Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

Part III. Picking Winners

Chapter 13. Emerging Sector and Industry Opportunities

IN THIS CHAPTER

Distinguishing sectors from industries

Asking questions about sectors and industries

Keeping an eye on bullish and bearish sectors and industries

Suppose that you have to bet your entire nest egg on a one-mile race. All you need to do is select a winning group. Your choices are the following:

·        Group A: Thoroughbred racehorses

·        Group B: Overweight Elvis impersonators

·        Group C: Lethargic snails

This isn’t a trick question, and you have one minute to answer. Notice that I didn’t ask you to pick a single winner out of a giant mush of horses, Elvii, and snails; I only asked you to pick the winning group in the race. The obvious answer is the thoroughbred racehorses (and no, they weren’t ridden by the overweight Elvis impersonators because that would take away from the eloquent point I’m making). In this example, even the slowest member of Group A easily outdistances the fastest member of either Group B or C.

Industries, like groups A, B, and C in my example, aren’t equal, and life isn’t fair. After all, if life were fair, Elvis would be alive, and the impersonators wouldn’t exist. Fortunately, picking stocks doesn’t have to be as difficult as picking a winning racehorse. The basic point is that it’s easier to pick a successful stock from a group of winners (a growing, vibrant industry). Understanding industries only enhances your stock-picking strategy.

A successful, long-term investor looks at the industry (or the basic sector) just as carefully as he looks at the individual stock. Luckily, choosing a winning industry to invest in is easier than choosing individual stocks, as you find out in this chapter. I know some investors who can pick a winning stock in a losing industry, and I also know investors who’ve chosen a losing stock in a winning industry (the former is far outnumbered by the latter). Just think how well you do when you choose a great stock in a great industry! Of course, if you repeatedly choose bad stocks in bad industries, you may as well get out of the stock market altogether (maybe your calling is to be a celebrity impersonator instead!).

Telling the Difference between a Sector and an Industry

Very often, investors confuse an industry with a sector. Even though it may not be a consequential confusion, some clarity is needed here.

sector is simply a group of interrelated industries. An industry is typically a category of business that performs a more precise activity; you can call an industry a subsector. Investing in a sector and investing in an industry can mean different things for the investor. The result of your investment performance can also be very different.

Healthcare is a good example of a sector that has different industries. The sector of healthcare includes such industries as pharmaceuticals, drug retailers, health insurance, hospitals, medical equipment manufacturers, and so on.

remember Healthcare is actually a good (great!) example of why you should know the distinction between a sector and an industry. Within a given sector (like healthcare), you have industries that behave differently during the same economic conditions. Some of the industries are cyclical (like medical equipment manufacturers), whereas some are defensive (like drug retailers). In a bad economy, cyclicals tend to go down while defensive stocks generally hold their value. In a good or booming economy, cyclicals do very well while defensive stocks tend to lag behind. (I talk more about cyclical and defensive industries later in this chapter.)

Given that fact, an exchange-traded fund (ETF) that reflected the general healthcare sector would be generally flat because some of the industries that went up would be offset by those that went down. Flip to Chapter 5 for more about ETFs.

Interrogating the Sectors and Industries

Your common sense is an important tool in choosing sectors and industries with winning stocks. This section explores some of the most important questions to ask yourself when you’re choosing a sector or industry.

Which category does the industry fall into?

Most industries can neatly be placed in one of two categories: cyclical or defensive. In a rough way, these categories generally translate into what society wants and what it needs. Society buys what it wants when times are good and holds off when times are bad. It buys what it needs in both good and bad times. A want is a “like to have,” whereas a need is a “must have.” Kapish?

Cyclical industries

Cyclical industries are industries whose fortunes rise and fall with the economy’s rise and fall. In other words, if the economy and the stock market are doing well, consumers and investors are confident and tend to spend and invest more money than usual, so cyclical industries tend to do well. Real estate and automobiles are great examples of cyclical industries.

Your own situation offers you some common-sense insight into the concept of cyclical industries. Think about your behavior as a consumer, and you get a revealing clue into the thinking of millions of consumers. When you (and millions of others) feel good about your career, your finances, and your future, you have a greater tendency to buy more (and/or more expensive) stuff. When people feel financially strong, they’re more apt to buy a new house or car or make some other large financial commitment. Also, people take on more debt because they feel confident that they can pay it back. In light of this behavior, what industries do you think would do well?

