The Energy sector has seemingly fallen out of favor with generalist investors, with its weighting declining from around 16% in early 2008 to 4.1% as of April 30, 2024.
Despite increasing power and energy demand amid decarbonization efforts and strong cash flow generation, investors frequently ask what the appropriate sector weighting in the index should be.
In an attempt to answer this question, Mizuho Securities strategists note that the Energy sector appears “cheap” compared to the broader market based on multiples like EV/EBITDA and FCF/EV, despite improved fundamentals.
While the XLE index has outperformed the S&P 500 by around 6% year-to-date, investors are increasingly curious about how much further the sector can re-rate against the broader market, Mizuho said.
In their analysis, the investment banking firm compared the Energy sector's market cap weight in the S&P 500 and its contribution to two-year forward free cash flow from 2008 to 2024, revealing a noteworthy discrepancy.
Although Energy has historically contributed around 9.4% to market FCF, its market weight was once aligned with this contribution. However, this alignment broke post-2018, despite the rise of Shale 3.0.
By April 30, the sector is expected to contribute about 12% of the S&P 500 FCF in 2025, strategists said.
“While a tripling of the sector market weight from current levels seems unlikely, we believe the sector should account for 8-9% of the total market,” the strategists estimated.
“This would suggest that despite its recent strong run, the sector has more room to go,” they added.
In terms of specific stocks, Mizuho continues to prefer quality players such as Chevron (NYSE:CVX), Coterra Energy (NYSE:CTRA), Civitas Resources (CIVI), Diamondback Energy (NASDAQ:FANG), EOG Resources (NYSE:EOG), Permian Resources (PR), Range Resources (NYSE:RRC), and Chesapeake Energy (CHK) “to participate in this potential uptrend.”