Value-Investing Winner Bets Big on Out-of-Favor Energy Stocks. Think Conoco, APA.

An oil refinery in Houston, shown in June. (Brandon Bell/Getty Images)

Investors are cool on energy stocks, but one fund has put a big chunk of its holdings in the sector, including APA, Conoco Phillips, Diamondback Energy, and Occidental Petroleum.

The $4.5 billion Smead Value fund, run by Bill Smead and his son Cole Smead, has 21% of its assets in energy, against a 3% weighting for the sector in the S&P 500 index. Energy is the largest industry weighting in the fund, which has outperformed the Russell 1000 Value Index over the past five, 10, and 15 years.

Cole Smead called the current situation the “second-best buying opportunity” in energy over the past 20 years. The most appealing time was in 2020, during the pandemic, when U.S. oil prices briefly went negative.

“People hate the oil stocks. It’s a capital-intensive cyclical business,” Cole Smead told Barron’s. It hasn’t helped that U.S. oil prices are down about 5% to $67 a barrel this year, and that the futures market indicates prices will be lower a year from now.

He ticked off the positives: improved balance sheets industrywide with many companies carrying little or no net debt; higher returns on capital; and signs that production in the Permian Basin may be peaking.

Few generalist investors share the Smeads’ enthusiasm for energy. BofA Global Research’s most recent survey of institutional investors in June found that they were 23% underweighted in energy relative to benchmarks, a rare event over the past decade.

Energy stocks are trailing behind the S&P 500 this year and the sector’s weighting in the index isn’t much above the record low of 2.3% set in 2020. At 3% of the index, energy is down from 4% at the end of 2023, and 8% in 2016. The peak was about 28% in 1980, when the sector dominated the stock market.

The Energy Select SPDR ETF is up 2% this year, while the SPDR S&P Oil & Gas Exploration & Production ETF is down 2%. The S&P 500 index has gained more than 7%.

Hurt by its energy exposure and double-digit losses in such other large holdings as Merck, Macerich, and Lennar, the Smead Value fund was down 4% year to date through Wednesday.

In their second-quarter letter, the two Smeads addressed the underperformance, writing that they were bullish on energy and many of the stocks trading at low price/earnings ratios in the portfolio. They noted that the concentrated fund has no exposure to the Magnificent Seven stocks. It has next to nothing in technology.

They ended the letter with “Play the Long Game.”

Cole Smead told Barron’s that the criticism that energy is capital-intensive should now be applied to tech companies like Meta Platforms. Its capex may reach $70 billion this year as it bets big on artificial intelligence. Capex is pushing 25% of revenue at some big tech companies, double what it was more than five years ago, he said.

“Tech industry capex is looking similar to the oil industry,” he said. That likely means lower returns on investment in tech.

At the same time, energy stocks, particularly those focused on extracting oil and gas from the ground, look inexpensive, Smead said. Shares of APA, formerly Apache, are down about 20% this year to around $19 and trade for about seven times projected 2025 earnings. APA is generating a 10% return on its total invested capital, he said.

The fund favors energy producers rather than the diversified majors like Exxon Mobil and Chevron because returns are better for pure-play producers, he said. ConocoPhillips is the largest such play, while the fund recently added Diamondback Energy, one of the best-managed Permian producers. It also has exposure to Canadian energy companies such as Cenovus.

Smead said he is encouraged that private-market energy transaction are occurring at higher prices than where the public companies trade. That suggests the public plays are cheap.

Write to Andrew Bary at andrew.bary@barrons.com