The ratio of a stock’s current price to its earnings over the prior year – the famous price to earnings ratio – is perhaps the most widely used of all financial ratios.  Likewise, the price-earnings effect is among the earliest and most widely documented asset pricing anomalies.  It’s well known that a strategy of purchasing low P/E stocks allows investors to outperform market benchmarks over long time frames.  What is less well-known, however, is that a variation on the P/E can be a more effective strategy for picking stocks that will outperform.

The long-term, price-earnings ratio attempts to quantify the value of permanent earnings power.  Instead of using the trailing 12 months of earnings, which can be noisy, this “normalized” ratio uses the average earnings over the past 8 years to determine the denominator in the P/E.  This idea is not new: Ben Graham proposed this many years ago and Bob Shiller has popularized the concept with the 10-year Shiller CAPE ratio.

At Turnkey Analyst, we provide a stock screening tool that allows you to screen for stocks with lowest long-term P/Es.

We ran the screen recently, and were surprised to see a mega cap name appear in the top 5% of our output.

ConocoPhillips is engaged in oil and gas exploration and production, natural gas gathering, processing and marketing, and oil refining.  It is the third-largest U.S. integrated energy company, by market capitalization, and the largest oil refiner in the U.S.  The company employs almost 30,000 people, and operates in 30 countries.

Below is our summary Fundamental Factor output for COP:

COP generates an overall Turnkey Score of 73.9%, consisting of a Quality Measures score of 62.0% and a Pricing Measures score of 85.8%.  On its face, it appears COP is a fairly high quality company, trading at a good price.  Let’s look at some of the data that contribute to these numbers and see if they can shed light on COP’s current financial situation.

Looking over our Financial Health output, above, COP’s profitability looks solid.  Over the past 12 months, the company has generated positive cash flow and net income, leading to respectable returns on capital and assets.  It’s worth noting that normalized (8 yr average) earnings are significantly higher than TTM earnings, suggesting that if COP’s earnings mean revert they will increase from here.  Turning to Turnkey’s Stability output, the Altman Z score, which predicts the risk of bankruptcy, is 2.91, which is below our preferred threshold of 3.0, but not off by much.  Debt does not appear to be a major concern, as debt/capital stands at 34.5%, and EBIT/interest expense coverage is a comfortable 21.6X.  Liquidity ratios are a little weak, with a current ratio of 1.2, which is significantly below our preferred level of 2.0, although the quick ratio, at 0.94, is only slightly below our preferred level of 1.0.  COP’s f-score, a general measure of financial strength, is very strong, at 8.0.  Our overall Stability Score of 50% is probably a little skewed to the downside, as the company only barely missed a couple of our benchmarks.  Overall, the financial health of COP appears strong, with no glaring issues, at least from a statistical perspective.

Turning to our Economic Moat output, above, it appears the results are neither especially good nor especially bad.  The company lost money in 2008, when oil prices crashed during the recession.  Normalized (8 yr average) cash from operations – capex / assets was 26.7%, which was above average for our screening universe.  Normalized (8 yr average) returns on assets and capital of 4.7% and 5.5% respectively, were also above average.  COP’s margin stability of 10.3% is below average, versus our universe.  Looking at the graph of gross profits, above left, you can see margins have been getting squeezed over the past few years.  The output generally ranges in the middle of our comparison universe, and thus our composite Economic Moat score of 50% suggests a company with some moat-like features, but nothing that is particularly compelling.  This should not be too surprising as the oil and gas is a highly competitive commodity business where differentiation is difficult when large amounts of capital and large acreage positions are involved.

At Turnkey Analyst, we like to look at accrual factors as a measure of earnings quality, since research has shown investors tend to underweight cash flows and overweight accruals when making judgments about a company’s future prospects.  COP generates operating accruals / assets return of -4.5%, which places it in the 57^th percentile of our universe, while its operating accruals / net income return is -62.7%, about average.  Additionally, COP’s net operating assets/assets return of 9.7% is average in our universe.  So the good news is that there are no obvious signs that management is playing games with accruals, and COP’s Earning Quality score is respectable at 55%.

Our Shareholder Yields output is really quite stunning, in my view (especially compared to nominal bond rates).  Normalized (8 yr average) cash flow and earnings yields are extremely strong.  In the case of Normalized EBIT/TEV yield of 17%, the company is near the top 3% of our universe.  TTM EBIT/TEV also looks very good at 22%, which is the top 5% of our universe.  The company’s TTM net income yield of 13% suggests earnings are cheap.  It appears that the market is heavily discounting COP’s past cash flow and earnings results as a predictor of future success.  You could probably make an argument that the company is priced for a lower oil price environment than in fact exists today, although that is beyond the scope of our quantitative methodology, which merely provides a big picture statistical overview, and highlights areas for additional research.

The bearish argument for integrated oil companies is outlined by Jim Chanos:  http://www.marketfolly.com/2011/10/jim-chanos-beware-global-value-trap.html

Let’s face it.  COP is in a cyclical industry, and to a great extent as goes the global economy, so go the company’s fortunes.  In a world threatened by sovereign debt defaults, the risk of another recession is very real.  But in a challenging environment, a stock with a low valuation, a large, stable, diversified business model and a strong balance sheet could have some protective features.  Furthermore, it can sometimes be the case that the mega cap blue chip names trade near P/E parity with the overall market, yet today that doesn’t seem to be the case with COP.

So it appears there could be several ways to win with ConocoPhillips.  COP is cheap, stable, and of reasonable quality, so in a down market, you have a margin of safety.  If we don’t dip back into recession and earnings mean revert, you could seem some upside to earnings and cash flow.  Finally, you might see some multiple expansion, as the market moves back to historical earnings yields for mega caps.

In sum, COP seems like reasonable place to put some capital to work in the current environment.