Play Sectors, Get Burned

1/16/2017


How did the market perform in 2016? The simple answer is that the S&P 500 Index gained 3.8% in the first half and 7.6% in the second half, combining for a full-year increase of nearly 12%. A solid showing.

Of course, a more nuanced answer to the question depends on your perspective, because most people don't simply buy and hold the market. As the chart below suggests, the sectors you buy and when you buy them matter. For example:

• Investor Smith was nervous about stocks at the start of the year, so he went conservative, sinking all his money into the three sectors perceived as the most defensive (consumer staples, telecom, and utilities), and the beaten-down energy sector. Then, at the end of June, he felt the call of the economy and moved into economically sensitive sectors (consumer discretionary, financials, industrials, materials, and technology.

Assuming Smith indulged his sector preferences using equal-weighted positions in the S&P Sector SPDR exchange-traded funds or other funds tracking the sector indexes, he'd have seen his portfolio return about 19% in the first half and about 13% in the second half, for an impressive 2016 gain of more than 30%.

• Investor Jones, on the other hand, felt bullish at the start of the year, then got nervous in June, reversing Smith's strategy. He earned about 2% in the first half and lost a little money in the second half.

Yes, the index performed fairly well last year. But if you guess wrong about which sectors to own, you can generate poor results even when stocks behave well. The fates of Smith and Jones illustrate why — even though the Forecasts sometimes ends up with sector weightings that vary widely from the S&P 500 — we don't sell out of cyclicals or drop defensives in an effort to time market moves. We prefer, instead, to let the stocks themselves tell us what to buy — which brings us to the table below.

CYCLICALS EARN THE TOP QUADRIX SCORES
Of the five S&P 1500 Index sectors with Overall scores averaging at least 58, four (consumer discretionary, financials, industrials, and technology) tend to be economically sensitive. On the other hand, defensive sectors such as consumer staples, telecom, and utilities average Overall scores well below the index average of 59. These numbers suggest cyclicals have stronger fundamentals than noncyclicals. They also tend to be cheaper, with economically sensitive sectors accounting for four of the top five in terms of Value score.
S&P 1500 Sector
(Number Of Cos.)
Momen-
tum
Value
Quality
Financial
Strength
Earnings
Estimates
Perfor-
mance
Overall
Cons. discret. (251)
52
70
74
57
42
46
69
Consumer staples (70)
50
54
69
58
33
33
53
Energy (84)
27
35
22
29
52
64
26
Financials (213)
58
60
65
75
67
72
72
Health care (166)
56
55
69
58
44
35
58
Industrials (233)
45
57
67
56
46
63
59
Materials (93)
44
56
57
47
45
63
54
Real Estate (97)
48
38
61
57
44
39
43
Technology (224)
57
50
63
61
52
56
58
Telecom Services (15)
41
55
50
61
45
56
50
Utilities (54)
51
62
45
63
58
34
52
S&P 1500 (1,500)
51
56
63
58
49
53
59
Note: Quadrix scores are percentile ranks, with 100 the best.

At the moment, economically sensitive sectors have a lot to offer, with strong Quadrix scores and a rich selection of high-ranking stocks. Not surprisingly, we recommend a number of stocks from those sectors; below we discuss three of those stocks. For more on how we approach sectors, see the story below.

Lear ($144; LEA), an auto-parts maker, is our top selection in the consumer-discretionary sector. The company, which earns a Quadrix Overall score of 100, announced encouraging guidance on Jan. 10. Lear expects 2017 revenue of $19.5 billion, up 4%, topping the consensus of $19.3 billion at the time of the announcement. Lear also projected income and free cash flow slightly above market expectations. Perhaps the most encouraging news involves the sales backlog of $2.8 billion for the period from 2017 through 2019, well above earlier numbers.

The company offered an ebullient take on long-term growth, projecting its global market share in seating to reach 27% in 2021, up from 22% in 2016. Lear's market share in luxury cars, which average $1,500 in content per vehicle versus $700 for all cars, is a robust 38% and expanding. The consensus projects per-share-profit growth of 8% in the December quarter and 7% next year, targets Lear should be able to beat. Yet the shares trade at just 10 times expected 2017 earnings, 29% below the industry median. Lear, a Focus List Buy and Long-Term Buy, plans to announce December-quarter results Jan. 26.


Shares of Southwest Airlines ($52; LUV) jumped after the company issued better-than-expected projections for December-quarter unit revenue on Jan. 10. Citing an improvement in prices for flights booked on short notice, the company estimated a 3% to 4% decline in unit revenue, versus earlier expectations of a 4% to 5% drop. In December, traffic rose 4.2% while capacity increased 4.8%.

