What works on Wall Street

Extracted from the book

  • Stocks with the worst price momentum are horrible long-term performers
  • Single value factors have vastly better returns and battling averages than pure growth factors. The one exception to this is price momentum and should always be used in connection with a value constraint.
  • Using several value factors offers much better and consistent returns than a single factor.
  • Accounting variables such as accruals to price, asset turnover, external financing, and percentage change in debt offer key insights into which stocks have higher quality earnings. Using Several accounting variables – total accruals to total assets, the percentage change in operating assets, total accruals to average assets, and depreciation expense to capital expense – improve the quality of stocks and the return.
  • Consumer staples and utilities offer investor excellent returns at low levels of risk by focusing on value factors and shareholder yield
  • buying wall street’s current darlings with the richest valuation is one of the worst things you can do.
  • A simple strategy that buys the 25 best-performing stocks based on six-month price momentum from the stocks scoring in the upper 10 percent of value composites earn more than 20 percent per year since 1963

Industrial Industry

Characteristics

  • Diverse – Both in where the companies are and in the end markets served
  • Tends to be economically sensitive
  • Highly correlated to broad markets
  • Tends to have lower profit margins

Sector Drivers

  • Corporate Spending – Economic strength, Corporate financial health, access to cheap capital
  • Construction spending in turn driven by
    • available market supply,
    • real estate prices,
    • vacancy rates,
    • consumer spending,
    • financing conditions and tax incentives,
    • regional economic and population growth and demographics,
    • input availability
  • Beneficiaries of increased construction spending
    • Aerospace and Defense (heating systems, air con, elevators, security systems)
    • Building Products
    • Construction and Engineering
    • Commercial services such as waste management services
    • Industrial Conglomerates
    • Machinery
    • Transportation Industries
  • Beneficiaries of increased manufacturing
    • Electrical Equipment
    • Industrial Conglomerates
    • Machinery
    • Trading companies & Distributors
    • Transportation Industries
  • Transportation Equipment demand is primarily driven by an overall growing economy and industry profitability. Major industry beneficiaries are:
    • Aerospace & Defense
    • Industrial Conglomerates
    • Machinery
  • Industrials exposed to commodities
    • Construction and engineering
    • Industrial Conglomerates
    • Machinery
    • Marine
    • Road & Rail
    • Trading Companies & Distributors
  • Government Spending
    • Defense Spending (Aerospace & Defense, Construction & Engineering, Machinery, Industrial Conglomerates)
    • Infrastructure Spending (Machinery, Construction & Engineering, Industrial Conglomerates, and Electrical Equipment)
  • Capital Goods’ industries make up the bulk
    • Wide sector weights deviations can occur from country to country
    • Concentrated in relatively few large players
      • Market values of the largest firms outweigh global peers by far
      • Barriers to entry in some industries
      • Government involvement in some

 

Industrial Classification

based on https://www.msci.com/gics

Capital Goods Aerospace & Defense Aerospace & Defense

Manufacturers of civil or military aerospace and defense equipment, parts or products. Includes defense electronics and space equipment.

Defense companies mainly found in US and dependent on the size of US defense budget. Defense backlog often include

  • Fixed price contracts
  • time-and-materials (fixed hourly wage)
  • cost-reimbursable contracts (fixed fee and reimbursement for allowable costs)

Aerospace companies manufacture non-defense related commercial airplanes and other industrial goods. Mainly duopoly of large aircrafts but extremely competitive with emerging countries designing new planes.

Building Products Building Products

Manufacturers of building components and home improvement products and equipment. Excludes lumber and plywood classified under Forest Products and cement and other materials classified in the Construction Materials Sub-Industry. Competition is a major issue due to limited barriers to entry. Demand is driven primarily by residential and commercial construction and remodeling activity.

Construction & Engineering Construction & Engineering

Companies engaged in primarily non-residential construction. Includes civil engineering companies and large-scale contractors. Excludes companies classified in the Homebuilding Sub-Industry. Projects usually take years and awarded based on their technical expertise, prior track record, and bid competitiveness.

Electrical Equipment Electrical Components & Equipment

Companies that produce electric cables and wires, electrical components or equipment not classified in the Heavy Electrical Equipment Sub-Industry.

Demand for both mainly driven by global industrial production and capacity utilization levels, corporate capital expenditures and manufacturing capacity investments (upgrades, expansions, new facilities, etc).

Heavy Electrical Equipment

Manufacturers of power-generating equipment and other heavy electrical equipment, including power turbines, heavy electrical machinery intended for fixed-use and large electrical systems. Excludes cables and wires, classified in the Electrical Components & Equipment Sub-Industry.

Industrial Conglomerates Industrial Conglomerates

Diversified industrial companies with business activities in three or more sectors, none of which contributes a majority of revenues. Stakes held are predominantly of a controlling nature and stakeholders maintain an operational interest in the running of the subsidiaries.

Machinery Construction Machinery & Heavy Trucks

Manufacturers of heavy duty trucks, rolling machinery, earth-moving and construction equipment, and manufacturers of related parts. Includes non-military shipbuilding.

Agricultural & Farm Machinery

Companies manufacturing agricultural machinery, farm machinery, and their related parts. Includes machinery used for the production of crops and agricultural livestock, agricultural tractors, planting and fertilizing machinery, fertilizer and chemical application equipment, and grain dryers and blowers.

Industrial Machinery

Manufacturers of industrial machinery and industrial components. Includes companies that manufacture presses, machine tools, compressors, pollution control equipment, elevators, escalators, insulators, pumps, roller bearings and other metal fabrications.

Trading Companies & Distributors Trading Companies & Distributors

Trading companies and other distributors of industrial equipment and products.

Commercial  & Professional Services Commercial Services & Supplies Commercial Printing

Companies providing commercial printing services. Includes printers primarily serving the media industry.

Environmental & Facilities Services

Companies providing environmental and facilities maintenance services. Includes waste management, facilities management, and pollution control services.  Excludes large-scale water treatment systems classified in the Water Utilities Sub-Industry.

Office Services & Supplies

Providers of office services and manufacturers of office supplies and equipment not classified elsewhere.

Diversified Support Services

Companies primarily providing labor oriented support services to businesses and governments.  Includes commercial cleaning services, dining & catering services, equipment repair services, industrial maintenance services, industrial auctioneers, storage & warehousing, transaction services, uniform rental services, and other business support services.

