Beauty, as they say, is in the eye of the beholder. When shopping for a new car, for example, some buyers almost instinctively opt for the “quality” package combining greater acceleration, the latest in power steering, enhanced road handling and so on—usually at higher cost. Others tend to gravitate to a more rugged model, with greater cargo space and perhaps a few dings—potentially a good “value,” provided you can get it for the right price.

Likewise, in the energy sector, varying valuation yardsticks are often applied to what are sometimes categorized as “quality” and “value” stocks. And recently, the valuation gap has narrowed considerably between these two, a trend attributed to greater shareholder activism and corporate restructuring.

According to a mid-May note by Morgan Stanley, the “quality gap” that has emerged in the large-cap E&P sector between quality growth names and their lower-growth peers has come close to a 10-year low. Using price-to-cash flow multiples based on forward 12-month estimates, the premium accorded to quality, growth names has swung within a multiple range of 4.5 to 1.1 times higher than the multiple accorded lowergrowth or “value” E&Ps.

With a premium multiple of just 1.9 times higher, the “quality premium” stands close to the bottom end of the historical range.

Which companies are examples of quality, growth names in the large-cap sector? Morgan Stanley highlights “top picks” Noble Energy Inc. and Anadarko Petroleum Corp., and it also favors equal- weighted EOG Resources. Coincidentally, Simmons & Co. International also cites these names in a “high-quality diversified asset” category, noting that all three E&Ps represent “bestin- class companies that should produce impressive long-term production growth from their respective deep asset bases.”

Part of the explanation for a reduced quality gap is that portfolio managers in general are underweight energy. After recent years of underperformance relative to the broader equity market, energy is viewed as a sector in which an underweight position carries little risk—especially if oil and gas prices are likely to be range-bound in the near term.

But a major factor in the narrowing of the quality gap is the uplift in price accorded certain so-called “value” stocks in the energy sector, as investors have supported activist and restructuring themes. Clearly, asset divestitures and monetization of midstream operations do bring into focus value that may otherwise be given little credit in a sum-of-the parts or net asset value methodology. This has helped increase valuations for a number of energy stocks, notably Hess Corp. (Another, at press time, Devon Energy Corp. announced it would drop its midstream assets into a new MLP.)

As of mid-May, Hess’ stock price was up roughly 30% from its 2012 year-end price of $52.96, a gain twice that of some of its peers. Pressure from activist shareholder Elliott Management led to a revamped board, including five new Hess nominees, and three of Elliott’s nominees being added to the 2015 director class. In addition, measures were adopted to separate the roles of chairman and CEO.

These moves followed Hess’ earlier initiatives to transform itself into a more focused E&P company. Plans call for divesting assets in Indonesia and Thailand; monetizing Bakken midstream assets, expected in 2015; and fully exiting its downstream businesses. Hess anticipates growing production by a compound annual growth rate of 5%-8% over five years, based on 2012 pro forma production.

How long will shareholder activism last, such as the example Hess offers?

“Activism is cyclical, and is ripe when equities are relatively inexpensive, there is a means or market to unlock value, and the investor base is frustrated with management,” says Morgan Stanley’s North American E&P research team, led by Evan Calio.

“Post-restructuring phase, we expect quality growth names to once again outperform,” says Morgan Stanley. “We see relative upside in resource ‘haves,’ as investors begin to rotate out of the now more mature activist/restructuring stories.”

Morgan Stanley notes that many of the first-quarter earnings beats were driven by larger than expected production growth, bringing renewed focus on E&Ps that can execute on their game plans. This should “support share price outperformance for quality, growth names when the activism/restructuring cycle runs its course.”

If Morgan Stanley is right—and it’s only time before activist momentum fades—then maybe it’s time to upgrade to a quality vehicle at what is today a low valuation premium.

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