The market seems to be in upheaval this year, yet the S&P is only down 1% year to date. So what's going on?
Simply put, we're seeing a rotation in the market -- namely, from growth to value.
In hindsight, this development was easy to predict. We're in the latter stages of an economic cycle, which tends to be characterized by rising interest rates and inflation, combined with lower corporate profit margins. This spells bad news for momentum-based growth stocks, and we've seen the effects of that play out in the past couple weeks.
In an effort to moderate investment risk during cycles like this, investors tend to take a flight to safety, looking for stocks with value, represented by good cash positions, low debt, dividends, low price-earnings (P/E) ratios -- and, of course, earnings growth.
This raises the question: Where exactly should investors be looking right now for safe, value-based stocks?
One of my favorite sectors right now is energy -- specifically oilfield services.
Oilfield service stocks are currently leading the pack in the energy space, spurred on by strong earnings growth and low valuations. Let's take a look at three of my favorite leaders in this field...
Baker Hughes (NYSE: BHI) is expanding internationally and currently operates in 90 countries. Just more than half its record $22.3 billion in revenue last year came from North America. Margins are currently expanding in Baker Hughes' Gulf of Mexico projects but contracting in North American land projects, due to a supply glut which is also affecting its competitors.
Those Gulf of Mexico projects helped Baker Hughes beat first-quarter earnings expectations this week: Earnings per share (EPS) came in at $0.84 a share, compared with analyst expectations of $0.79 a share and up a solid 40% from the same quarter last year.
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Such aggressive earnings growth is great to see in a late-cycle stock -- especially one with a forward P/E as low as BHI's 13.6. As a rule of thumb, undervalued stocks typically have P/Es lower than their earnings growth rates.
But there's another important component to value stocks: debt. I like to see a long-term debt-to-capitalization ratio below 40%. Just as you don't want your personal debt to overwhelm your monthly budget, investors don't want a corporation's debt payments to strangle its ability to deploy cash where needed. Baker Hughes has consistently held its long-term debt ratio below 20% for the past decade, but it hasn't increased its dividend (currently yielding 0.9%) in quite a few years.
Standard & Poor's projects BHI's 2014 return on equity (ROE) at 9.5%. That's significantly higher than in the past three years, indicating strong corporate management. Wall Street must agree, because institutions own 89% of this large-cap growth stock.
Halliburton (NYSE: HAL) is similar in size and scope to Baker Hughes, achieving a record $29.4 billion in sales in 2013, with 52% of revenue coming from North American operations.
Halliburton's fundamentals are very attractive, and the Street expects EPS growth of nearly 20% or better for the next three years. HAL's forward P/E is 12.1, on the low end of its historical range, and the dividend yield is 1%. The 2013 long-term debt ratio is fair at 36%.
I'm happy with any stock with a low P/E, low debt, and annual EPS growth of 15% or more. But Halliburton is also buying back stock -- a bullish sign that almost always indicates a strong balance sheet. Halliburton bought back $4.4 billion of its stock last year and has about $1.7 billion left on its current repurchase authorization.
The stock recently retraced its highs from August 2011, then rose further to the current range of $57 to just over $60. The chart is extremely bullish, with no overhead price resistance -- but HAL's erratic year-to-year P/E swings makes setting a price target difficult.
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Schlumberger (NYSE: SLB) is also experiencing margin pressure due to overcapacity in North America and weakness in natural gas production. To address this, the company is shifting to higher-end technologies with higher margins.
Schlumberger is also more focused on international business than Halliburton and Baker Hughes, with only 31% of revenue coming from North American operations.
Schlumberger's international business generated margins of 22.2% in 2013, a full 2.5 percentage points higher than its North American operations.
Like Baker Hughes, Schlumberger also beat earnings expectations this week, with EPS coming in at $1.21, a penny higher than forecast. SLB's forward P/E is 14.8, and its long-term debt ratio is 20.8%.
The company has better international exposure than its rivals and a higher dividend (currently yielding 1.6%). The downside is that SLB's earnings growth is projected to be less spectacular, between 10% and 19% over the next three years.
SLB shares broke past four-year price resistance around $94 on March 25. The chart is bullish, with some long-term resistance at $110.
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How high could the stock climb? SLB reached a P/E of 25 or higher in eight of the past 10 years. A P/E of 25 on expected 2014 EPS of $5.67 would put the stock price at $141.75.
That's better than 40% upside from today's price.
Risks to Consider: The oversupply of oilfield services in North America could last for several years, putting ongoing pressure on pricing and profitability. In addition, oil and natural gas prices can be volatile, capital spending decisions by customers can change with a poor economy, and political risk can affect both domestic and international energy markets. In addition, Halliburton is still facing potential legal costs from the 2008 Deepwater Horizon incident. (My colleague Marshall Hargrave took a look recently at the company at the center of the Deepwater Horizon incident.)
Action to Take --> Now is a good time to buy these three stocks, as oilfield services stocks are on a distinct uptrend. Schlumberger represents the best opportunity within oilfield services for investors to maximize capital gains while minimizing risk. Baker Hughes has strong earnings growth, a low P/E ratio and low debt levels. The biggest caveat is three-year upside price resistance near $80, because the stock could easily stop climbing for a while at that point. In light of Halliburton's potential legal liabilities, my suggestion is that only veteran traders invest in Halliburton, using stop-loss orders to protect their capital.