Security & Alarm Services

Companies providing security and protection services to business and governments. Includes companies providing services such as correctional facilities, security & alarm services, armored transportation & guarding.  Excludes companies providing security software classified under the Systems Software Sub-Industry and home security services classified under the Specialized Consumer Services Sub-Industry. Also excludes companies manufacturing security system equipment classified under the Electronic Equipment & Instruments Sub-Industry.

Commercial  & Professional Services Professional Services Human Resource & Employment Services

Companies providing business support services relating to human capital management. Includes employment agencies, employee training, payroll & benefit support services, retirement support services and temporary agencies.

Research & Consulting Services

Companies primarily providing research and consulting services to businesses and governments not classified elsewhere.  Includes companies involved in management consulting services, architectural design, business information or scientific research, marketing, and testing & certification services. Excludes companies providing information technology consulting services classified in the IT Consulting & Other Services Sub-Industry.

Transportation Air Freight & Logistics Air Freight & Logistics

Companies providing air freight transportation, courier and logistics services, including package and mail delivery and customs agents. Excludes those companies classified in the Airlines, Marine or Trucking Sub-Industries.

Airlines Airlines

Companies providing primarily passenger air transportation.

Mainly three types of airlines – the major airlines, the regional airlines and the low-cost airlines.

Marine Marine

Companies providing goods or passenger maritime transportation. Excludes cruise-ships classified in the Hotels, Resorts & Cruise Lines Sub-Industry.

Shipping generally is broken down into wet and dry bulk. Dry bulk shipping is the transportation of bulky raw materials such as coal, iron ore that react badly to water.

Demand is driven by the strength of the global economy and demand for food and commodities. Industry profitability is driven by freight rates, which are most commonly linked to the Baltic Dry Freight Index.

Wet bulk shipping is the transportation of wet goods, primarily oil and petrochemicals. The industry is very cyclical.

Road & Rail Railroads

Companies providing primarily goods and passenger rail transportation.

4 types of railroads in US:

  1. Class I railroads (1 percent of railroads but make up of 67 percent of mileage and main revenue)
  2. Regional railroads
  3. Local line haul
  4. Switching & Terminal Carriers
Trucking

Companies providing primarily goods and passenger land transportation. Includes vehicle rental and taxi companies.

Transportation Infrastructure Airport Services

Operators of airports and companies providing related services.

Highways & Railtracks

Owners and operators of roads, tunnels, and rail tracks.

Marine Ports & Services

Owners and operators of marine ports and related services.


 

Bullish and Bearish Industrial Fundamentals

Bullish Drivers Bearish Drivers
Increasing GDP Decreasing GDP
Increasing Industrial production Decreasing Industrial production
Increasing Durable goods orders Decreasing Durable goods orders
Improving ISM Manufacturing numbers Decreasing ISM Manufacturing numbers
Increasing Construction spending Decreasing Construction spending
Increasing Defense spending Decreasing Defense spending
Increasing Commodity prices Decreasing Commodity prices
Improving Corporate financial health Worsening Corporate financial health
Easy Access to capital Difficult Access to capital
Increasing Monthly sales orders Decreasing Monthly sales orders
Increasing Rail volumes Decreasing Rail volumes
Increasing Cargo volumes Decreasing Cargo volumes
Increasing Truck tonnage Decreasing Truck tonnage

Ways to evaluate economic health

Measuring corporate health

  • Company Earnings Announcements
  • SEC Filings
  • News Sources
  • Corporate Profit reports (www.bea.gov)
  • Interest Rates
  • Equipment Leasing and Finance Association’s monthly leasing and finance index (http://www.elfaonline.org/)
    • New Business Volume
    • Aging of Receivables
    • Average losses as a percentage of net receivables
    • Credit approval ratios as percentage of all decisions submitted
    • Total number orf employees
  • Loan Survey  (www.federalreserve.gov)

Industry Specific Indicators


 

Infrastructure Market

Infrastructure can be broken to

  1. Energy – Electric power generation, transmission, and distribution, and natural gas transmission and distribution.
  2. Social – Schools, Hospitals, Stadiums, public housing, community facilities and prisons.
  3. Telecommunications – Fixed and mobile phone lines, the internet, cable networks, satellite, television and radio towers.
  4. Transport – Airport runways and terminals, railways, toll roads, bridges, highways, tunnels, ports, logistics centers, and other transit systems.
  5. Water and Sanitation – Potable water generation and distribution and sewage collection and treatment.

Infrastructure Investment Drivers

  • Supporting Economic Growth
  • Overusing aging infrastructure
  • Growing Urbanization
  • Encouraging Foreign Direct Investment
  • Ensuring Public Safety

Risks to Infrastructure Growth

  • Economic and government – bureaucracy, corruption, budget, lack of public support. Delays are common.
  • Execution – Labor shortages, commodity and machinery shortages, and cost overrides and increases
  • Financial Market – Difficulty raising funds.

Participating in Infrastructure Boom

  • Public Private Partnerships
  • ETFs and mutual funds
    • Broad-based – IGF, GII, MGU, FGIAX, CSUAX, KGIAX
    • Water exposure – PHO, FIW, CGW, PIO
    • Energy exposure – NLR, MFD, TYG
    • Other – PKB, EVX
  • Buying infrastructure-related stocks
    • Construction & Engineering
    • Electrical Products
    • Industrial Conglomerates
    • Machinery
    • Transportation Infrastructure

Industry Summary

Aerospace & Defense

  • Defense companies tend to do well when expectations for future defense spending and military modernization efforts are rising
  • Defense companies have historically outperformed in bear markets and recessions because product demand is less variable compared to more economically sensitive industries
  • Aerospace companies tend to do well when air travel fundamentals are favorable, including sustained economic growth, increased air traffic, and airline profitability.
  • Market acceptance of a new design is crucial given production and design costs and the number of years the planes remain in service
  • A number of the larger US Aerospace & Defense companies reach a diversified set of markets, linking them to the broad economy as a result

Air Freight & Logistics

  • Package delivery demand tends to correlate with economic strength and do well when economic growth expectations are increasing.
  • Weak economic conditions and oil high prices can limit profits and industry success.

Airlines

  • Driven by consumers wealth and travel demand.
  • Both discretionary and elastic. Hence airline pricing can affect demand, profitability, and share prices.
  • Rising oil prices can have a detrimental effect on profits and share prices.

