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In physics, the dynamic energy of an object is a measure of how much energy the object can release under favorable conditions. In a similar way, a stock portfolio has higher dynamic energy when it consists of stocks with great upside potential thanks to a headwind and its resultant sell-off. The article suggests replacing some stalwarts, whose growth has stumbled but still trade at elevated P/E, with some oil stocks that have been extremely punished due to the oil plunge. In physics, the dynamic energy of an object is a measure of how much energy the object can release under favorable conditions. To clarify this through an example, two objects that are still, with the one at the sea level and the other one on the top of a hill, both have zero kinetic energy. However, the one on the top of the hill possesses much greater dynamic energy because a minimal push can make it start moving at an increasing speed, whereas the other one will remain still under any conditions. Given this definition, investors should try to build a portfolio that has high dynamic energy, i.e., its stocks will greatly appreciate under favorable conditions. Of course this does not involve purchasing extremely high-risk stocks that will return great profits under extremely specific conditions, which have minimal chance of prevailing. Instead this strategy involves purchasing stocks that have asymmetrical reward to risk, as they have been beaten to the extreme due to a temporary headwind despite their strong fundamentals. In the past, it was much easier to build a portfolio with high growth potential. More specifically, all an investor needed to do was to purchase some stalwarts, such as Coca-Cola (NYSE: KO ), PepsiCo (NYSE: PEP ), McDonald’s (NYSE: MCD ), Wal-Mart (NYSE: WMT ), General Mills (NYSE: GIS ), Philip Morris (NYSE: PM ) and Procter & Gamble (NYSE: PG ), and hold them forever without even checking on them. As these companies have historically grown their earnings per share [EPS] at a rate higher than 10%, they have historically offered excellent returns to their shareholders. However, as these stalwarts have now expanded to almost every country, further growth has become much harder to accomplish and hence their EPS growth has stumbled in the last 2 years, as shown in the table (data from morningstar.com for 2013-2014 and finance.yahoo.com for 2015): KO PEP MCD WMT GIS PM PG 2013 growth -4% 10% 4% -3% 19% 2% 6% 2014 growth -2% 5% -8% -2% 1% -5% 4% 2015 growth [Exp.] 0% 4% 5% 5% 0% -10% -2% P/E TTM 21 21 19 17 22 16 21 Given the low growth rate of the above stalwarts, their high market cap and their relatively high P/E, investors should realize that a portfolio consisting largely of such stocks possesses limited upside (fortunately it also has limited downside, as these stocks greatly outperform the market during a downturn). Therefore, investors should add some stocks that have been unfairly beaten to the extreme due to a temporary headwind. At the moment, there are some off-shore drillers and oilfield service companies that possess strong balance sheets and great managements but have been sold off to the extreme due to the sell-off of their entire sector. Investors should realize that oil is very cyclical in nature and hence it will not remain for many years at its current level, which is half of the level that prevailed in the last 4 years. To be sure, the number of oil rigs has consistently decreased in the last 10 weeks, reaching the level of March-2010, and will keep declining if oil remains pressured. Moreover, all oil companies have significantly curtailed their capital expenses for future growth, which will ultimately result in lower production levels in the future. Thus it is a question of time before oil returns to a more reasonable range, which will render more rigs profitable than the current price does. The table below includes some stocks with strong earnings and low amounts of debt, which will strongly recover when oil returns to a more reasonable level, around $70-$80. The table depicts the decline of these stocks off their peak in the summer, the upside from their current price to their peak and the upside from their current price to half way till their peak, which will correspond to an oil price within $70-$80. NOV HAL ESV NOV Decline off peak 41% 42% 46% 40% Upside to peak 69% 72% 85% 67% Upside if oil rises to $70-$80 35% 36% 43% 33% P/E TTM 9 11 5 6 Given the extremely low P/E of Ensco (NYSE: ESV ), its low debt and its high dividend yield (10%), it is the stock with the greatest upside potential if oil rises to $70-$80. Noble Energy (NYSE: NE ) has a very low current P/E but its forward P/E is higher, around 9, while the company also carries a much higher relative amount of net debt ($7 B) than Ensco, standing at about 9 years’ earnings. National Oilwell Varco (NYSE: NOV ) has a low P/E and high backlog, which can fully protect its profitability for at least one more year, while its balance sheet is essentially debt-free, as its net debt ($2 B) is worth only one year’s earnings. Halliburton (NYSE: HAL ) has a low P/E but its earnings are expected to plunge almost 50% this year so it is a riskier choice. To sum up, investors should always look for stocks that have strong fundamentals but have been punished due to a temporary headwind, thus possessing great upside potential. As the market always overreacts to headwinds and any factor of uncertainty, it is only natural that asymmetric reward to risk shows up whenever an unforeseen headwind emerges. Of course this does not mean that an entire portfolio should consist of such stocks, particularly in the case of defensive investors. Nevertheless, when a stock of a portfolio reaches an overvalued level that leaves very limited further upside, it is prudent for investors to exchange that stock with another one as shown above so that their portfolio maintains high dynamic energy. Disclosure: The author is long ESV, NOV. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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