RealMoney Silver - Oil Service Firms Are Gushing

Oil Service Firms Are Gushing
By John Reese
RealMoney.com Contributor
8/29/2007 6:06 AM EDT

While the stock market skids, the oil industry seems greased to do well in the coming months. Oil prices will wax and wane, no doubt, but they are still very high from what they were two or three years ago (at about $70 a barrel) and show no signs of significantly softening.

This means that companies that address the oil sector should continue to do well. The risks associated with oil are, I believe, less than those of the overall stock market. Winners will not be confined to oil companies, but will include oil well services and equipment companies that service the oil industry.

Of course, there are risks here, as with any industry. Even small signs of softening oil prices can cause some drillers to cut back on exploration and production. The industry has also experienced considerable growth, as oil prices rose in the last few years and oil companies boosted their exploration and production activities. Smart investors look at various industry sectors, decide which are the likely winners and then minimize their risks by carefully studying the companies within the chosen industries and picking the best.

I have been looking at the oil support industry. One of the "guru strategies" I use to pick stocks, the one based on the thinking of the legendary mutual fund manager Peter Lynch, likes a number of these oil well services and equipment companies.

I started following the Lynch strategy four years ago this July, and since then, it has generated a return of 118%, close to three times the S&P 500's return of 45% in the same time period. This tells me that the strategy works over the long term. By focusing on a specific industry sector that the Lynch strategy likes and that seems destined to do well over the next few years -- oil well services and equipment -- and cherry-picking the best companies in that industry, we have a powerful combination for picking some winning investments.

Let me tell you about several of the oil-related companies liked by the Lynch strategy.

One is National Oilwell Varco (NOV) , a company that makes oil and gas drilling equipment and which grows via both internally generated growth and acquisition. The stock's P/E is 19.57, while the company's growth rate (based on the historical three-, four- and five-year growth rates, which is used for all the analyses in this column) is 43.96%.

When P/E is combined with the growth rate in Lynch's famous PEG ratio, we get a result of 0.45. Anything less than 1.0 is acceptable and when the PEG falls below 0.5, it's time to gush like a wildcatter; National Oilwell Varco is in gushing territory. There are two other factors in its favor that make it a sound candidate for your portfolio: Management is keeping inventory growth under control -- witness the fact that inventories have declined relative to sales despite the company's high growth rate -- and debt is a modest 14.64% of equity.

The company is unlikely to be able to sustain its growth rate, but that's OK because its PEG ratio is so strong that even some slowing in the growth rate will not alter the fact that this company is doing well and its stock is reasonably priced.

Cameron International (CAM) is another company that can stand the test of a deep-drilled analysis, which is appropriate since subsea drilling is an important part of the market for this oil- and gas-equipment maker and services company.

Like National Oilwell Varco, Cameron earns a very favorable PEG ratio. Its growth rate is a sizzling 49.12% and its P/E is 20.51, giving it a PEG of 0.42. This is even slightly better than National Oilwell Varco's, but its growth rate is also slightly higher and not likely to be sustainable. Again, that's acceptable because the PEG is so low and so favorable that even a fairly significant drop in the growth rate would still leave the stock within range of being desirable.

For example, if growth were to drop in half and the P/E stayed constant, the PEG would be 0.83, well within the 1.0 or less that is acceptable. This kind of wiggle room lowers your investment risk. Also, inventories are falling relative to sales, and debt, while higher than National Oilwell Varco's, is still acceptable.

Smith International (SII) is another drilling-equipment-and-services company that is performing well. The stock's P/E is 20.46 and its growth rate is 45.42%, producing an excellent PEG of 0.45.

Inventories as a percentage of sales went up in the last year, but not enough to be of concern. And the company's debt as a percentage of equity runs about the same as Cameron's.

Also note that in addition to the Lynch strategy, another automated strategy I use, based on James P. O'Shaughnessy's writings, also likes Smith. Two thumbs up from the guru strategies is reason enough to pay attention to this stock.

FMC Technologies (FTI) and Cameron are in similar businesses and are therefore competitors. And like Smith, FMC is also liked by the O'Shaughnessy strategy, making this a strong investment candidate as well.

FMC's P/E is 16.95, while its growth rate is 39.10%, producing a solid PEG of 0.43. Inventories as a percentage of sales have gone up this year, but not enough to cause concern. Debt runs just over half of equity, which is okay.

Like the other stocks mentioned in this column, FMC is a good candidate for your portfolio because its PEG ratio is so strong that even a weakening in growth will still allow the stock to be an acceptable buy.

All of these companies are in similar businesses, so do not load up on them all. You need to diversify. But certainly any one of these stocks would make a welcome addition to virtually every portfolio.

The oil well services and equipment market is doing well, these companies are doing well, their stocks are reasonably priced and the Lynch strategy favors them all. You do not have to be sitting in the oil patch to get excited about these stocks.