Finance 824 Stock Market

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Finance 824Stock Market

• Sector Analysis
• Energy Sector
• By Patrick Kempton,
• Chi-Hsien Pan,
• Alek Skorniakov

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Outline

• Sector overview
• Business Analysis
• Financial Analysis
• Valuation Analysis
• Recommendation

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Sector Overview

• Size 648.7 billion of market cap (6.3 of SP
  500)
• Current 824 portfolio weight 2.83
• Composition 24 companies listed in SP500,
  classifiable into 2 major industries
• Energy equipment services
• Oil and gas
• Largest companies Exxon Mobile (267.9b), Royal
  Dutch Petroleum (105.4b),Chevron Texaco (95.6b)

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Business Analysis

• Phase of life cycle Mature
• Classification by business cycle Cyclical
• YET
• Valuations are not highly correlated with changes
  in US GDP, while oil prices, earnings and
  revenues are
• External factors influence sector performance

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Business Analysis

• External factors
• Supply controlled (or not controlled) by OPEC
  decisions
• Oil prices are very volatile

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Business Analysis

• 5 Forces Analysis
• 1. High barriers of entry
• New capacity requires high initial investments
• Costly to exit
• New capacity takes time to impact market
• Exploration
• Exhumation
• Refining

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Business Analysis

• 2. Fierce competition
• Many domestic and international competitors
• Recent major consolidations
• 3. Strength of customers
• High
• Commodity Customers keep close eyes on prices

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Business Analysis

• 4. Strength of suppliers
• Hard to say energy sector is a competitive
  environment
• OPEC controls roughly 10 of the output
• Non-OPEC countries represent a greater percentage
  of supply (Mexico and Russia have been increasing
  output driving the prices and supplier strength
  down)
• 5. Substitutions
• Little to none

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Financial Analysis

• Sales Earnings
• Sales and earnings fluctuated a lot
• Growth rates are difficult to predict
• Capital Expenditures
• Slowing down until 2000 and rising roughly 20 in
  2001 due to increased drilling activities
  worldwide

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Financial Analysis

• Profitability
• Pretax profit margin, net profit margin, ROE,
  asset turnover Fluctuated a lot in recent years
• Current margins are strong, but will probably
  decline since 2000
• Asset turnover is declining
• Historically, margins were low compared to
  SP500, but hiked in recent years

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Financial Analysis

• Dupont Analysis
• Margins strong
• Asset turnovers Declining
• Leverage Constant
• ROE Relatively high in 2000
• Are these going to continue?
• Revision trend

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Valuation Analysis

• What did the market tell us in the past?
• Relatively stable prices regardless highly
  volatile revenues and earnings
• Adjusted earnings models?

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Valuation Analysis

• P/E, P/S, P/B, and P/CF
• All figures below SP500
• Value stocks
• Cheap stocks time to buy?

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Valuation Analysis

• A Closer Look
• A negative correlation between P/E and EPS
• Due to relatively stable prices (i.e. prices
  change of 10 in response to 50-150 change in
  earnings)
• Positive correlations between P/S and net profit
  margin
• Positive correlations between P/B and ROE

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Valuation Analysis

• E1 (1 payout)
  P ______________________
  (r g)
• Payout gt assumed to be constant
• r gt expected to maintain at low level
• E1 and g gt who knows?

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Valuation Analysis

• Technical Analysis
• Horizontal trend
• Resistance at 50
• Support at 35
• Current 41
• It is not time to buy
• Is it time to sell?

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Recommendations

• OPINION
• Fifth consecutive weekly rise in inventories to
  1.5 above 10-year average, despite shrinking
  refinery utilization(85 vs. 90 average), is an
  evidence of continuingly slowing demand. Although
  profit margins may stay stable, asset turnover is
  likely to decline. Economic recovery has not
  materialized despite multiple positive
  projections. If the economy remains weak, the
  sector will continue to look troublesome due to
  rising supply from non-OPEC producers,questionabil
  ity of OPECs influence and the falling demand.
  If the economy rebounds the energy sector will
  benefit, but will not pick up as quickly as will
  growth stocks.

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Recommendations

• Given all the information above, we recommend to
• UNDERWEIGHT the sector
• Yet pay more attention to drilling businesses
  drilling ativities have edged up recently

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Recommendations

• Risks
• Uncertainty regarding oil prices
• Looking at history, current high profitability is
  unlikely to continue
• Opportunity costs facing a low inflation rate
  and a recovering growth rate in the market, it is
  time to buy growth cyclical stocks, not value
  cyclical stocks (again, this sector is not very
  responsive to changes in GDP)

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Recommendations

• Negatives / Risks
• Favorable oil prices
• Recovering economy creates strong demand
• Everyone rush to buy after looking at P/E, P/B,
  P/S, P/CF relative to SP500

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Recommendations

• Mood on the Street
• SSB remain defensive on energy.
• UBSW increased short interest in oil futures a
  negative sign. Conservative outlook.
• MSDW neutral on major energy stocks

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CONCLUSION

• UNDERWEIGH the energy sector
• Keeping the current SIM portfolio weight 2.83
  (vs. actual 6.3 in SP500) makes a lot of sense