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How to Make the Right Sector Calls

David Edwards

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:

1. You are less diversified than you think, and

2. 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
Industry Groups	Projected Growth 2001	Projected Growth Next 5 Years	PEG Ratio
Chemicals
Diversified	8.7%	13.5%	N/A
Fibers	8.6	20	N/A
Plastics	19.3	16.5	N/A
Specialty	9	10.9	1.93
Containers
Metal / Glass	14.8%	11.5%	N/A
Paper / Plastic	19.3	15.5	2.41
Metal
Product Distributors	8.8%	12.8%	1.22
Products / Fasteners	9.4	14.8	0.79
Processing / Fabrication	20.9	12.3	N/A
Mining
Gold	8.1%	21.4%	0.97
Iron	25	10	N/A
Miscellaneous	21.1	19.6	N/A
Non Ferrous	34.7	15.9	0.34
Silver	24.5	14.3	N/A
Rubber
Plastics	12.1%	15.0%	0.32
Tires	21.7	7.6	N/A
Steel
Pipe and Tube	33.3%	21.7%	0.74
Producers	8.7	13.3	3.78
Specialty	30.0	10.4	0.39
Source: Standard & Poor's, Zacks

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
Industry Groups	Projected Growth 2001	Projected Growth Next 5 Years	PEG Ratio
Aerospace
Defense Electronics	20.4%	16.1%	10.14
Defense	15.5	12.1	1.67
Electrical
Misc. Components	29.7%	26.5%	0.86
Components - Semiconductors	29.9	31.7	0.76
Connectors	36.1	14.4	3.27
Manufacturing Machinery	23.7	23.9	0.47
Military	16.6	19.9	5.97
Measuring Instruments	24.7	25.1	0.6
Parts Distributors	14.9	17	0.15
Misc. Products	33.4	24.9	0.86
Instrumentation
Control	20.4%	17.5%	2.32
Scientific	22.6	23.5	1.56
Machinery
Construction and Mining	11.5%	16.7%	N/A
Electrical	15.9	21.5	3.95
Farm	14.3	10.6	21.36
General Industrial	20.0	12.4	1.87
Material Handling	14.8	11.5	0.31
Print Trades	47.1	30	5.25
Thermal Processes	19.6	14.8	1.46
Machine Tools	14.9	13.8	1.65
Office
Automation	26.3%	16.8%	9.11
Equipment and Supplies	10.7	12.8	1.18
Source: Standard & Poor's, Zacks

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
Industry Groups	Projected Growth 2001	Projected Growth Next 5 Years	PEG Ratio
Auto
Domestic	-13%	6.1%	N/A
Foreign	15.5	11.8	N/A
Parts - Retail / Wholesale	9.7	14.7	N/A
Truck Original Parts	1.9	14.2	N/A
Truck Replacement Parts	9.3	15.5	2.30
Building and Construction
Cement / Concrete / Aggregate	14.8%	11.7%	N/A
Miscellaneous	12.7	13.0	4.87
Heavy Construction	27.7	17.8	0.93
Maintenance and Service	18	15.7	1.29
Mobile / Manufactured and RV	14.2	12.6	N/A
Heating and Air Products	14.5	11.3	0.63
Doors and Trim Products	33.8	19	0.72
Lighting Fixture Products	16.6	12.2	0.55
Retail / Wholesale Products	16.9	16.1	1.32
Wood Products	-2.8	11	N/A
Residential / Commercial Products	10.1	13	0.33
Leisure and Recreation
Gaming	19.7%	15.2%	0.78
Products	18	17.3	0.46
Services	25.2	15.4	42.76
Publishing
Books	4.7%	14.3%	1.37
Newspapers	13.1	12.8	5.71
Periodicals	1.1	16.7	1.17
Real Estate
Development	-4.5%	11.2%	N/A
Operations	16.7	12.8	0.72
Real Estate Investment Trusts
Equity	7%	8.0%	0.20
Mortgage	4.7	8.3	N/A
Retail
Apparel / Shoes	19%	18.9%	1.14
Convenience Stores	15.4	18	0.59
Consumer Electronics	20	19.8	0.60
Discount	23.4	17.8	3.00
Drug Stores	19.3	16.1	3.58
Home Furnishings	18.1	20.6	0.88
Jewelry	23.2	14.9	0.78
Mail Order	25.3	24.3	0.62
Miscellaneous / Diversified	18.6	18.7	0.87
Major Department Stores	12.9	10.2	1.72
Restaurants	15.3	18.5	0.98
Regional Department Stores	20.5	16.5	3.80
Supermarket	16.5	15.8	14.71
Vending	8.6	7.9	N/A
Wholesale Components	24.9	21.7	0.65
Textile
Apparel	18.7%	15.2%	1.25
Home Furnishing	18.4	13.1	0.71
Products	24.1	12	N/A
Source: Standard & Poor's, Zacks

