Scoping out the sectors

4/21/2008


2008 has not been a friendly year for stocks, but some sectors have fared better than others.

As the chart below illustrates, the materials and energy sectors have delivered the best year-to-date performance, while the telecommunications-services and technology sectors have lagged. Over the last year, financials and consumer-discretionary stocks have been particularly weak.

A review of sector returns can be educational, illustrating how different types of stocks respond to economic and business conditions. But investors need to know more than how a sector has performed. Shrewd investors can often find a few choice names in weak sectors — and plenty to avoid in strong sectors.

Stocks in the S&P 1500’s energy sector average a Quadrix Overall score of 79, and the industrial and technology sectors also boast above-average Quadrix scores. Not surprisingly, the Forecasts has identified several attractive stocks in these high-scoring sectors.

Our equal-weighted Buy List and Long-Term Buy List overweight all three of these sectors relative to their market-value weightings within the S&P 1500 Index. This overweight stems not from a conscious decision to load up on energy or technology, but simply because we are finding several appealing stocks from these sectors.

The following paragraphs review top picks from four sectors:

Consumer staples
PepsiCo ($71; NYSE: PEP) is expanding in Russia with gusto. In March, the drink and snack giant agreed to make two purchases of local bottlers and beverage makers that will give it more than a 30% share of the fast-growing Russian juice market. PepsiCo’s purchase of Sobol-Aqua for an undisclosed amount should close by the end of June. PepsiCo and Pepsi Bottling Group ($34; NYSE: PBG) also agreed to pay $1.36 billion for a 76% stake in Lebedyansky, taking control of Russia’s largest juice maker.

Russia’s nonalcoholic-beverage sales topped $9 billion last year, ranking it No. 12 in the world. With annualized sales growth of almost 24% from 2001 through 2007, Russia is also among the world’s fastest-growing markets for nonalcoholic beverages.

While the company has focused heavily on Russia in recent months, PepsiCo has a broad international presence, operating in more than 200 countries. International operations are driving most of the company’s growth. While last year snack and beverage volumes in North America grew 3% and 0%, respectively, they were up at least 8% internationally. PepsiCo is a Focus List Buy and a Long-Term Buy.

Energy
Despite several high-profile discoveries over the last few years, Chevron ($90; NYSE: CVX) has struggled to boost production. Between 2002 and 2006, the company replaced 120% of its reserves through exploration, well above the rate of most rivals. From 2008 through 2010, Chevron expects to add reserves equal to 117% of production.

However, oil and gas production fell 1.8% in 2007. The company still forecasts 3% annual growth in production between 2005 and 2010, which after last year’s decline will require greater than 6% growth in 2009 and 2010.

So, can Chevron turn its achievement in the field into higher production? Investors should have a good idea by the second half of this year. Chevron operates at least 42 development projects, including 25 in design or construction, and the company says oil will begin flowing on several of these projects in 2008. The Agbami field in Nigeria should begin producing in the September quarter, with the eventual goal of about 170 million barrels a day. In Kazakhstan, Chevron should hit peak production of about 500 million barrels a day in the September quarter. While the company has failed to meet production targets in recent years, Chevron should finally capitalize on its exploration efforts this year. Chevron is a Buy and a Long-Term Buy.

Financials
Since the Forecasts started recommending Manulife Financial ($37; NYSE: MFC) in March 2004, the stock has more than doubled, generating more than twice the return of the S&P 1500 Life & Health Insurance Industry Index. Through a mix of acquisitions and internal expansion, Manulife has become the second-largest North American life insurer by market capitalization. But the company’s growth prospects still look good, especially overseas.

Earnings from Asia increased 23% in 2007. While Asian operations accounted for just 20% of 2007 earnings, they are expanding rapidly. Manulife received five new licenses to open offices in China in the December quarter, bringing the total to 28. New offices in such cities as Zigong in the Sichuan Province provide an opportunity for significant growth. The province’s 3.2 million people enjoy growing prosperity, yet few have life insurance.

The stock has retreated from its November highs and now trades at 12 times estimated 2008 earnings, below its three-year average forward P/E ratio of 13. Unlike many other financials, Manulife has avoided serious problems stemming from mortgage-backed securities and has the cash to repurchase shares. Manulife is a Focus List Buy and a Long-Term Buy.

Technology
Since CEO Mark Hurd took charge at Hewlett-Packard ($46; NYSE: HPQ) in 2005, the stock has more than doubled. Revenue increased at an annualized rate of nearly 10% over the last two fiscal years, while operating profit margins expanded to 8.4% from 5.7%. In the wake of an impressive two years, H-P seems poised to continue that strong run.

Two-thirds of revenue comes from outside the U.S., and the financial sector accounts for just 8% to 10% of sales. That business mix fortifies H-P against a U.S. recession. The company sees significant growth in the emerging markets of Brazil, Russia, India, and China, where revenue is increasing at least 30% annually.

Software accounts for only 2% of H-P’s sales, but the division seems capable of revenue growth of more than 20% annually over the next five years. Additionally, margin expansion should significantly improve profitability as H-P gains scale. The software unit managed operating margins of 9% in fiscal 2007 ended October, well below the 20% to 30% margins common in the industry.

Companywide cost cuts should further improve profit margins. Hewlett-Packard is consolidating its 85 data centers into six and sharply reducing the number of computer programs it uses to manage its business. The company estimates it is halfway toward realizing $1 billion in annual savings from these initiatives. Hewlett-Packard is a Long-Term Buy and a Focus List Buy.


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