The Importance and Opportunities of Sector Investing

Transcription

1 The Importance and Opportunities of Sector Investing INVESTMENT STRATEGY GROUP

2 The Importance and Opportunities of Sector Investing While most market observers focus on the direction of the stock market as a whole, there are very important dynamics occurring under the surface of the market that offer significant investment opportunities. Sector exposure has been a major determinant of stock market returns and is widely considered the second-largest return factor after individual security selection. The Economic Sectors of the Stock Market The stock index is made up of 10 sectors and 70 industries within these sectors. The following 10 broad sectors segment the significantly diverse companies of the :,,,,,, Information,, munication Services, and. Sector classifications benefit from being intuitive and stable. Companies are classified based upon the nature of their major business line and tend to remain in their sector. This segmentation tends to put companies with similar operating characteristics and industry fundamentals into the same sector. The economic cycle and interest rate environment also tend to impact companies of a given sector in a similar manner (more on this below). These factors cause the performance of sectors to vary significantly relative to the market as a whole, and to other sectors. It is this variability of returns between different parts of the market that presents the opportunity for investors to enhance portfolio returns. Performance History of Stock Market Sectors Table 1 shows the range of returns for the best sector and worst sector for the last decade. While the had an average return of 9.2%, the bestperforming sector had an average return of 29.8%, while the worst had an average of 5.6% indicating that proper sector exposure is critical for portfolio performance. The table also shows that proper sector exposure is much more important than the decision on capitalization (large vs. small) or style (growth vs. value). While the average difference between best vs. worst sector performance is 35.3%, it is only 4.6% for large vs. small capitalization, and 6.3% for growth vs. value. The sector decision is also more important than the decision on international exposure, with the average difference between U.S. and developed international performance only 7.8%. A savvy investor pays attention to his sector exposure at all times. The rank order of sector performance also fluctuates significantly from one period to the next. Appendix 1 shows the significant yearly variation in sector performance. Table 1: Range of Returns by Sector, Capitalization, Style, and Region Average Best Sector Worst Sector Average Difference Large Cap Stocks Small Cap Stocks Average Difference Large Growth Large Value Average Difference Developed International Average Difference from (Source: Janney ISG, Bloomberg) 2

3 Table 2: Sector, Industry, and Stock Correlations Sector Stock Correlation with its Sector Average Correlation of Industry Returns with Sector Returns Sector Correlation with Financial Information munications 0.90 (T & VZ) Source: Janney ISG, Bloomberg, and BCA Research Sector Allocations Drive Portfolio Returns Numerous academic studies have examined the impact of sector performance variability. Not surprisingly, these studies confirm that sector selection is the critical determinant of portfolio performance. Stocks and Industries are Highly Correlated with Sectors Table 2 shows that most stocks and industries are highly correlated with their sector. The average industry has a very high correlation of 0.80 with its sector (correlation measures the strength of a relationship with 1.0 implying a perfect relationship, 0.0 implying no relationship, and 1.0 implying a perfect inverse relationship). In addition, the underlying stocks are usually highly correlated with their sector as shown in Table 2. This implies that owning stocks in the right industry and sector is critically important for portfolio performance. The high correlations of the, Financial,,, and sectors with their underlying stocks indicate that the stocks in these sectors are driven by macroeconomic factors or strong industry dynamics, more so than firm-specific issues. For these sectors, exposure to the sector is more important than exposure to the individual stocks within the sector. Exchangetraded Funds (ETFs) offer an excellent way to participate in sector or industry themes without taking on firm-specific risk and are very appropriate for these sectors. By contrast, the relatively low sector/stock correlations of the,, and Information sectors imply that more can be gained by exposure to firm-specific issues rather than industry/macro issues. New drugs, and hot consumer and technology products are examples of firm-specific issues that can enable individual stock outperformance. Analytical Approach to Sector Analysis The 10 S&P sectors can be classified as defensive or cyclical. Defensive sectors have stable earnings that are not a strong function of the economic cycle. They provide goods and services that people need, independent of economic conditions. They tend to outperform when the economy is performing poorly. Defensive sectors include,, munications, and. Cyclical sector profitability is a strong function of economic conditions. When economic conditions are good, these sectors see strong profits and, consequently, they tend to outperform the overall market. Cyclical sectors include,,,, Information, and. The economic cycle and corresponding Federal Reserve (Fed) interest rate policy are major top-down determinants of sector performance. We break the economic/interest rate cycle into phases determined by whether interest rates are restrictive (tight) or accommodative (easy) for economic activity and whether rates are moving higher or lower. Table 3 shows relative performance for the sectors during interest rate cycles since July