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 Staples
Industry Groups	Projected Growth 2001	Projected Growth Next 5 Years	PEG Ratio
Beverages
Alcoholic	17.2%	13.7%	1.17
Soft	26.3	16.5	0.78
Consumer Products
Staples	20.2%	18.4%	1.22
Discretionary	16.5	15.2	N/A
Food
Canned	19.1%	9.7%	N/A
Confectionary	12	10.2	2.41
Dairy Products	42.7	22.1	3.95
Flour and Grains	18.8	11.1	1.32
Wholesale Items	19.3	13.6	1.16
Meat Products	31.7	10.6	N/A
Source: Standard & Poor's, Zacks

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
Industry Groups	Projected Growth 2001	Projected Growth Next 5 Years	PEG Ratio
Canadian Export and Production	23.5%	21.1%	0.17
Canadian Integrated	1.7	14.1	N/A
Field Services	42.3	21.9	3.25
Field Machinery and Equipment	45.8	24.8	N/A
Oil and Gas Drilling	33.5	24.8	31.38
International Integrated	-8.5	18.9	0.19
International Specialty	0.1	11.6	N/A
Production / Pipeline	13.0	10.9	2.74
Refining and Marketing	14.6	10.8	1.07
US Export and Production	18.9	18.2	2.47
US Integrated	-14.9	10.0	N/A
US Royalty Trust	-5.9	10.0	N/A
Source: Standard & Poor's, Zacks

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
Industry Groups	Projected Growth 2001	Projected Growth Next 5 Years	PEG Ratio
Banks
Foreign	15.1%	12.8%	1.86
Major Regional	11.1	10.7	7.58
Midwest	12.4	11.9	1.68
Money Center	13.5	10.9	N/A
Northeast	9.4	10.7	1.81
Southeast	13.2	13	2.95
Southwest	16.6	12.9	0.95
West	16.6	12.5	0.99
Finance
Consumer Loans	23.6%	21.2%	1.04
Investment Bankers	12.2	20.6	0.95
Investment Funds	8.8	25.7	N/A
Investment Management	14.6	15.7	0.75
Leasing Companies	15.4	18.7	8.08
Mortgage and Related Services	15.9	14.9	1.26
SBIC and Commercial	17.0	13.2	N/A
Savings and Loans	11.9	10.7	1.43
Insurance
Accident and Health	22.7%	14.2%	N/A
Brokers	24.0	14.7	10.46
Life	10	12.8	1.89
Multi Line	15.4	12.0	N/A
Property and Casualty	18.8	11.3	N/A
Source: Standard & Poor's, Zacks

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
Industry Groups	Projected Growth 2001	Projected Growth Next 5 Years	PEG Ratio
Medical
Biomedical / Gene	20.1%	33.1%	N/A
Dental Supplies	18.7	18.9	NA
Drugs	21	25.9	N/A
Generic Drugs	30.6	20.7	N/A
HMO	7.9	15.9	1.54
Hospitals	21.1	18.9	2.31
Instruments	14.2	26.9	N/A
Nursing Homes	3.9	16.5	0.91
Outpatient / Home Care	17.5	21.9	7.30
Products	23.6	26.9	14.5
Wholesale Drugs	21.2	20.9	1.17
Source: Standard & Poor's, Zacks

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
Industry Groups	Projected Growth 2001	Projected Growth Next 5 Years	PEG Ratio
Computer
Graphics	49.0%	28.7%	N/A
Integrated Systems	16.0	26.3	1.78
Mainframe	13.0	31.0	N/A
Micro	38.0	22.9	18.23
Mini	14.0	22.5	2.12
Networks	35.3	36.3	N/A
Peripheral Equipment	5.4	26.5	108.0
Services	29.2	31.4	8.51
Software	35.1	33.2	18.62
Storage Devices	31.7	26.6	14.41
Internet
Internet Content	68.3	44.5	N/A
Internet Services	32.5	48.5	N/A
Internet Software	35.8	51.0	N/A
Source: Standard & Poor's, Zacks

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
Industry Groups	Projected Growth 2001	Projected Growth Next 5 Years	PEG Ratio
Equipment	26%	32.7%	6.85
Services	25	31.5	N/A
Source: Standard & Poor's, Zacks

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
Industry Groups	Projected Growth 2001	Projected Growth Next 5 Years	PEG Ratio
Air Freight	14.3%	14.4%	30.0
Airline	21.7	14.2	1.12
Equipment and Leasing	12.5	12.7	N/A
Railroad	19.9	13.6	2.09
Services	21.0	15.6	1.66
Shipping	36.2	22.3	0.52
Truck	18.5	14.8	1.64
Source: Standard & Poor's, Zacks

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
Industry Groups	Projected Growth 2001	Projected Growth Next 5 Years	PEG Ratio
Electric Power	12.2%	9.3%	1.62
Gas Distributors	14.2	7.4	1.30
Telephone	8.6	23.0	2.30
Water Supply	8.7	7.7	5.16
Source: Standard & Poor's, Zacks

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.