The same point holds for business spending. When businesses think that economic times are good and foresee continuing good times, they tend to spend more money on large purchases such as new equipment or technology. They think that when they’re doing well and are flush with financial success, it’s a good idea to reinvest that money in the business to increase future success.

Defensive industries

Defensive industries are industries that produce goods and services that are needed no matter what’s happening in the economy. Your common sense kicks in here, too. What do you buy even when times are tough? Think about what millions of people buy no matter how bad the economy gets. A good example is food — people still need to eat regardless of good or bad times. Other examples of defensive industries are utilities and healthcare.

remember In bad economic times, defensive stocks tend to do better than cyclical stocks. However, when times are good, cyclical stocks tend to do better than defensive stocks. Defensive stocks don’t do as well in good times because people don’t necessarily eat twice as much or use up more electricity.

So how do defensive stocks grow? Their growth generally relies on two factors:

·        Population growth: As more and more consumers are born, more people become available to buy.

·        New markets: A company can grow by seeking out new groups of consumers to buy its products and services. Coca-Cola, for example, found new markets in Asia during the 1990s. As communist regimes fell from power and more societies embraced a free market and consumer goods, the company sold more beverages, and its stock soared.

tip One way to invest in a particular industry is to take advantage of exchange-traded funds (ETFs), which have become very popular in recent years. ETFs are structured much like mutual funds but are fixed portfolios that trade like a stock. If you find a winning industry but you can’t find a winning stock (or don’t want to bother with the necessary research), then ETFs are a great consideration. You can find out more about ETFs at websites such as www.etfdb.com or by turning to Chapter 5.

Is the sector growing?

The question may seem obvious, but you still need to ask it before you purchase stock. The saying “the trend is your friend” applies when choosing a sector in which to invest, as long as the trend is an upward one. If you look at three different stocks that are equal in every significant way but you find that one stock is in a sector growing 15 percent per year while the other two stocks are in sectors that have either little growth or are shrinking, which stock would you choose?

warning Sometimes the stock of a financially unsound or poorly run company goes up dramatically because the sector it’s in is very exciting to the public. The most obvious example is Internet stocks from 1998–2000. Stocks such as Pets.com shot up to incredible heights because investors thought the Internet was the place to be. Sooner or later, however, the measure of a successful company is its ability to be profitable (Pets.com went bankrupt in 2000). Serious investors look at the company’s fundamentals (see Chapter 11 to find out how to do this) and the prospects for the industry’s growth before settling on a particular stock.

tip To judge how well a sector or industry is doing, various information sources monitor all the sectors and industries and measure their progress. Some reliable sources include the following:

·        MarketWatch (www.marketwatch.com)

·        Standard & Poor’s (www.standardandpoors.com)

·        Hoover’s (www.hoovers.com)

·        Yahoo! Finance (finance.yahoo.com)

·        The Wall Street Journal (www.wsj.com)

The preceding sources generally give you in-depth information about the major sectors and industries. Visit their websites to read their current research and articles along with links to relevant sites for more details. For example, The Wall Street Journal (published by Dow Jones & Co.), whose website is updated daily (or more frequently), publishes indexes for all the major sectors and industries so that you can get a useful snapshot of how well each one is doing.

tip Standard and Poor’s (S&P) Industry Survey is an excellent source of information on U.S. industries. Besides ranking and comparing industries and informing you about their current prospects, the survey also lists the top companies by size, sales, earnings, and other key information. What I like is that each industry is covered in a few pages, so you get the critical information you need without reading a novel. The survey and other S&P publications are available on the S&P website or in the business reference section of most libraries (your best bet is to head for the library because the survey is rather expensive).

Are the sector’s products or services in demand?

Look at the products and services that the sector or industry provides. Do they look like things that society will continue to want? Are there products and services on the horizon that could replace them? What does the foreseeable future look like for the sector?

remember When evaluating future demand, look for a sunrise industry — one that’s new or emerging or has promising appeal for the future. Good examples of sunrise industries in recent years are biotech and Internet companies. In contrast, a sunset industry is one that’s either declining or has little potential for growth. For example, you probably shouldn’t invest in the DVD manufacturing industry because demand is shifting toward digital delivery instead. Owning stock in a strong, profitable company in a sunrise industry is obviously the most desirable choice.

Current research unveils the following megatrends:

·        The aging of the United States: More senior citizens than ever before are living in the United States. Because of this fact, healthcare and financial services that touch on eldercare or financial concerns of the elderly will prosper.

