How to Make the Right Sector Calls

At the start of each year, my firm decides in which sectors to concentrate our clients' money. We believe the only way to consistently beat the S&P 500 index is to focus on those industry groups whose earnings have a reasonably good shot of growing faster than the earnings of the S&P 500 over the next year and the next five years, but whose valuations remain reasonable.

Today I'll walk you through the numbers my firm uses to determine the strongest sectors. Keep in mind, though, we don't put all our funds in any one sector. That kind of concentration would introduce more risk to our portfolios than our clients could stomach. This diversification requirement meant that while we gave up some of the upside in technology stocks in 1999, we weren't killed by the tech sector's selloff in 2000.

For definitions of the sectors, see my last column, Making the Most of Your Sector Plays.

If you own individual stocks, I recommend sorting your stocks by sector and calculating the percentage of your portfolio in each sector. Compare it to the sector breakdown of the S&P 500 (which you can find in its monthly report). For more information on how to do this, take a look at last January's Tune Your Portfolio With a Year-End Review.

If you own mutual funds, check the sector allocations to understand what risks the fund managers are taking relative to the market. For example, if you own three growth funds, and all three are 50% invested in technology:

You are less diversified than you think, and
You'd better hope tech does better this year than last.

If you focus your research on those industry groups expected to grow the fastest over the next year and the next five years, select from the highest-ranked companies within those groups and keep your portfolio reasonably diversified (30 to 40 stocks across several sectors), you should end up with good (12% to 15% annualized) returns in a tax-efficient portfolio that allows you to sleep at night.

Now let's look at each sector. The percentage next to the sector name indicates its weighting in the S&P 500 index.

Tables are broken down into industry groups and offer one-year and five-year growth rates plus a measure of the industry group's valuation relative to its growth rate, known as the PEG ratio.

Bear in mind that many of these estimates seem high (supermarkets with a five-year growth rate of 15.8%?) compared with the S&P 500's estimated growth rate of 8.6% for 2001 and 14.1% over the next five years. Also keep in mind that companies with high growth prospects can be expensive, so seek out stocks with lower PEG ratios than others in their industry group. Stocks and industry groups with PEG ratios less than 1 (for example, a current price-to-earnings ratio of 20 and current-year earnings growth of 25% implies PEG of 0.80) are very attractive. The S&P 500's PEG ratio is 1.90.

The entry N/A results from negative current earnings growth. You probably want to avoid industry groups that didn't grow this past year while the U.S. economy was running flat out.

Basic Materials (2.36%)

Basic materials stocks appreciated at a 3.1% annual rate over the last five years, the slowest of any sector. Most of the companies here produce commodities whose sale price tends to converge with the cost of production, especially in the low-inflation environment as we have seen in recent years. I would not put money here unless I saw capacity constraints or a surge in inflation. Gold stocks have proved particularly bad investments over recent years as T-bills have supplanted bullion as the safe haven of choice.

Capital Goods (8.96%)

Capital goods stocks appreciated at a 17.5% annual rate over the last five years. This group does well when U.S. and world economies are expanding, and when interest rates are flat or falling. The riskiest time to own these stocks is during a slowdown or at the start of a recession, so be careful investing in this sector right now. The best companies to own are those that have the largest market share of their respective industry groups.

Consumer Cyclicals (7.51%)

Consumer Cyclicals stocks appreciated at a 13.4% annual rate over the last five years. As with capital goods, these stocks perform poorly heading into economic slowdowns and perform well in expanding economies. This sector is less sensitive to overall interest rates (consumers buy homes, cars and furnishings very happily on credit while corporate purchasers worry about budgets). Given current high levels of consumer debt and an increasingly picky and bargain-aware consumer (as we saw in holiday retail sales figures), we're shying away from this sector right now.

Consumer Staples (11.23%)

Consumer stables appreciated at a 12.2% annual rate over the last five years. This sector is traditionally recession-proof (consumers buy toothpaste and beer no matter what the state of the economy). We rarely invest in the food group -- low margin, labor intensive and the products must be sold before spoilage.