Building Products

  • Tend to do well when residential and non-residential construction is strong and remodeling activity is elevated.

Construction & Engineering

  • Tend to do well when corporate and government spending on infrastructure and commercial construction is strong
  • Pay attention to major project delays and escalating project costs as it will affect profits.
  • Global shortages of qualified engineers can cap the growth of individual firms

Commercial Services & Supplies

  • Very diverse and generally do well when corporate spending is high and the economy is strong.
  • Environmental & Facilities Services tend to do well during periods of economic growth and strong construction levels.
  • Tend to be more defensive than other industrial industries.

Electrical Equipment

  • Demand historically follows economic conditions and sensitive to activity in the construction market, industrial production levels, electronic component production and spending by utilities for replacements, expansions, and efficiency improvements.
  • Do well when pricing increases can stay above input cost pressures.
  • A slowdown in corporate profitability and a decrease in manufacturing levels can slow electrical equipment demand.

Industrial Conglomerates

  • Do well when the global economy is strong.
  • Strong infrastructure spending helps drive the larger industrial conglomerates that manufacture large fixed assets.
  • Global diversification helps drive relative outperformance when the global economy performs better than the domestic economy.

Machinery

  • Demand for machinery has historically followed general economic conditions and sensitive to construction market activity, industrial production levels, commodity prices, and corporate capital expenditure trends.

Marine

  • Dry bulk shipping demand is generally driven by the strength of the global economy and demand for food and commodities. Shipping rates are also driven by dry bulk demand, as well as available ship supply and port capacity, both of which are expected to increase moving forward.
  • Wet bulk shipping demand is driven by demand for oil and oil derivatives like petrochemicals.
  • Container ship firms are driven by global trade and available supply ships.

Professional Services

  • Driven by corporate activity and consulting and legal service needs.
  • Human Resource & Employment Services companies tend to be driven by employment demand and corporate profitability

Road & Rail

  • Trucking and Rail companies are driven by global economic growth and consumer and corporate spending levels.
  • Historically highly sensitive to oil prices and corporate success will be likely be driven by how well it can pass on higher costs to its customers.
  • Operational improvements play heavily on stock prices and profitability

Trading Companies & Distributors

  • US trading companies tend to be leveraged to US economic growth and industrial production and manufacturing levels, while foreign firms tend to be driven by global economic growth and commodity prices.
  • Sales are driven by both corporate and government spending levels

Transportation Infrastructure

  • Historically considered the defensive industry as toll-road demand is usually fairly stable.
  • Decrease in road traffic primarily driven by the macro environment and oil prices
  • Port operators tend to do well when global trade is strong. Limited global capacity magnifies the industry’s sensitivity to elevated product demand.

Examples of falling demand:

  • Recession – regional or global; perceived or real
  • Reduction in corporate capital expenditures
  • Weakening corporate profitability
  • Difficulty accessing credit to purchase new equipment
  • Falling construction activity
  • Commodity pressures – high prices drive commodity producer expansions but hurt manufacturers who have the commodity as an input cost
  • Reduction in government infrastructure and defense spending
  • Removal of government tax incentives for equipment purchases and alternative energy spending
  • Inability to source necessary parts and supplies

Industrial Websites and Data Sources

Forecasts/Annual Reports

Aerospace Industries Association Forecast http://www.aia-aerospace.org
AIA Construction Forecast https://www.aia.org
Annual Construction Equipment Business Outlook https://www.aem.org/
Current Market Outlook (Commercial Boeing) http://www.boeing.com/commercial/market/
FAA Aerospace Forecast https://www.faa.gov/data_research/aviation/
International Air Traffic Association Industry Outlook www.iata.org
ISM Manufacturing Report on Business https://www.instituteforsupplymanagement.org
USDA Agricultural Projections https://www.ers.usda.gov/

News

Air Cargo World http://aircargoworld.com/
Air Transport Association http://airlines.org/
Association of Equipment Manufacturers https://www.aem.org/news/
Aviation Week http://aviationweek.com/
Construction Equipment https://www.agc.org/agc-news
Defense News http://www.defensenews.com/
Industrial Market Trends http://news.thomasnet.com/
Industry Week http://www.industryweek.com/
Logistics Management http://www.logisticsmgmt.com/
Manufacturing Economy Daily http://www.nam.org/
MAPI Manufacturing https://www.mapi.net/
McGraw Hill Construction https://www.construction.com/
Quadrennial Defense Report https://www.defense.gov/News/Special-Reports/QDR/
Supply Chain Brain http://www.supplychainbrain.com
Journal of Commerce http://www.joc.com/
Transport Topics http://www.ttnews.com

Data

Bureau of Economic Analysis https://www.bea.gov/
Bureau of Transportation Statistics https://www.bts.gov/
Cass Information Systems Freight Index http://www.cassinfo.com/transportation-expense-management/supply-chain-analysis/cass-freight-index.aspx
Census Bureau https://www.census.gov/
Department of Defense https://www.defense.gov/
Electroindustry Business Confidence Indices https://www.nema.org/Intelligence/Pages/Electroindustry-Business-Conditions-Index.aspx
Equipment Leasing and Finance Association https://www.elfaonline.org/
Federal Reserve https://www.federalreserve.gov/
IMF http://www.imf.org
OECD http://www.oecd.org/
Robotics Industries Association https://www.robotics.org/
United Nations http://www.un.org
World Bank http://www.worldbank.org/
World Trade Organization https://www.wto.org/

Energy Sector Summary

Two main industries

  • Oil, Gas & Consumable Fuels
  • Energy Equipment & Services

Oil, Gas & Consumable Fuels

Companies engaging in the exploration, production, delivery, refining and marketing of petroleum products to consumers are all part of the integrated process

  • Upstream: exploration, taking the resources out of ground and selling them. E.g. Devon Energy, Anadarko Petroluem, Apache
  • Midstream: Processing, storage, and transportation of hydro-carbons including ships, pipes. E.g. TransCanada, Williams Companies, Enbridge, KMI
  • Downstream: Refining oil and natural gas into usable products. E.g. Valero, Sunoco, Tesoro
  • Well known giants like Exxon, Chevron, BP, Shell engaged in all three segments
Key Characteristics
Upstream Exploration and Production. Big profits but bigger risks, negotiating with unpredictable foreign governments. Capital intensive.

Two types of reserve – unconventional and conventional.

