There are thousands of stocks on the ASX. How do you narrow the field when it comes to finding potential investments to research?

One way I have approached this in the past is to look for sectors or themes that are out of favour. From there I look for companies that have been tossed out with the bathwater but are of a high enough quality to hold through the current downturn in sentiment.

My previous articles on this approach both had a global remit. In both of those articles, I used the same method to unearth potential candidates: I filtered for Wide Moat stocks with a four- or five-star Morningstar rating and went hunting for themes.

I wanted to do something similar for the ASX but opted against it. Running the above screen on a global basis currently gives me over ninety names to comb through. When I limit the search to Australia, the number shrinks to just six. Instead, I used a couple of methods to see what the cheapest sector is instead.

Method #1: Average Price to Fair Value

The first method I tried was to take a simple average of Price to Fair Value ratios in each sector. Not many sectors looked cheap on this measure. Out of the 11 ASX sectors, six were overvalued, three had an average P/FV of above 0.95 but below 1.00 which we can consider fairly valued, and only two were below 0.95.

average-price-to-fair-value

Figure 1: Average Price to Fair Value by sector on October 15. Source: Morningstar, author calculations. Created with Datawrapper.

As a result, the chart above is skewed towards the fully valued to overvalued. Yet there is a clear outlier on the cheap side. The average energy stock trades at roughly 25% below our analysts’ estimate of Fair Value.

Does that make the energy sector a fertile hunting ground for attractive shares, though? Let’s look at it from another angle.

Method #2: Percentage of 4 or 5 star stocks in each sector

A Morningstar Star Rating expresses how attractive we think a stock is at the current price for long-term investors.

This is not just a measure of how discounted a share is relative to our Fair Value estimate. It also considers the range of potential outcomes according to our analysts (measured by its Uncertainty Rating).

Again, energy stood out like a sore thumb. 80% of the companies we cover in the sector screen had a four or five star rating!

percentage-of-four-five-star-stocks

It is hard to pin down an exact reason why. Maybe it’s because oil prices have come off a bit recently. Maybe there are some lingering concerns about the global economy. Maybe the rise of ESG means that fewer investor dollars are making their way into oil, gas and coal stocks and the shares will be cheap forever.

Who knows. Whatever the reason, I am pretty confident in calling Energy the ASX’s cheapest sector right now – and you don’t have to search hard to find examples at the stock level. Two of our analysts’ top picks in the sector are household names in the oil and gas industry.

Woodside Energy

  • Fair Value estimate: $45 per share
  • Economic Moat: None
  • Uncertainty Rating: Medium
  • Star Rating: ★★★★★

Woodside (ASX: WDS) is Australia’s premier oil and gas company with operations across liquid natural gas, natural gas, condensate and crude oil. LNG interests in the North West Shelf Joint Venture, or NWS/JV, and Pluto offshore Western Australia are the firm’s mainstay and enjoy a low-cost advantage.

A big chunk of Mark Taylor’s intrinsic value estimate for Woodside comes from future project development. This is both a complicated and expensive endeavor, but it is one that Woodside has excelled in for over 25 years and has unparalleled experience domestically.
Woodside also benefits from 20-year off-take agreements several blue-chip Asian energy utilities including Tokyo Electric, Kansai Electric, Chubu Electric, and Osaka Gas. These help ensure sufficient project financing during development and should also add stability to cash flows after completion.

Woodside's deep development pipeline is backed up by what Taylor views as an attractive demand growth picture for gas. Demand for LNG, he says, is “likely to grow by around 50% over the next decade thanks to a rising world population and energy usage in developing economies rising with GDP per capita”.

As gas is a far cleaner energy source than coal, demand could also benefit from it displacing coal as a source of baseload power. Taylor is also more bullish than most on long-term demand for oil, where he says that media headlines and forecasts of “peak oil” as soon as 2030 don’t seem to be reflected by actual demand data.

Instead, Taylor thinks it is likely that total oil demand will continue to grow for several years before tapering off far more slowly than many expect. As oil supplies naturally decline 5-6% each year with consumption, investment from players like Woodside in new supply is essential and must be incentivised by oil prices that support this endeavour.

At a recent share price of around $26 per share, Woodside Energy is materially undervalued versus Taylor’s Fair Value estimate of $45 per share. At this level the shares also offer a prospective 7.5% forward dividend yield if Taylor’s forecast of $2 per share in dividends this fiscal year is accurate.

Santos Ltd

  • Fair Value estimate: $12.50 per share
  • Economic Moat: None
  • Uncertainty Rating: High
  • Star Rating: ★★★★★

Santos (ASX: STO) is Australia’s second largest oil and gas exploration and production pureplay behind Woodside.

The company has with interests in all of Australia’s hydrocarbon provinces as well as in Indonesia and Papua New Guinea. Santos' Gladstone and Papua New Guinea LNG projects are attractive in that they are large, long-life, have low cash operating costs, and offer expansion potential.

Santos is one of Australia’s largest coal seam gas producers and its biggest domestic domestic gas supplier, although the firm is now generating a growing portion of its revenue from higher margin export pricing.

Looking forward, Santos’s future production and revenues look set to be boosted materially by its Barossa LNG project in the Timor Sea and the Pikka oil project in Alaska. The work to bring Barossa online is nearing completion and the project should see first-production in 2025.

Meanwhile, Pikka is over halfway there and should come online in 2026. Taken alongside share buybacks and a healthy demand picture for natural gas, these two new projects add to Taylor’s confidence that Santos can grow its earnings per-share at a double-digit annual rate for the next decade.

At a recent price of around $7 per share, Santos traded approximately 45% below Taylor’s Fair Value estimate of $12.50 and commanded a five-star Morningstar rating.

Got a question about Woodside, Santos, or another ASX200 stock?

Our new Ask the analyst feature lets you submit questions about the companies in Morningstar’s ASX coverage. I will put select questions to the analyst covering that stock and put their answer in a future article. Please email your question to [email protected].

You can read previous editions of Ask the analyst here:

A reminder: cheap isn’t enough

When you are considering any investment, it’s important to not only think about the valuation but also about how the investment aligns with the strategy you have laid out to reach your goals.

Going through the various steps to define your strategy can help you set investing criteria that are a lot more solid than ‘what looks cheap right now’ or what stock pitch sounds smartest.

To do this, I recommend you take a look at the four-step process in my colleague Mark LaMonica’s article how to define an investing strategy.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.