Since oil has been down (bouncing back some recently), there has been keen interest in finding deep value among the oil stocks. Very recently, I received a question from a reader of my book, “Choose Stocks Wisely,” who wondered if my strategy could be tweaked based on the industry sector.

I’ll share my response to that questioner in today’s post.

As you know, with energy, especially oil and gas service companies, the operating performance of the companies is directly correlated to the underlying commodity price. While some expect oil prices to keep rising now, it’s good to digest the specific risk associated with dependency on a commodity price.

There seems to be some good values in the sector after the lambasting of oil prices a short while back into the mid $40s. In my view, the greatest concern would be a situation where oil declined again and remained down for a lengthy period. Oil service companies are capital-intensive, asset-wise, meaning they have a lot of liquidity tied up in property, plant and equipment.  In my book, I talk about what happened with dry-bulk shipping companies I had selected after that sector got crushed a number of years back. That industry, of course, requires companies to pour tons of money into ships. That sector bounced back very briefly after the initial drop off a cliff only to collapse further into a very extended malaise where many company casualties resulted.

Companies in the oil sector often reflect a balance sheet heavily weighted in property, plant and equipment assets accompanied by significant long term debt. This is not problematic while commodity prices are strong as the entrenched fixed asset position is usually in high demand and can produce significant positive operating cash flow, more than sufficient to service the debt and increase company cash profits. However, if oil prices fall low enough and stay low enough for long enough, many companies will struggle servicing the debt through the malaise where the fixed asset base may not able to generate adequate cash flow during the downturn. So, in order to survive an extended spell, if necessary, the company must have very ample working capital (current assets less current liabilities), preferably with a very significant portion of the current assets being in the form of cash.

My strategy can certainly be tweaked for things because, after all, it’s my personal approach developed after a lot of trial and error (as I stated recently with Jacob Taylor on Five Good Questions). On that interview, I was asked about whether I ever make adjustments and I answered that I do on occasion when a situation simply calls for it.

As to my strategy, it involves filtering and scoring. I think you might look at filtering. You might play with the P/E, the insider transactions, the P/S; these are not balance sheet ratios and might be relaxed, for example, to produce more stocks to consider. At the same time, you might make the current ratio and quick ratio filters more stringent (meaning you are looking for companies with very strong current working capital positions which might enable them to continue paying operating bills and servicing debt for an extended downturn). The point is to see the company you choose be a member of the survivor club if, again, oil does not go back up but rather remains depressed for an extended period.

You might observe the balance sheet and say you want companies that have more in current assets than the sum of all liabilities (current + noncurrent). This also points to a wide comfort margin with regard to the company’s working capital position.

This concluded my answer.

Everyone, have a blessed Memorial Day Weekend. It is very good to often remember the sacrifices made to keep us free. Many families today have experienced the loss of loved ones serving in the military and we remember you in our prayers. And my heart-felt appreciation to all who currently serve us in the armed forces.