·        Advances in high technology: Internet, telecom, medical, and biotechnology innovations will continue.

·        Security concerns: Terrorism, international tensions, and security issues on a personal level mean more attention for national defense, homeland security, and related matters.

·        Energy challenges: Traditional and nontraditional sources of energy (such as solar, fuel cells, and so on) will demand society’s attention as it transitions from fossil fuels to new forms of energy.

tip One of my favorite resources for anticipating megatrends is Gerald Celente and his Trends Journal (www.trendsresearch.com). They have been spot on with forecasting megatrends as they unfold.

What does the industry’s growth rely on?

An industry doesn’t exist in a vacuum. External factors weigh heavily on its ability to survive and thrive. Does the industry rely on an established megatrend? Then it will probably be strong for a while. Does it rely on factors that are losing relevance? Then it may begin to decline soon. Technological and demographic changes are other factors that may contribute to an industry’s growth or fall.

remember Keep in mind that a sector will either continue to grow, shrink, or be level, but individual industries can grow, shrink, or even be on a track to disappear. If a sector is expanding, you may see new industries emerge. For example, the graying of the United States is an established megatrend. As millions of Americans climb into their later years, profitable opportunities await companies that are prepared to cater to them. Perhaps an industry (subsector) offers great new medical products for senior citizens. What are the prospects for growth?

Is the industry dependent on another industry?

This twist on the prior question is a reminder that industries frequently are intertwined and can become codependent. When one industry suffers, you may find it helpful to understand which industries will subsequently suffer. The reverse can also be true — when one industry is doing well, other industries may reap the benefits.

In either case, if the stock you choose is in an industry that’s highly dependent on other industries, you should know about it. If you’re considering stocks of resort companies and you see the headlines blaring, “Airlines losing money as public stops flying,” what do you do? This type of question forces you to think logically and consider cause and effect. Logic and common sense are powerful tools that frequently trump all the number-crunching activity performed by analysts.

Who are the leading companies in the industry?

After you’ve chosen the industry, what types of companies do you want to invest in? You can choose from two basic types:

·        Established leaders: These companies are considered industry leaders or have a large share of the market. Investing in these companies is the safer way to go; what better choice for novice investors than companies that have already proven themselves?

·        Innovators: If the industry is hot and you want to be more aggressive in your approach, investigate companies that offer new products, patents, or technologies. These companies are probably smaller but have a greater potential for growth in a proven industry.

Is the industry a target of government action?

You need to know if the government is targeting an industry because intervention by politicians and bureaucrats (rightly or wrongly) can have an impact on an industry’s economic situation. Find out about any political issues that face a company, industry, or sector (see Chapter 15 for political considerations).

warning Investors need to take heed when political “noise” starts coming out about a particular industry. An industry can be hurt either by direct government intervention or by the threat of it. Intervention can take the form of lawsuits, investigations, taxes, regulations, or sometimes an outright ban. In any case, being on the wrong end of government intervention is the greatest external threat to a company’s survival.

remember Sometimes, government action helps an industry. Generally, beneficial action takes two forms:

·        Deregulation and/or tax decreases: Government sometimes reduces burdens on an industry. During the late 1990s, for example, government deregulation led the way to more innovation in the telecommunications industry. This trend, in turn, laid the groundwork for more innovation and growth in the Internet and expansion of cellphone service.

·        Direct funding: Government has the power to steer taxpayer money toward business as well. In recent years, federal and state governments have provided tax credits and other incentives for alternative energy such as solar power.

Outlining Key Sectors and Industries

In this section, I highlight some sectors and industries that investors should take note of. Consider investing some of your stock portfolio in those that look promising (and, of course, avoid those that look problematic).

remember Many investors can benefit from a practice referred to as sector rotation (not quite like crop rotation, but close enough). The idea is that you shift money from one sector to another based on current or expectant economic conditions. There are a number of variations of this concept, but in most cases, they follow some essential ideas. If the economy is doing poorly or if the outlook appears bearish, you shift to defensive sectors such as consumer staples and utilities. If the economy is doing well, you shift money to cyclicals such as technology and base materials. Given today’s problematic economic conditions, sector rotation makes sense and is worth a look by long-term investors. Find out more using the resources I mention in the earlier section “Is the sector growing?” and in Appendix A.