4 Table 3: Sector Returns Relative to Overall Index Returns during Rate Cycles from 1970 CYCLICALS Accommodative and lowering rates Accommodative but rising rates Restrictive and rising rates Restrictive but lowering rates 7.6% 8.1% 5.4% 0.1% 4.5% 12.0% 1.1% 5.1% 2.4% 8.4% 1.7% 4.1% 0.1% 8.9% 1.3% 3.0% 2.6% 15.0% 4.6% 4.2% DEFENSIVES 3.8% 2.7% 4.9% 14.3% 3.4% 1.9% 10.2% 5.2% 4.2% 9.2% 4.1% 8.2% 9.1% 14.4% 1.3% 8.7% Source: Janney ISG, BCA Research An accommodative credit environment is conducive for economic activity and is favorable for stocks, particularly cyclical sectors. Table 3 shows the cyclical sector outperformance during the accommodative phases. Table 3 also shows that an accommodative environment is unfavorable for defensive sector outperformance. Defensive sectors tend to perform well during a restrictive credit phase. Restrictive credit conditions are a major cause of recessionary economic conditions where defensive sector profitability holds up better and hence the stocks outperform. The U.S. economy has been in an accommodative interest rate environment since the financial crisis, and the economy has been in recovery since the summer of The ultra-accommodative interest rates are now ending, and the Fed is contemplating raising rates. We anticipate rates will be accommodative well into This rate environment remains favorable for economic activity and cyclical sectors. It should also be quite some time before restrictive credit conditions cause an unfavorable environment for stocks and allow for sustainable outperformance from the defensive sectors. Sector Fundamentals Also Determine Performance A thorough analysis of sector fundamentals is also important for determining the potential for outperformance. This includes valuation analysis that looks at whether a sector is expensive or cheap relative to its own history, and relative to other sectors. The potential for revenue and earnings growth and competitive dynamics of the sector are important considerations. In addition, sectors see secular trends that provide headwinds or tailwinds for performance that need to be thoroughly analyzed. The following section looks at favorably positioned sectors. 4

5 Sectors that are Currently Well-Positioned : There are strong secular drivers for tech spending. Tech investment has fallen to close to a 15-year low as a share of overall investment, underscoring that the average age of its capital stock is particularly high. The corporate sector also needs to address weak productivity growth (an indication that prolonged underinvestment may have begun to take a toll on corporate efficiency). Meanwhile, corporations are in a solid position to invest with profits at new highs, while the barriers for investment are falling as the economy continues to improve. Recent manufacturing data show that technology new orders are firming, suggesting that capital spending budgets are being directed toward technology goods. Despite the positive cyclical and secular backdrop, tech valuations remain reasonable. : Health care also has a positive secular backdrop due to aging demographics and the associated increasing demand for health care services. Overall health care demand is recovering, as the U.S. economy improves and unemployment levels continue to decline. The pace of health care expenditure growth should exceed that of the overall economy with pent-up demand for health care services, lower unemployment levels, and rising commercial insurance membership bolstering the sector. While the pace of growth may be slowed by new reforms, that should be outweighed by the positive impact on valuations from a lifting of health care reform uncertainty. Growing affluence in emerging markets is also providing opportunities for equipment and pharmaceutical companies. : As private sector balance sheets and credit quality have improved, bank lending standards have been relaxed. Both consumers and businesses are benefitting from this easier access to funding, and loan demand has been slowly improving with employment growth. Indicators also show small-business lending returning to levels seen prior to the financial crisis. Meanwhile, there remains significant pent-up demand for housing, autos, and corporate capital expenditures implying strong pent-up demand for consumer and business loans. More readily available credit (and demand for it) has typically been a leading indicator of financial sector profit acceleration. This cycle, the sector has the added benefit of rising productivity growth, measured as total credit growth per employee. Productivity is now growing at its fastest pace since the global financial crisis. In addition, loan charge-offs have declined to pre-crisis levels, and non-current loans have also dropped below 2008 levels. While deflationary pressures from abroad are keeping financial sector valuations depressed, this should be viewed as a buying opportunity given the positive profit outlook. This sector is also a strong dollar winner (keeps inflation low and supports domestic purchasing power both positive for loan growth), which should provide a further incentive for a valuation re-rating. Table 4 (on page 6) summarizes the stocks and ETFs that are benefiting from these positive sector themes. Michael J. Halloran, CFA, Strategy Analyst Mark Luschini, Chief Investment Strategist 5