Conventional – Trapped between layers of rock and can be extracted using ground pressure

Unconventional – oil sands and shale and extracted through a more costlier mining process. Canada contains tar sands and estimated second largest behind Saudi and oil shale in North America estimated to be the biggest

Midstream Most often done via ships and pipes
Downstream Profit margins much slimmer than exploration and production

Upstream

  • Six steps
  • Acquire the rights to explore for and develop oil and gas from reserve holder
  • Conduct geological, geophysical and seismic surveys to find oil and gas deposits
  • Perform exploration drilling to test for deposits
  • Conduct appraisal and development drilling to determine if the field contains commercially viable deposits
  • Begin oil and gas production (or abandon if no deposits found)
  • Ensure payment to compensate reserve holders via royalties and/or production sharing agreements

Midstream

  • Transportation methods depend on hydrocarbon type
  • Crude usually tankers, pipelines, rails,trucks or even planes
  • Natural gas mainly pipelines. If by ships, it need to be cooled to LNG and requires special terminals and ships

Downstream

  • Includes refining and processing crude oil into petroleum products
  • Refineries produce petroleum products based on location and demand
  • Differences in Crude Oil
    • Light versus Heavy Crude refers to the density, or weight per volume, measured as American Petroleum Institute gravity (API gravity), expressed in degrees. The higher the API gravity, the greater the density. Heavy – API < 22 degrees, light – API >38. Light is more valuable than heavy because it’s less expensive to refine and has higher energy content
    • Sweet versus sour crude refers to the sulfur content of oil. Sweet contains less sulfur and is more valuable
  • Marketing & Distribution: Retail stations reflect the entire integrated process.

Energy Equipment & Service Industry

Firms assist oil and gas firms with exploring, drilling and producing reserves but they generally don’t own oil and gas directly and hired by pure upstream and integrated firms.

Two main types

  • Oil & Gas Drilling
    • Rigs used for exploring that is rented out such as Seadrill, Transocean, Diamond Offshore Drilling
  • Energy Equipment & Services such as Schlumberger, Halliburton, Baker Huges
    • Drilling equipment (NOV)
    • Pressure pumping services
    • Wireline services
    • Directional Drilling and measurements
    • Seismic imaging and analysis
    • Engineering and construction services: Designing, building, operating oil and gas infra
    • Helicopters and boats: Transportation services like ferrying (KNOP)

Key Drivers of the Energy Sector

  • Commodity prices
  • Oil and gas production growth
  • Finding and development costs
  • Exploration and production capital expenditures
  • Refining margins
  • Share buybacks and mergers and acquisitions (M&A)
  • Sentiment
  • Taxes, Politics, and regulations
  • Absolute and relative oil and natural gas prices are the most influential factor

Oil Demand Drivers

  • Global Economic growth, growth in oil demand has followed world GDP growth fairly consistently
  • List of countries by oil consumption
  • Breakdown of Oil use
    • Transportation (69 percent)
    • Industrial (24 percent)
    • Residential (4 percent)
    • Electricity Generation (2 percent)
    • Commercial (1 percent)

Oil Supply Drivers

Natural Gas Demand Drivers

  • Natural gas used for different purposes and difficult to transport from large reserve to global end users
  • Driven by combination of economic activity and weather
  • Breakdown of US Natural Gas Use
    • Electricity Generation (39.5)
    • Industrial (30.5)
    • Residential (17.4)
    • Commercial(12.4)
    • Vehicle (0.2)

Natural Gas Supply Drivers

Additional Drivers

  • Oil and Gas Production Growth
    • Oil firms can grow through organic by increasing production or through acquisitions
    • Widely followed performance measure is the reserve replacement ratio, measures the ratio of a company’s increase in reserves to its oil and gas production annually. Reserve ratio more than 100 means a growth in reserves.
  • Finding and Development Costs
    • Costs generally rise and fall in concert with hydrocarbon prices
    • Firms within Energy Equipment & Services industry may benefit directly from rising finding and development costs
    • Costs are usually expressed as dollars per barrel of oil equivalent (BOE)
  • Exploration and Production Capital Expenditure
  • Refining Margins, differ greatly depending on the country or region
  • Share Buybacks and M&A Activity
  • Sentiment
  • Taxes, Politics and Regulations

Breakdown of Energy Industry based on GICS

Energy Equipment & Services Oil & Gas Drilling
Drilling contractors or owners of drilling rigs that contract their services for drilling wells
Oil & Gas Equipment & Services
Manufacturers of equipment, including drilling rigs and equipment, and providers of supplies and services to companies involved in the drilling, evaluation and completion of oil and gas wells.
Oil, Gas & Consumable Fuels Integrated Oil & Gas
Integrated oil companies engaged in the exploration & production of oil and gas, as well as at least one other significant activity in either refining, marketing and transportation, or chemicals.
Oil & Gas Exploration & Production
Companies engaged in the exploration and production of oil and gas not classified elsewhere.
Oil & Gas Refining & Marketing
Companies engaged in the refining and marketing of oil, gas and/or refined products not classified in the Integrated Oil & Gas or Independent Power Producers & Energy Traders Sub-Industries.
Oil & Gas Storage & Transportation
Companies engaged in the storage and/or transportation of oil, gas and/or refined products. Includes diversified midstream natural gas companies facing competitive markets, oil and refined product pipelines, coal slurry pipelines and oil & gas shipping companies.
Coal & Consumable Fuels
Companies primarily involved in the production and mining of coal, related products and other consumable fuels related to the generation of energy.  Excludes companies primarily producing gases classified in the Industrial Gases sub-industry and companies primarily mining for metallurgical (coking) coal used for steel production.

