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A Hedged Trade for Oil Sector

By Sean Hannon, CFA, CFP, of EPIC Advisors from Covestor.com

Determining the fair value of an asset is both art and science. While traditional metrics such as price-to-earnings and dividend discount models offer the appearance of precise mathematical answers, these methods are widely used and do not always provide investors an edge.

Over the years, I have used non-traditional metrics as a way to determine fair value targets and identify trading opportunities. One example featured in EPIC Insights, my weekly investment newsletter, would be the method I use to value energy stocks.

Having seen large increases in the price of oil and gas, integrated oil companies trade at low P/E multiples with high return on equity and sizable dividend yields. If you used a P/E or dividend discount model, the price targets would be so high that an investor would think they should put all of their money into this industry. The lack of diversification and recent stock performance highlight the negatives of this action.

Since traditional metrics are not useful, how does one trade this sector? An alternative metric I have used is to examine the reserves each company reports, the current price of energy and then determine a fair-value estimate.

With any alternative method, we must ask if the process intuitively makes sense and why it would be a valid measure. After all, investors valuing Internet companies based on eyeballs during the dot-com bubble soon realized that alternative measures are full of risks.

With energy companies, their business is to drill, refine and sell energy. Their reserves offer a view of future production and future earnings.
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