Vanguard Energy ETF: This Is The Time To Be Greedy When The Market Is Fearful – Vanguard Energy ETF (NYSEARCA:VDE)

ETF Overview

Vanguard Energy ETF (VDE) owns a portfolio of giant and large-cap U.S. stocks in the energy sector. The ETF seeks to track the investment results of the MSCI U.S. Investable Market Energy 25/50 Index. VDE has not performed well in the past year due to weak demand caused by a slowdown in the global economy. Fortunately, most of these stocks are large-cap or giant-cap stocks that have been through numerous economic cycles. These companies also have a good competitive advantage over its peers. Stocks in VDE’s portfolio are now trading at P/E ratios much lower than their historical averages. Given the strong cash flow generation of these stocks, we believe investors should take advantage of the current negative market sentiment and buy shares while they remain significantly undervalued.

Data by YCharts

Fund Analysis

Most of the stocks are large-cap or giant-cap stocks with competitive positions

Energy sector is a cyclical sector. Demand for energy typically increases sharply when the global economy is booming. On the other hand, demand can fall quickly as the global economy weakens. Therefore, it is important for us to examine the strength of stocks in VDE’s portfolio to see if they do have competitive advantage over its peers. VDE’s portfolio of stocks are mostly large-cap or giant-cap stocks. As can be seen from the table below, 40.17% and 39.42% of VDE’s portfolio consists of giant-cap and large-cap stocks. These companies usually are in better financial position than small and mid-cap companies. These companies have also been through numerous economic cycles. This is important for companies in the energy sector because the key to success for many companies in the energy sector is their financial strength as many companies need to reinvest in new oil wells and pipelines in order to continue to thrive.

Source: Morningstar

VDE’s top-10 holdings are mostly companies with moats. As can be seen from the table below, 8 out of the top-10 holdings in VDE’s portfolio receive narrow moat status according to Morningstar’s research (one is not rated). These 8 stocks represent nearly 62% of its total portfolio. These are companies that have either economies of scale, or hold important key infrastructure assets (e.g. pipelines, storage facilities) that are difficult for its smaller peers to replicate.

Source: Created by author

Demand for energy is not heading for a decline anytime soon

While oil demand growth is expected to be slower in the next few years, global oil consumption is not heading for a decline anytime soon. In fact, International Energy Agency still expects oil demand to grow by nearly 1 million barrels per day (year over year) in 2024 (see chart below). According to Fatih Birol, the executive director of the IEA, peak demand for oil is unlikely to materialize over the next 15 years. Although demand for crude by the automotive sector is likely to peak in the next 15 years due to the uptake in electric vehicles, crude will remain important and find more use as feedstock in the manufacture of chemicals and refined products. Aviation industry will also continue to rely on fossil fuels.

Source: IEA 2019

VDE is trading at a significant discount to the S&P 500 Index

Energy sector has not done well in the past year. In fact, VDE’s fund price has declined by nearly 23% in the past 1 year. The worry of a global economic recession, coupled with the increased production of U.S. shale oils, has weighed on crude prices globally. As a result, many of these energy stocks in VDE’s portfolio are trading at a significant discount to their historical averages. As can be seen from the table below, all 7 stocks in its top 10 holdings are trading at low P/E valuations than their 5-year averages.

Source: Created by author

Despite its discount valuation, these stocks generate strong cash flow in the past year. In fact, stocks in VDE’s portfolio saw strong cash flow growth of 25.84% in the past year. They are also trading at a very low price to cash flow ratio of 4.89x. This is significantly lower than S&P 500 Index’s 9.21x. Therefore, we believe VDE is trading at a significant discount.

Risks and Challenges

Concentration Risk

There is considerable concentration risk for investors of VDE as Exxon Mobil and Chevron represent about 40% of the total portfolio. Fortunately, these two companies are integrated oil & gas companies. They have operations that span the full energy supply chain and get to keep most of the profits that they would otherwise have to pay out to energy services companies or midstream companies. We also like the fact that both companies have a solid balance sheet with investment grade credit ratings.

Source: Vanguard Website

Investor Takeaway

While energy sector may not fare well in the near term due to negative market sentiment, we believe VDE is significantly undervalued based on our analysis, especially considering the fact that these companies do generate strong cash flow, and most of these companies are stocks with moats. As Warren Buffett often says, “be fearful when others are greedy and greedy when others are fearful.” We think this may be the right time to be greedy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.