Using quant screening tools to assess potential stock investments in the oil & gas sector is in many respects as useful as drilling a well without looking at seismic data. The financials might tell some of the story but resource companies carry a great deal of information that’s not always easy to compare on a stock-for-stock basis. Items like asset values, resources and reserves, geography, tax, farm-outs and royalty issues add to the complexity. It’s not impossible to screen them – but it’s a complicated affair.
That’s not to say that there is anything lost in comparing oil & gas stocks on some metrics – if only to spark some ideas about where investor money is flowing and why. Share price momentum is among the most obvious tools in the box for tracking stocks that are in and out of favour, often because it is an indicator that is influenced by positive news flow. Not only that, but paring down the sector to find shares that are outperforming the general market – an indicator known as relative strength – could also point the way to those that are likely to keep rising.
Why relative strength works
Stocks that are displaying relatively strong price appreciation (or depreciation in the case of shorting) are magnets for momentum investors. And when that relative strength begins to weaken, the time to move on is likely to be fast approaching. The general consensus in support of momentum claims the phenomenon can be blamed on several factors, the most prominent of which is a type of behaviour known as the “disposition effect”. This relates to how both private and institutional investors react to news about a stock; the main point being that they tend to sell too quickly on good news to lock-in profits while selling too slowly on bad news in the hope of eventually breaking even.
In a seminal piece of research back in 1993, researchers Jegadeesh and Titman not only claimed that relative strength worked, they proved it with a strategy that was surprisingly straightforward. Their findings showed that selecting stocks based on their past 6-month returns and holding them for 6 months, realised a compounded excess return of 12.01% per year on average between 1965 and 1989.
Another explanatory factor behind momentum is a phenomenon called ‘post earnings announcement drift’ (Bernard and Thomas,…