Don’t Buy Another Oil Stock Until You Read This

Warren Buffett famously observed that success in investing is mostly about what you don’t do, rather than what you do.

Specifically, that if you have guidelines for investments (which you should), only a few companies will meet these hurdles.

Otherwise, it’s better to leave the bat on the shoulder than take a swing.

This is today’s problem with the petroleum sector… it isn’t meeting my guidelines for a great investment.

Back in February, I outlined some of the reasons why I’m largely staying away from this sector.

The simple fact is that great business performance isn’t the only thing I’m looking for from my stock picks. You see, an excellent business doesn’t necessarily make a great investment. It all depends on price.

#-ad_banner-#The oil sector is still loved by investors who are fascinated with the “miracle” of surging U.S. shale production.

Income investors are loving several of these oil-related stocks too — especially ones paying lucrative dividends that grow increasingly larger every year.

As a result, valuations for popular oil producers are pushing multi-year highs.

Consider a high-profile petroleum developer such as Range Resources (NYSE: RRC).

This company has done a phenomenal job discovering and producing natural gas from its acreage in the Marcellus Shale of Pennsylvania. Its revenues from production have soared by 80%, spurred by successful drilling results.

The problem with this great company is that everyone knows it’s great.

Investors have jumped all over Range, driving its share price to $85 from $35 just a little more than three years ago.

The company now trades at five times more than the value of its petroleum reserves, meaning that everything — and I mean everything — has to go right in terms of business performance and growth in order to justify today’s share price.

Given that such performance is highly unlikely, I consider such overvalued companies to be poor investments.

Meanwhile, as valuations are buoyant, business performance in the sector is facing increasing headwinds too.

Rising costs are eating into the profits of many well-known oil companies, and based on the latest 2013 numbers coming in, these companies are hurting. Exxon Mobil’s (NYSE: XOM) net income was down 27% from 2012. Shell’s (NYSE: RDS-A) dropped 23%. And BP’s (NYSE: BP) fell 20%.

I certainly don’t want to be left holding the bag if investors start selling these well-known companies either.

As I mentioned earlier, to find good investments in the oil sector, the key is finding great businesses that are selling at low valuations.

With so much investor excitement over shale gas and other high-profile companies, valuations have been driven to premium levels.

Fortunately for us, disconnects between results and share price happen all the time, especially in the natural resources business — one of the reasons this sector is extremely lucrative, if you approach it the right way.

One place I’ve been looking for value has been in the international oil and gas sector. Firms outside the United States are selling at considerable discounts to their American peers.

But a recent review of the oil space has uncovered what I think is an even better opportunity — one that’s returned exceptional results from an unexpected place. And it’s much closer to home.

I believe this company’s success may be pointing us to the best place to invest in the oil sector today…

It has the same fundamental success as its U.S. peers but trades at a 25% discount to its reserves value (i.e. what its oil assets are actually worth). Remember, Range Resources trades at 5 times more than its reserves value.

That’s a phenomenal situation. When you can buy an exceptional business at below what its assets are worth, take it every time.

And to top it off, this company has a management team that is consistently generating excellent returns on the capital it invests. Typically, as companies grow, most management teams increase pay, hire more staff, and generally spend more. This company has actually reduced expenses. This shows me that this firm is committed to running a tight ship — creating value for shareholders rather than lining their pockets with fat salaries.

My proprietary Capital Efficiency Ratio shows this company’s performance has been exceptional. For every dollar spent, this company (shown as Company X in the chart below) created over $2 of asset value. That’s a 100% return on investment.

A 100% return is outstanding for any business, let alone the high-cost exploration and production space.

As for other oil & gas stocks that are on the right side of this chart — like Range — I’d stay away from these companies. They’re likely some of the more frothy stocks in this space, and as the chart shows, they aren’t allocating capital efficiently, either — which is a recipe for disaster.

The company I mentioned earlier (Company X in the chart above) has a valuation so low, I wouldn’t be surprised to see it make 75% from these levels. Even better, it has grown its dividend by 71% over the past year — and I expect the dividend hikes to continue.

Out of fairness to my Junior Resource Advisor subscribers, I can’t give the name of this company away today. But some of the other companies on the left side of this chart might be worth considering before the crowd catches on.

The bottom line is that disconnects between fundamentals and perception don’t last. I expect investors will soon recognize the discrepancies in the oil & gas sector, and this will bring a surge of buying into the few undervalued companies in this space — and big, sustained losses for the ones that are clearly overvalued.

P.S. — If you want to know more about my favorite undervalued company in the oil sector, I’ve included its name and ticker symbol — along with two other firms trading at a substantial discount — in a recent report, “3 Oil Stocks With Up To 200% Potential.” You can learn how to get this report in my latest research video.