 

  • Integrated Oil & Gas sub-industry is by far the largest by market cap
  • Many of the world’s most significant Integrated Oil & Gas companies are owned by foreign governments and are not publicly traded. At the present moment, Saudi is looking at privatizing theirs.
  • Majority of publicly traded Oil & Gas exploration firms are in the US
  • Another US heavy industry is Energy Equipment and Services
  • Oil & Gas Refining & Marketing is a relatively small weight except for Emerging Markets
  • Smallest are oil & gas storage & transportation and coal & consumable fuels. Storage and transportation are almost entirely concentrated in the US and Canada.
  • Top 250 energy companies

Oil, Gas & Consumable Fuels Industry – Sub Industries

  • Integrated Oil & Gas (upstream and downstream)
  • Oil & Gas Exploration & Production (upstream)
  • Oil & Gas Refining & Marketing (downstream)
  • Oil & Gas Storage & Transportation (midstream)
  • Coal & Consumable Fuels (coal and uranium mining)

Oil & Gas Drilling

Oil & Gas Drilling (OGD) firms own and operate the rigs responsible for exploration and production activities. Their main customers are mainly exploration companies, IOCs and NOCs. Their main business is contract drilling. Main type of rigs are as below:

  1. Land Rig – Designed to drill on dry land and heavy duty ones can drill over 30,000 feet.
  2. Submersible – Offshore rig floating on water when moved but is submerged to the lower part of the rig hits the seafloor. Typically operates in wetlands and water depth up to 85 feet, drilling over 30,000 feet.
  3. Jack-up – Offshore rig with legs extending to sea floor. Generally, operates in shallow waters less than 400 feet deep but can drill over 30,000 feet.
  4. Semi-submersible – Offshore rig submerged a few feet below water surface and drill more than 30,000 feet, in water up to 10,000 feet deep.
  5. Drill ship – Ship drilling while floating on water surface, can drill more than 30,000 feet, in water up to 10,000 feet deep.

OGD firms have 2 growth strategies: building new rigs or growth through acquisition. Drilling is a boom-bust industry.

Oil & Gas Equipment & Services Sub-Industry

Similar to drillers, E&S firms’ main customers also include public and private oil and gas exploration and production firms, IOCs and NOCs, as well as drillers. Largest firm Schlumberger followed by Haliburton, Tenaris, National Oilwell Varco. E&S is extremely diverse and can operate in different sectors and activities.

Integrated Oil & Gas, Exploration & Production, and Refining & Marketing Sub-Industry Drivers

  • Oil and natural gas prices
  • Oil and gas production growth
  • Finding and development costs
  • Exploration and production capital expenditures
  • Share buybacks and m&A
  • Regulatory environment
  • Refining margins
  • Light/heavy spread

Oil & Gas Storage & Transporation Sub-industry drivers

  • Hydrocarbon volumes
  • Interest rates (affect interest expense and future growth plans), tend to be better with lower interest rates
  • Demand for defensive/high income-yielding securities

Coal & Consumable Fuels Sub-Industry Drivers

  • Coal prices
  • Transportation costs and bottlenecks
  • Exports/imports
  • Legislation/environmental regulation
  • Relative costs of alternative fuels

Energy Equipment & Service Drivers

  • Upstream Capital Expenditures
  • Oil and natural gas prices
  • Worldwide rig count
  • Dayrates

Instead of questioning if we will run out of energy resources, a better question to ask when will we reach the production peak? It is important as energy is cyclical and once it reaches a peak, there will be a down cycle. Other indicators look out is the reserves to oil consumption ratio. And to take note of the unconventional reserves.

Primary Factors affecting oil prices

  • Oil Demand
  • OPEC oil production
  • Non-OPEC Oil production
  • Spare oil production capacity
  • Global refining utilization
  • Global oil inventories

Primary factors affecting natural gas prices

  • Natural gas demand
  • Natural gas production
  • Natural gas/liquefied natural gas (LNG) imports
  • Natural gas storage inventories
  • Prices of natural gas substitutes

Refining Margin Fundamentals

  • Petroleum product demand (combination of economic activity and weather)
  • Crude oil prices (Falling is bullish)
  • Refining utilization
  • Petroleum product inventories
  • Petroleum product imports
  • Light/heavy spread

Energy Equipment & Services Fundamentals

 


Alternative Energy

Often refers to sources of energy other than those generated through fossil fuels like oil and natural gas, often termed as renewable energy.

4 distinct sectors

  • Power generation (largest)
  • hot water and space heating
  • transport fuels
  • rural (or off-grid) energy

Types of renewable

  • Water – Hydroelectric power is the leading renewable energy source. It has the advantage of being a cheap, reliable source of power capable of running 24 hours a day.
  • Ethanol and Other Biomass/waste – Produced from non-fossilized materials such as wood, waste, biofuels (ethanol and biodiesel). Ethanol mainly made from sugar
  • Wind – wind turbines relatively low maintenance but limitation to the weather. Transmission lines are also a factor
  • Solar – dependant on weather
  • Geothermal – being able to run 98 percent of time but limited to number of geothermal reservoirs
  • Nuclear Power – mainly from uranium but drawback is its risk

Alternative Energy Drivers

  • Oil and natural gas prices
  • Taxes, subsidies, politics and regulations (many are not economical and depends on subsidies)
  • Geopolitical environment
  • Technological advancements
  • Supply chain costs
  • Sentiment

Questions to ask when analyzing

Integrated Oil & Gas, Exploration & Production, and Refining & Marketing Sub-Industries

  1. How are the revenue and earnings divided between exploration and production, refining and marketing, or other divisions like petrochemicals?
  2. How are the firm’s production and reserves split between oil, natural gas, or some other mix?
  3. Is the firm consistently growing oil and gas production or experiencing declines? What is it production growth relative to peers? Is growth organic or due to acquisitions? What is the company’s strategy to grow oil and gas reserves?
  4. Is the company doing hedging and how exposed is the company’s operations to oil and gas prices?
  5. What is the history of the company reserve replacement? How many years can it sustain production with current reserves?
  6. How do the company’s finding and development costs, operating costs and exploration expenses compare with peers? Is the company a low cost producer or engaged in high-cost operations like oil sands, oil shale, or other unconventional resources?
  7. What is the company’s geopolitical risk profile? Where are most of the company’s current and future planned production sites and refining assets? Are the sites in politically stable or unstable countries? What percentage are in unstable countries? Does the company has a history of operating in foreign territories? Has the company ever face challenges and disruptions due to geopolitical problems?
  8. Are the company’s shares owned or controlled by the government?
  9. How is the company spending its cash flow?
  10. How complex are the company’s refineries? Does it do just one kind of refining or many? How diversified are the company’s sources and types of crude oil? Is it dependent on one supplier or many?
  11. What is the company’s mix of petroleum products (gasoline/diesel/heating oil/chemicals)?

