exploring for energy is not a worthwhile business at this time.  I couldn’t disagree more and am a buyer of Nabors at this price.  The upside seems significantly higher to me than the potential downside, so I’m willing to weather this storm and wait for the hedge funds and mutual funds to stop selling, and the volatility to ease up, so that the bull market in energy can commence.

The chart shows that over the last two years, we’ve always had times when energy has sold off.  The short-term players get out, the investors that buy on the fundamentals see value and buy, and the bull market continues.  Its tough weathering the storm while its happening, but ultimately the fundamental investors win as the oversold holdings march forward.  The supply/demand imbalances are not going away, even if US economic growth slows for a quarter or two due to higher interest rates.  Owning a company with > 60% earnings growth  that you buy when its undervalued will always make you money in  the end.

Hang in there as we await the turn around.