6 Table 4: Stocks and ETFs of Well-Positioned Sectors Company Name Ticker Forward P/E Earnings Growth Dividend Yield Credit Rating Notes Coverage Tech investment has fallen to a 15-year low as a share of overall investment. This indicates significant pent-up demand for technology products that will be needed to address weak productivity growth. Corporate confidence is improving, and companies are well-positioned to execute on their capital expenditure plans. Providing leading edge wireless APPLE INC. AAPL AA+ productivity solutions for /J consumers and business. MICROSOFT CORP MSFT AAA New product releases are just in time to help increase productivity. ORACLE CORP ORCL A+ Enterprise technology solutions are at center of corporate productivity enhancements. QUALCOMM INC. QCOM NR Leading provider of wireless broadband technology. EMC CORP/MA EMC A Storage is always at the top of the IT budget list. /J VANGUARD INFO TECH ETF VGT Cap-weighted basket of 410 info tech stocks. ISHARES SOFTWARE ETF IGV Cap-weighted basket of 55 U.S.- traded software companies. ISHARES COMMUNICATION ETF IGN Cap-weighted basket of 32 U.S.- traded multimedia networking companies. The Financial sector has healed from the financial crisis, and is well-positioned to extend the needed credit for pent-up business and consumer expenditures as the economy improves. PNC FINANCIAL SERVICES GROUP PNC A- Major regional bank with focus on Pennsylvania and Ohio. AMERICAN EXPRESS CO. AXP BBB+ Leading global payments and travel and expense services company. /J ALLSTATE CORP ALL A- Second largest U.S. personal lines property-casualty insurer. /J PRUDENTIAL FINANCIAL INC. PRU A Provides a wide range of insurance and investment management /J products. GOLDMAN SACHS GROUP INC. GS A- Leading position in investment banking, securities, and wealth management. FINANCIAL SELECT SECTOR SPDR XLF Includes 80 stocks for broad-based financial sector exposure. SPDR S&P REGIONAL BANKING KRE Includes 79 equally weighted regional bank stocks. ISHARES U.S. INSURANCE ETF IAK Includes 64 U.S. insurance provider stocks. ISHARES U.S. BROKER-DEALERS IAI Includes 22 U.S. investment services stocks with GS and MS largest holdings. The sector is a major beneficiary of an aging population and future high levels of health care spending. Very diverse product line, strong MEDTRONIC INC. MDT AA- *- cash flow, valuation and dividend support. Leading health information CERNER CORP CERN technology firm is helping to transform healthcare. UNITEDHEALTH GROUP INC. UNH A+ Leading market position with product diversity. JOHNSON & JOHNSON JNJ AAA AAA rated blue chip with valuation and dividend support. MYLAN INC. MYL BBB- Leading manufacturer of generics with valuation support. World s largest pharma company, PFIZER INC. PFE AA solid pipeline, exposure to emerging markets. VANGUARD HEALTH CARE ETF VHT Broad exposure from cap-weighted basket of 293 companies. ISHARES MEDICAL DEVICES ETF IHI Cap-weighted basket of 40 manufacturers and distributors. ISHARES HEALTHCARE PROVIDERS ETF IHF Broad-based exposure to U.S. health care providers. ISHARES PHARMACEUTICALS ETF IHE Cap-weighted basket of 36 pharmaceutical companies. Definitions: Forward P/E - Current stock price divided by EPS consensus estimate for the next four quarters. Earnings Growth Estimate - Mean broker estimate of the compounded annual growth rate of the operating eps over the company s next full business cycle (typically 3-5 years). Dividend Yield - Trailing 12-month dividend per share divided by share price. Credit Rating - Rating assigned by Standard & Poor s to the long-term obligations of the issuer if repaid in the local currency of the issuer. (Source: Janney ISG, Bloomberg) S&P 6

7 Appendix 1: Historical Sector Returns (Source: Janney ISG, Standard and Poor s, Bloomberg)

8 JANNEY MONTGOMERY SCOTT LLC The Highest Standard of Success in Financial Relationships 2014, Janney Montgomery Scott LLC Member: NYSE, FINRA, SIPC This report is provided for informational purposes only and shall in no event be construed as an offer to sell or a solicitation of an offer to buy any securities. The information described herein is taken from sources which we believe to be reliable, but the accuracy and completeness of such information is not guaranteed by us. The opinions expressed herein may be given only such weight as opinions warrant. This Firm, its officers, directors, employees, or members of their families may have positions in the securities mentioned and may make purchases or sales of such securities from time to time in the open market or otherwise and may sell to or buy from customers such securities on a principal basis.