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Scouring S&P 500 Sectors For Bargains

The energy sector looks to be the last pocket of value in a fairly priced market.

Ben Johnson, 05/22/2015

As the S&P 500 continues to notch fresh all-time highs, investors' bullishness has ebbed. Stock market valuations look fair at best--and, in some corners, stretched. According to our equity analysts, the S&P 500 looks fairly valued at present, as indicated by our current price/fair value estimate for SPDR S&P 500 SPY, which stands at 0.99.

However, looking one layer deeper reveals a potential opportunity in the energy sector. In the table below, I've looked at valuations across each of the nine sectors of the S&P 500, as represented by the Select Sector SPDRs that track the relevant sector benchmarks. Based on this snapshot--which includes our analysts' fair value estimates and current and historical average yields, price/book value ratios, and price/earnings ratios--most sectors appear to be either fairly or modestly overvalued at present. However, the late-2014 downdraft in oil prices appears to have created a potential opportunity in the energy sector. Below, my colleague John Gabriel shines a spotlight on the largest and most-liquid ETF tracking the sector, Energy Select Sector SPDR XLE.

XLE can be used by investors as a tactical satellite holding to achieve broad exposure to the energy sector. The fund offers diverse exposure to the various industries that comprise the sector. Integrated oil and gas firms make up the largest portion of the portfolio at 32% of assets, followed by oil and gas exploration and production firms (29%), equipment and services companies (17%), storage and transportation firms (10%), refiners (10%), and coal and consumable fuels companies (1%). The fund represents an inexpensive and efficient way to invest in the U.S. energy sector without assuming too much idiosyncratic risk. 

As a market-cap-weighted fund, the fund's portfolio is fairly top-heavy. Vertically integrated supermajors Exxon Mobil XOM and Chevron CVX alone make up nearly 30% of XLE's portfolio. While these two firms represent a large chunk of assets, they operate in a diverse set of businesses across the energy complex. Their operations range from exploration and production all the way down to distribution. This helps damp the supermajors' sensitivity to energy prices but does not eliminate it entirely.

Other segments of the oil patch, such as exploration and production, are much more sensitive to volatile energy prices. Investors should expect the underlying firms' reliance on energy prices to translate into higher volatility for XLE relative to the broader market. For example, the S&P 500 experienced a standard deviation of returns of 14.7% over the trailing 10 years. Over the same period, the standard deviation of returns for XLE was more than 22%. Geopolitical risks can be a key factor driving volatile energy prices. Current turmoil in the Middle East, speculation about production cuts (or lack thereof) by Saudi Arabia and other OPEC members, and surging shale oil volumes out of the United States have all contributed to recent energy price volatility.

Over the years, the diversification potential of XLE seems to have been eroding. Over the trailing 15-year period, XLE has been 64% correlated with the S&P 500. However, over the trailing 10- and five-year periods, its correlation to the S&P 500 has increased to 71% and 84%, respectively. Still, the fund remains an effective tool for investors seeking to have an overweighting to the energy sector within a broadly diversified portfolio. The energy sector currently makes up about 9% of the S&P 500. Keep in mind that as a U.S. sector fund, XLE does not offer exposure to international supermajors such as BP BPor Royal Dutch Shell RDS.A.

Fundamental View
Integrated oil and gas companies have operations that span the full energy value chain. These companies, which represent about 32% of XLE's assets, explore for and produce oil and gas, transport it, refine or process it, and sell it to end users. The integrated model has historically provided firms like Exxon Mobil and Chevron with competitive advantages. By integrating across the energy value chain, these firms are able to gain much tighter control over the production and sale of oil and gas, and they get to keep profits they would otherwise have paid out to middlemen in the form of economic rents.

Ben Johnson is Morningstar’s Director of European ETF Research.

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