Oil and Gas Storage & Transporation Industry

  1. What percentage of the company’s earnings are regulated? Does the company have production or trading asset? And which of the two are more important to the bottom line?
  2. What is the competitive landscape? Does the company operate in a region with a significant barrier to entry? Generally, pipelines face less competition.
  3. Does the company have the financial ability to make large acquisitions to fuel growth? Does the company’s balance sheet allow it to take on additional leverage?
  4. How are the company’s operations affected by regulation? Does the company operate in a favorable regulatory environment? How might that change? What is the company’s history with gaining regulatory approval for its projects?
  5. How sensitive are the company’s operations to interest rates? Are rising or falling rates good or bad for the company’s operations and share price?
  6. Does the company have a reliable history of paying and growing distributions to shareholders?
  7. Are there tax implications for investing in the firm?

Coal & Consumable Fuel Sub-industry

  1. What is the supply-demand environment for coal within the company’s countries of operation? How have prices been affected?
  2. What is the company’s production growth history? What is its strategy for increasing coal production?  Is growth organic or due to acquisitions?
  3. In which regions does the company generate its sale? Is the company an exporter or does main to its own country? Is the company beholden to trade problems with other regions?
  4. What are the company’s production costs relative to its peers? What factors are driving its production costs?
  5. Does the company benefit from vertical integration? To what degree is it reliant on other company in its operations?
  6. How does the company deliver its coal to end user? Are there bottlenecks and if so, how did the company responded?
  7. Are there legislative risks regarding carbon emissions in the company’s countries of operations that could materially affect operations?
  8. Does the company secure free market pricing for its coal or are prices set by the government?

Oil & Gas Drilling Sub-Industry

  1. What is the breakdown of the company’s rig fleet? Do these rigs drill primarily for natural gas or oil?
  2. Which type of contracts does the company use to contract its rigs? What percentage of its fleet use each?
  3. What has been the trend of the company’s dayrates? What is the potential for dayrate expansion once its rig contracts expire?
  4. When do the company’s current rig contracts expire? How many of the firm’s rigs are due to come off contract in the short or long term?
  5. Are the company’s rigs more technologically advanced than competitors? Do oil and gas companies pay a premium for the company’s rigs?
  6. Where are the rigs located? What are the supply-demand dynamics in each region? Is it the company’s strategy to stick to a specific region or expand geographically? How easily can it move its rig to more attractive locations?
  7. What percentage of the company’s rigs is in service? Is utilization growing, stable, or falling?
  8. What is the company’s strategy to grow its asset base? Does it plan to build new rigs or acquire a competitor? At what pace can it build new rigs?
  9. What is the average age of the company’s fleet? Is it expanding its rig fleet or retiring old rigs? To what extent will the company need to take rigs out of service for upgrades or maintenance?
  10. How do the company’s operating and maintenance costs compare with peers? What is the company’s strategy to mitigate industry cost inflation?

Oil & Gas Equipment & Services Sub-industry

  1. What is the breakdown of the company’s revenue and earnings between products and services? Do the company’s business rely on the spot market, long term contracts, or both? Are the company’s revenues coming mainly from new products or more mature ones?
  2. What drives demand for the company’s products and services? What is the competitive landscape for these products?
  3. Does the company possess any proprietary technologies or patents giving it a competitive edge? Does the company continually release new products or does it specialize in more mature markets?
  4. What is the company’s geographic mix? Does the company plan to focus on one region or expand geographically? Do its core competencies jibe with that strategy?
  5. What is the company’s market share in each of its business segments? Does the company have pricing power for its products and services?
  6. Does the company execute its projects on time and on budget? Does the company put cost contingencies in its contracts? Have projects ever been disrupted in the past due to unforeseen problems?
  7. How healthy is the company’s product backlog? Is it rising or falling? Do is competitors have a bigger or smaller backlog?

Materials Industry

Most of the information is extracted from “Fisher Investments on Materials”.

Overview

Materials sector is composed largely of metals, chemicals, paper, lumber, cement, “construction aggregate” and packaging. Not all commodity falls under materials. The largest commodity falls in the Energy Sector and most agricultural products are found in the Consumer Staples Sector.

Some Key Characteristics of Materials Sector are:

  • Capital Intensive
  • Hypersensitive to Economic Growth
  • Regional Pricing may varies due to shipping costs, availability, import or export taxes. Shipping costs depend on the value-to-weight ratio. Pricing is usually set by the largest producers-“price setters” and the small producers -“price takers”.
  • Usually can be classified into Upstream and Downstream

Life Cycle of Metal

  • Finding Metal and Securing Permits
  • Building a Mine (capital intensive and sometimes must built transport system)
  • Separating Metal from Rock
  • Metal Smelting (lower profit margins)
  • Metal Recycling

Life Cycle of Chemical

  • Commodity Chemicals – fierce competition, mass produced
  • Specialty Chemicals – end market usually industrial manufacturing sector
  • Chemical Recycling – plastic

Life Cycle of Concrete

  • Making Construction Aggregate – Quarried near its end market
  • Cement – Primarily manufactured regionally
  • Concrete Recycling

Life Cycle of Paper

  • Cutting Lumber
  • Processing Paper
  • Paper Recycling

History of Materials

Much of the industry was developed with the industry revolution. As economy changes, materials also evolved. During certain events, some materials cost will go much higher (e.g. metals due to wars)

Materials Sector Drivers

  • Economic Growth
  • Commodity prices
  • Commodity production growth
  • Exploration and development costs
  • Production costs
  • Share buybacks and mergers and acquisitions (M&A) activity
  • Investor sentiment (can cause bubble)
  • Taxes, Politics, and regulations

Some questions to ask when analyzing a material include:

  • Is the material priced globally or regionally?
  • What is the material used for?
  • Who are the primary consumers?
  • Where is it produced?
  • Who are the largest producers?
  • What are Production’s Primary Costs?
  • Are there significant barriers to entry?
  • What is the expected change in supply and demand?