Energy (6.38%)

Energy stocks appreciated at a 13.9% annual rate over the last five years. This commodity has a different dynamic than most basic materials because the OPEC cartel of major oil exporting nations has a much firmer grip on production than other cartels (copper, for example). Large multinational companies are relatively unaffected by changes in the price of oil because of extensive hedging operations. We often own these for their dividend yields. Drillers and equipment and oil service companies are turbocharged by changes in the price of oil. As the price of oil falls to the cost of production (as we saw in the summer of 1999), the revenues of these companies are hammered. But as oil prices surge, exploration and production pick up (as we see right now) and industry stock prices surge as well.

Financial (17.66%)

Financial stocks appreciated at a 21.8% annual rate over the last five years. Stock prices in this sector used to be tightly correlated with changes in interest rates. In recent years, the companies have become more adept at managing interest-rate risk, but the stock prices still tend to move higher when rates move lower. Consolidation and cost control are a much bigger driver of stock prices, and with fewer takeover targets available, we don't see this group growing at quite the same rate as the past five years. Banks and finance companies tend to do poorly heading into recessions, as bad loans increase and as transaction income dries up. Insurance companies, particularly property and casualty companies, suffer when underwriting competition drives down premiums.

Health Care (14.07%)

Health care stocks appreciated at a 22.9% annual rate over the last five years. Companies in this sector also are relatively recession-proof -- when you need medicine you need medicine. Conventional pharmaceutical companies offer relatively predictable returns. Biotech companies offer outsize returns with outsize risks. Hospitals, HMOs and other care facilities are subject to mismatches between rate increases and cost increases. HMOs did very well last year (gaining 81%) as rates rose faster than costs. Medical equipment, products, supplies and services can do well. The whole sector is subject to regulatory oversight, which can be very deleterious, as we saw during the discussion of the Clinton health care proposals in 1993.

Technology (21.81%)

Technology stocks appreciated at a 25.8% annual rate over the last five years, the fastest of any sector. Growth in this sector is subject to the same pressures as other capital goods, but demand for technology remained high during the great productivity investments of the 1990s. Even when overall demand is high, companies are at great risk from "paradigm shifts" (e.g., mainframe computers supplanted by desktop computers supplanted by Internet-oriented machines.) Also, companies that fall behind the technology curve or fall to third or fourth in segment market share are very vulnerable. The mortality rate among companies exploiting new concepts is very high.

Communications Services (5.45%)

Communications services stocks appreciated at a 7.5% annual rate over the last five years. We usually group this sector with technology, but as phone services became commoditized in recent years, stocks in this sector have done poorly.

Transportation (0.67%)

Transportation stocks appreciated at an 8.8% annual rate over the last five years. Most of the growth in this sector has been in air freight and airline companies, and the stocks have performed accordingly. These companies are sensitive to rising fuel rates, rising interest rates (since most equipment is financed or leased) and the overall state of the economy. Since transportation is a commodity (an airline seat is an airline seat is an airline seat) pricing tends to converge with costs even in the best of times.

Utilities (3.89%)

Utilities stocks appreciated at an 11.5% annual rate over the last five years, reflecting the benefits of deregulation and increased demand. Future earnings depend on the cost of credit and beneficial oversight. Investors looking to utility stocks for dividend yields have to look very carefully at dividend coverage rates. In the early years of deregulation, electric power producers began investing aggressively in capacity, causing earnings to drop; dividends were cut sharply as a result.

Best Bets

Based on the information above and my opinions about where we are in the interest-rate and economic cycles, I find consumer staples, utilities and consumer cyclicals attractive (the cyclicals are way oversold). I would avoid basic materials and energy this year. I have to be selective among financials, health care, technology and transportation.

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David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. At the time of publication, his firm held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback at [e-mail].