Moving in: Real estate

I include real estate as a key sector because it’s a cyclical bellwether industry — one that has a great effect on many other industries that may be dependent on it. Real estate is looked at as a key component of economic health because so many other industries — including building materials, mortgages, household appliances, and contract labor services — are tied to it. A booming real estate industry bodes well for much of the economy.

Housing starts are one way to measure real estate activity. This data is an important leading indicator of health in the industry. Housing starts indicate new construction, which means more business for related industries.

tip Keep an eye on the real estate industry for negative news that could be bearish for the economy and the stock market. Because real estate is purchased with mortgage money, investors and analysts watch the mortgage market for trouble signs such as rising delinquencies and foreclosures. These statistics serve as a warning for general economic weakness.

In recent years, the real estate mania hit its zenith during 2005–2006. A mania is typically the final (and craziest) part of a mature bull market. In a mania, the prices of the assets experiencing the bull market (such as stock or real estate) skyrocket to extreme levels, which excites more and more investors to jump in, causing prices to rise even further. It gets to the point where seemingly everyone thinks that it’s easy to get rich by buying this particular asset, and almost no one notices that the market has become unsustainable. After prices are exhausted and start to level off, investor excitement dies down, and then investors try to exit by selling their holdings to realize some profit. As more and more sell off their holdings, demand decreases while supply increases. The mania dissipates, and the bear market appears. This is definitely what happened to real estate in 2007–2008, when the industry fell on hard times as the housing bubble popped.

The real estate industry first soared during 2000–2006 and then cratered during 2007–2012. As I write this, the real estate industry is stabilizing after several very difficult years. As you read this, the industry may very well start its path to normalization. Whether you’re a real estate investor or a stock investor looking at real estate–related companies and industries, it’s probably an appropriate time to see a slow return to normalization for the real estate world.

If you want to invest in real estate, start looking for companies that are showing consistent profits and taking advantage in a rebounding sector. Although the sector may not be out of the woods yet, the opportunities do outnumber the pitfalls. Stay tuned and do your homework (research) here.

Driving it home: Automotive

Cars are big-ticket items and are another barometer of people’s economic well-being — people buy new cars when they’re doing well financially (or at least perceive that they’re well-off). A rise in car sales is usually considered to be a positive indicator for the economy.

warning The automotive sector is still feeling its way. Although the government has used taxpayer funds to rescue some individual companies (such as General Motors), the automotive industry is still not on a healthy track despite the fact that it had record sales in 2015. The reason is that a huge percentage of those auto sales were due to subpar or subprime debt that was eerily similar to the subprime debt from the housing bubble. Some of these auto loans were for 84 months (a seven-year auto loan!), which is a bad idea for a depreciating asset that requires substantial repairs after five years of wear and tear. In other words, expect problems for the auto industry during 2016–2017.

Talking tech: Computers and related electronics

In recent years, technology stocks have become very popular with investors. Indeed, technology is a great sector, and its impact on the economy’s present and future success can’t be underestimated. The share price of technology companies can rise substantially because investors buy shares based on expectations — today’s untested, unproven companies may become the Googles and Apples of tomorrow.

With the success of Apple as it forges a path in the world of personal electronics (such as the iPhone and related technology), this area will continue to show growth as worldwide consumer demand continues to show strength. Don’t lose sight of the fundamentals as this industry continues to mature.

warning In spite of the sector’s potential, companies can still fail if customers don’t embrace their products. Even in technology stocks, you still must apply the rules and guidelines about financially successful companies that I discuss throughout this book. Pick the best in a growing industry and you’ll succeed over the long haul.

Banking on it: Financials

Banking and financial services are intrinsic parts of any economy. Debt is the most important sign of this industry for investors. If a company’s debt is growing faster than the economy, you need to watch how that debt impacts stocks and mutual funds. If debt gets out of control, it can be disastrous for the economy.

As one of my favorite credit specialists, Doug Noland, points out (he writes the Credit Bubble Bulletin at www.creditbubblebulletin.blogspot.com), the amount of debt and debt-related securities recently reached historic and troublesome levels. This trend means that many financial stocks are at risk if a recession hits anytime soon.

warning As this book goes to press, financial stocks have emerged from a tough period of troubles in subprime debt and related difficulties. Because this is an area susceptible to debt troubles, problems will persist during 2016–2017. Investors should be very selective in this industry and should embrace only those lenders that are conservative in their balance sheet and are generally avoiding overexposure in areas such as international finance and derivatives.