Materials Sector Breakdown

Metals & Mining

  • Diversified Metals & Mining
  • Steel
  • Gold
  • Aluminium
  • Precious Metals & Minerals

Chemicals

  • Commodity Chemicals
  • Speciality Chemicals
  • Diversified Chemicals
  • Fertilizers & Agricultural Chemicals
  • Industrial Gases

Construction Materials

  • Construction Materials

Paper & Forest Products

  • Paper Products
  • Forest Products

Containers & Packaging

  • Paper Packaging
  • Metal & Glass Containers

Some materials and their characteristics

  • Iron ore – priced globally on annual contracts. Infrastructure as important as mines in determining production. High barriers to entry, need for economies of scale, concentrated group of producers
  • Coal – priced regionally on annual contracts with some global export. Steam coal (for energy) and metallurgical coal (for steel production) are priced differently
  • Steel – Priced regionally with key distinctions among producers: bar vs flat steel production, and scrap-based mini-mills vs traditional iron ore-based operations. Significant trade and exports for many products exist as well.
  • Gold – priced globally and often a safe haven during uncertainties. India and China have the largest consumer demand while the rest are taken up by investors. Scarcity is its primary barrier to entry.
  • Aluminum – priced globally and most energy-intensive metal. Energy costs are the primary determinant of price and returns.
  • Commodity Chemicals – priced globally with economic growth as its primary driver, and oil and natural gas as its primary input cost.
  • Specialty chemicals – most priced regionally. Economic growth and specific end markets for each segment are the drivers.
  • Fertilizers & Agricultural Chemicals – priced regionally for most. Demand for increased crop production through greater yields is the primary driver.
  • Industrial Gases – priced regionally with natural gas as a primary input cost. Economic growth, industrial manufacturing, metal and chemical production, and oil refining are primary drivers
  • Construction materials – priced regionally and dependent on regional construction. Cement is more sensitive to residential construction while construction aggregate is more sensitive to non-residential construction.
  • Paper & Forestry – priced regionally with residential construction as primary driver for lumber, while economic growth is the primary driver for paper. Environmental legislation can play a big role.
  • Packaging – defensive sector with relatively inelastic demand due to food and beverage being its largest components.

3 Items to track

  1. Supply
  2. Demand
  3. Sentiment

Fundamentals to watch

  • GDP growth
    • Residential and non-residential construction
    • Durable goods orders
    • Industrial production
  • Global materials production growth
  • Inventories
  • Global materials trade (imports and exports)
  • Capacity utilization
  • Raw material costs
  • Marginal cost of production
  • Tariffs, royalties, subsidies, and price caps
  • Freight rates

Bullish Drivers

Bearish Drivers

Rising GDP growth Falling GDP growth
Rising construction Falling construction
Rising durable goods orders Falling durable goods orders
Rising industrial production Falling industrial production
Falling global materials production Rising global materials production
Falling inventories Rising inventories
Rising global imports Falling global imports
Rising capacity utilization Falling capacity utilization
Rising raw materials costs Falling raw materials costs
Rising marginal cost of production Falling marginal cost of production
Increased commodity regulation (tariffs, royalties, subsidies, etc) Decreased commodity regulation
Increased freight rates Decreased freight rates

Important Area to look in assessing companies

  • Supply/Demand Environment
  • Revenues and Earnings Breakdown
  • Production Growth
  • Reserve Replacement (e.g. mines)
  • Hedging
  • Geographic Breakdown & Geopolitical risks
  • Production Costs
  • Vertical Integration
  • Transportation
  • Government Control
  • Legislative Risks
  • Competition and Barriers to Entry
  • Technology and Innovation
  • Brand Name
  • Regulation
  • Market Share
  • Margins
  • Cash Flow Use
  • Balance Sheet
  • Interest Rates

Strategies on Materials Investments

  1. Overweighting and underweighting materials industries or sub-industries based on your market outlook and analysis.
  2. Adding value at the security level based on specific pricing outlook. Can also employed long-short, pairing style.
  3. Adding value in a materials sector downturn. Can also short or purchase inverse ETFs if bearish on materials.
  4. Investing in commodities such as futures, ETFs.

Industry Cheat Sheet

  • Metals & Mining
    • high beta and cyclical
    • Often outperforms when raw material prices are rising due to strong economic growth
    • Sensitive to EM economic growth recently
  • Diversified Metals & Mining
    • Holds large weight in most major materials index
    • extensively capital intensive, dominated by large producers and highly cyclical
    • Benefits from strong economic growth and when GDP per capita is rising
  • Gold
    • Safe haven and outperforms in times of uncertainty
  • Aluminium
    • Similar to Diversified Metals
    • Most energy intensive metal to produce. Outperforms in strong economic growth and falling energy prices
    • Performance between producers may vary due to access to lower or higher cost energy resources
  • Steel
    • Similar to Diversified Metals but less capital intensive and reduced barriers for entry
    • Evaluated regionally. Important comparison factors: iron-ore vs scrap-based producers, bar vs flat steel producers, and vertically integrated vs non-vertically integrated
    • often underperforms miners in periods of rising raw material costs
    • Vertically integrated producers with upstream raw material operations often outperform non-vertically integrated in periods of rising raw material prices
    • fragmented sub-industry of small producers and generally small cap outperforms large cap
  • Precious Metals & Minerals
    • Similar to Gold
  • Chemicals
    • most are intermediary and broad economic growth is one key factor
    • often outperforms in periods of strong economic growth and stable or falling energy prices
    • higher variable costs and lower operating leverage than mining industry. Less cyclical
  • Commodity Chemicals
    • often outperforms in periods of strong economic growth and stable or falling energy prices
    • characterized by large, highly cyclical firms competing primarily on efficiencies and production costs. Very little pricing power
  • Speciality Chemicals
    • Evaluated regionally
    • Sensitive to economic growth
    • most resistant in economic downturns
  • Diversified Chemicals
    • Analyzed depending on conglomerates product mix
  • Fertilizers & Agricultural Chemicals
    • heavily influenced by government intervention
    • Mostly evaluated as Speciality
  • Industrial Gases
    • Evaluated regionally, benefits from economic growth, oil exploration and oil processing
  • Construction Materials
    • Sensitive to construction expenditures
    • Evaluated Regionally
    • Construction aggregate producers more sensitive to non-residential construction. Cement producers more sensitive to residential construction
    • Global production is concentrated to a small group of dominant conglomerates producing cement and construction aggregate
  • Paper & Forest products
    • Small industry dominated by paper dominants
  • Paper Products
    • End markets are primarily in developed world. Often outperforms during periods when the economic growth rate in developed world is increasing relative to the economic growth rate in emerging markets
  • Forest Products
    • Primarily driven by regional residential construction
  • Containers & Packaging
    • Defensive
    • Rising raw materials are a negative
    • Compete on operating costs and distribution networks
    • Focused on food and beverage and least cyclical
  • Metal & Glass Containers
    • defensive and similar to above packaging
  • Paper Packaging
    • defensive and similar to above packaging

Useful Links

1 Perspective 1 Value 1 Mindset for Investing

Was sharing my investment knowledge to a small group of young people starting out their investing journey. And I highlighted 3 fundamentals as below:

  1. Perspective – We are not growing money but being good stewards of our finances

We need to view finance holistically. I had seen many people going into investment hoping to make their money grow. And yes we should try to maximize our capital but it’s also not just about growing money but also watching our expenses, having the right insurance to manage risks and other usages of money that contribute to one’s dreams and goals in life. Warren Buffett lives frugally and he manages his money very well. We must not forget that money is just a tool, a resource. There are other things in life and it is a tool or resource that helps us achieve our dreams.