Over the last 12 months, Southwest grew its sales 5%, per-share profits 32%, and operating cash flow 25%. Such growth is not sustainable, considering pressures on fuel and labor costs. However, the consensus calls for roughly flat per-share profits on 6% higher sales next year. Any leverage Southwest can gain on costs or pricing could yield upside to market expectations. Southwest trades at 13 times trailing earnings, 21% above the industry average but 20% below its own three-year average. The stock is a Focus List Buy and a Long-Term Buy.


Riding a wave of enthusiasm regarding interest-rate hikes and economic improvement, Zions Bancorp ($44; ZION) has jumped 35% since Election Day, above the average of 28% for financial stocks in the S&P 1500. Even after that gain, the shares appear reasonably valued. Zions trades at 18 times the 2017 profit consensus, in line with the typical regional bank despite its superior growth profile. Analysts expect Zions to grow per-share profits 25% next year and 14% annually over the next five years, well above the respective industry averages of 11% and 5%.

Zions is ramping up its efforts to sell mortgages and specialty loans, estimating that an increase of 0.25% in short-term interest rates would add $25 million to $30 million to annual net interest income, or roughly 1.5% to 1.7%. Fed funds futures project a 71% chance of at least a 0.25% hike by the end of July and a 26% chance of a rise of 0.5% or more. Zions, which plans to release December-quarter results Jan. 23, is a Focus List Buy and a Long-Term Buy.

TOP STOCKS IN FIVE SECTORS
12-Month
---- Growth ----
Expected Profit
--- Growth ---
------------------------- Quadrix Scores -------------------------
Company (Price; Ticker)
Div.
($)
Yield
(%)
Sales
(%)
Per-
Share
Profits
(%)
Curr.
Year
(%)
Next
Year
(%)
Trailing
P/E
Ratio
Momen-
tum
Value
Quality
Overall
12-
Factor
Sector
Reranked
Overall
Consumer discretionary
CBS ($63; CBS)
0.72
1.1
6
24
25
7
16
71
78
89
96
88
94
Lear ($144; LEA)
1.20
0.8
3
23
26
7
11
84
96
94
100
96
99
Mohawk Industries
($202; MHK)
0.00
0.0
9
25
23
5
17
69
80
94
95
31
86
Financials
Citizens Financial
($36; CFG)
0.48
1.3
8
16
18
17
20
93
73
60
97
53
87
J.P. Morgan Chase
($87; JPM)
1.92
2.2
3
(11)
(2)
9
15
65
72
56
89
62
75
Zions Bancorp
($44; ZION)
0.32
0.7
11
63
20
24
24
95
53
70
93
91
70
Health care
Biogen ($287; BIIB)
0.00
0.0
8
19
19
4
15
57
84
98
95
54
95
LabCorp Of America
($135; LH)
0.00
0.0
21
11
11
9
16
40
85
74
72
68
78
QuintilesIMS ($77; Q)
0.00
0.0
8
20
17
15
21
78
65
95
87
36
81
Industrials
FedEx ($189; FDX)
1.60
0.8
14
53
11
13
17
66
74
80
77
77
73
Owens Corning
($52; OC)
0.80
1.5
5
35
36
4
14
76
94
88
95
98
97
Southwest Airlines
($52; LUV)
0.40
0.8
5
32
4
0
13
50
86
98
92
50
89
Technology
Alphabet
($830; GOOGL)
0.00
0.0
19
29
18
19
25
93
45
97
88
85
84
F5 Networks
($144; FFIV)
0.00
0.0
4
9
13
11
20
80
61
95
95
82
95
Lam Research
($109; LRCX)
1.80
1.7
4
9
28
(2)
17
81
74
88
94
82
96
Note: Quadrix scores are percentile ranks, with 100 the best.

 


Quadrix drives sector weightings

At the moment, our Buy and Focus lists hold substantially more consumer discretionary and technology than the broad S&P 1500 Index. Our Focus List also overweights industrials. The sectors share three characteristics that help explain why we own so many stocks in those groups:

1) Size. The S&P 1500 contains more than 200 stocks in each of these three sectors, allowing plenty of choices. Every sector has a mix of eagles and turkeys, and it stands to reason that in a big sector, you'll find more eagles.

2) Solid fundamentals. Consumer-discretionary stocks average Quadrix Overall scores of 69, second-highest among the sectors. Industrials (59) and technology (58) are also among the top five sectors in Overall score.

3) No glaring weaknesses. For all three sectors, average scores for all six Quadrix categories are above 50. Overall, these fundamentally solid sectors offer the type of platform to support a strong portfolio.

We own larger positions in the consumer-discretionary, industrials, and technology sectors than the market not because we're making a bold call on the appeal of the sectors, but because we find plenty of individual stocks worth buying on their own merits.


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