Energy funds have been sizzling, returning 22.8% in the last three months and outdoing the S&P 500 by 7 percentage points. With the economy showing signs of life, energy stocks have been rising along with the prices of oil and coal. Can the funds keep climbing? Some fund managers think so, arguing that prices of energy stocks don't yet reflect the strength of reviving global markets. Among the bargain shares are the biggest integrated U.S. oil companies, says Will Riley, portfolio manager of Guinness Atkinson Global Energy Fund ( GAGEX). The group includes companies, such as Chevron ( CVX) and Hess ( HES) , which find and produce oil and gas. The integrated shares sell for a price-earnings ratio of 10.5 times next year's earnings compared with a multiple of 13.5 for the overall market, Riley says. During periods when the oil patch has prospered, the integrated companies have sold for the market multiple or higher. "The stocks are about 30% undervalued," Riley says. The portfolio manager that under normal circumstances energy stocks roughly track the value of the reserves owned by companies. At the moment, stocks are being priced as if oil sells for $50 a barrel. But the spot price hasn't been that cheap since April 2009 when the markets were just beginning to recover from the credit crisis. Since then prices have been trending upward. The spot price has climbed from $73 this August to the current level of $84. With demand for oil increasing at a 2% annual rate, prices should continue climbing gradually, Riley argues. To bet on rising prices, try Guinness Atkinson Global Energy, which has returned 7.8% annually during the past five years, outdoing 82% of competitors. The fund follows a value approach, looking for unloved stocks that seem poised to rebound. A favorite holding is Valero Energy ( VLO), a refiner. Earnings suffered as the recession hurt sales, and the stock dropped from $77 in 2007 to a low of $15 in 2009. Since then the stock has rebounded to $19 and sells for a forward multiple of 9. "As the U.S. pulls out of recession, the refining stocks will increase their earnings faster than people think," says Riley. He also likes Bill Barrett ( BBG), which develops oil and gas fields. The stock has been hurt partly by a fall in natural gas prices, which declined from over $6 per million BTUs a year ago to $4.13 now. Prices tanked as new exploration techniques seemed poised to deliver a surplus of gas. But Riley argues that prices have fallen too far. At current levels, some new fields will not be economical to develop, and production should lag projections. That will allow prices to strengthen.
To hold small and mid-sized stocks, consider BlackRock Energy & Resources ( SSGRX), which has returned 7.1% annually during the past five years, outdoing 72% of competitors. Portfolio manager Dan Rice emphasizes sectors that seem underpriced. He is currently keen on coal producers, holding Arch Coal ( ACI), Consol Energy ( CNX)(CNX) and Massey Energy ( MEE). With demand growing around the globe, the price of coal has climbed to $110 a ton in Europe and China. But coal remains at $65 in the U.S. Rice says that the price gap can't last. It costs $30 a ton to ship coal from U.S. mines to Europe. So it is now economical for European users to buy in the U.S. Foreign demand will push up U.S. prices, and boost profits sharply, says Rice. "If prices go up to $85 or $90, the stocks could increase 100%," Rice says. Another value fund is ICON Energy ( ICENX), which has returned 7.4% annually during the past five years. ICON follows a quantitative system, aiming to buy undervalued stocks that have begun outperforming the market. The fund recently has been increasing its weighting in integrated companies, including ConocoPhillips ( COP) and Exxon Mobil ( XOM). Portfolio manager Derek Rollingson says the integrated companies have been cheap for months, but his fund underweighted the sector because the stocks were lagging. "We have been waiting for them to show market leadership, and the stocks started to move in the last few months," he says.