2. Value of Contentment

This might baffle some. Shouldn’t we be ambitious and strive for more. Yes, ambition does has its place but I find that we need to be contented with what we have and made full use of it. This places us in a position of security. And in making investment decisions, we can be more sound and rational in it.

3. Learner Mindset

I had studied many investment gurus and hedge fund managers. One thing that is in common among them. They are inquisitive. They like to dig out, research on company and business fundamentals. In today’s business environment, business conditions are dynamic and with so much information out there, sometimes it is difficult to achieve a good alpha. A cutting edge will be having more information that the rest of the investors, and that needs us to be always learning how the business works and how would the business be in the future. In fact Warren Buffett spends a lot of time reading each day just to keep himself updated with what is going on around the world.

Small Cap Growth Investor based on the criteria of Motley Fool

Profit Margin

Companies with a minimum trailing 12 month after tax profit margin of 7% and rising.

Relative Strength

Companies whose relative strength is 90 or above (that is, the company outperforms 90% or more of the market for the past year), are considered attractive. Companies whose price has been rising much quicker than the market tend to keep rising.

Compare sales and EPS growth to the same period last year

Companies must demonstrate both revenue and net income growth of at least 25% as compared to the prior year.

Insider Holdings

Insider owns at least 10%.

Cash Flow from operations

Positive cash flow

Profit Margin Consistency

Profit margin must be consistent or on a rising trend

R&D as a percentage of sales

This is not that important for non-high tech and non-medical stocks. But for stocks in the high tech and medical ones, we would like to see an increase in spending on R&D to stay on the cutting edge.

Cash and Cash Equivalents

Consistent and Rising Trend

Account receivable to sales

This methodology wants to make sure that a company’s accounts receivable do not get significantly out of line with sales. It’s a warning sign if a company’s accounts receivable relative to sales increases significantly when compared to the previous year. Up to a 30% increase is allowed, but no more.

Long-Term Debt/Equity Ratio

Reasonable debt

The FOOL Ratio (P/E to Growth)

PEG <0.5

Average Shares Outstanding

Company is not increasing the shares to dilute it. E.g. Raising capital through new shares issuance to pay off debts and not for expansion

Daily Dollar Volume

Greater than 1 million and lesser than 25 million.

Price

Not less than $7

Income Tax Percentage

Make sure that the business is paying the full rate to Uncle Sam. Due to previous earnings losses, some companies can carry forward up to a few years of tax credits. While this is a wonderful thing for them, it can cause a misrepresentation of the true bottom-line growth. If companies are paying less than 34 percent per year in taxes, you should tax their income at that rate, to see through to the real growth.

Reference: Motley Fool Investment Workbook

 

 

 

 

Consumer Staples Summary

Reference Fisher Investments on Consumer Staples

Difference between Consumer Staples and Discretionary

Staples – Inelastic (necessity)

Discretionary – Elastic (income or price affects consumer demand)

Consumer Staples Sector Drivers

  • Economic
  • Political
  • Sentiment

Economic Driver

  • GDP Growth
    • Consumer Spending – Personal Consumption Expenditures (PCE) and what the consumers are spending on. Higher PCE, +ve for Consumer Staples
    • Business Spending
    • Government consumption and investment
    • Net exports
  • Interest Rates – Affects some companies on borrowings
  • Currency – Market of companies
  • Inflation
  • CPI
  • PPI (Cost of materials)
    • Crude, Intermediate Goods, Finished Goods (affect consumer staples company differently)

Political Drivers

  • Taxes
  • Trade Policy

Sentiment Driver

  • Elastic/Inelastic Preference
  • Brand Value

Consumer Staples Industry and corresponding sub-industries

  • Beverages
    • Brewers
    • Distillers & Vintners
    • Soft Drinks
  • Food Products
    • Agricultural Products
    • Packaged Foods & Meats
  • Tobacco
  • Household Products
  • Personal Products
  • Food and Staples Retailing
    • Drug Retail
    • Food Distributors
    • Food Retail
    • Hypermart & Super Centers

Food Industry Drivers

  • Population Growth
  • Wealth
  • Shifting Consumer Preferences
  • Demographic Shifts
  • Foreign Markets
  • Supply Drivers such as weather, competition for resources, and technology advancements

Beverages Industry Drivers (Non-Alcoholic)

  • Population Growth
  • Wealth
  • Innovation
  • Shifting consumer preferences
  • Distribution

Beverages Industry Drivers (Alcoholic)

  • Population Growth
  • Wealth
  • Innovation
  • Shifting consumer preferences
  • Demographics
  • Foreign Markets
  • Consolidation

Tobacco Industry Drivers

  • Price Increases Offset Volume Declines
  • Pricing and Mix
  • Foreign Markets
  • Litigation

Household & Personal Product Drivers

  • Brand Equity
  • Price
  • Demographics
  • Foreign Markets
  • Innovation. Firms operating in these industries spend a lot on R&D in the form of consumer learning to develop new products

Food & Staples Retailing Drivers

  • Demographic Trends
  • Convenience
  • Location
  • Private Label
  • Generics
  • Relatively noncyclical

Challenges in Consumer Staples

  • Finding ways to grow in mature industries
    • Innovation for organic growth
    • Merger & Acquisition but need to check whether there’s synergy
  • Dealing with volatile input costs
    • Hedging
    • Pricing
    • Product Formulations (use less expensive alternative)
    • Restructuring (e.g. JIT inventory)

Consumer Staples in Emerging Markets

  • Matching EM Needs (e.g. packing less for single serve)
  • Different Natural Resources Standards
  • Distribution
  • Direct Sales Networks
  • Building Distribution to match rapid growth
  • Advertising
  • Market Penetration Strategies

Useful Consumer Staples Sector Resources