Market euphoria is a good thing. Particularly if it’s based on solid facts, like a strong earnings season and steadily increasing estimates.
Because no matter how wonderful a company seems to be and however much management talks up its prospects, it’s the numbers that tell the real story.
The only problem is that when the numbers continue to tell a positive story, the sentiment turns excessively bullish, which leads to crazy valuations. And then it becomes harder and harder to find a story with more upside.
So then how should you pick stocks, if everything seems to be going on up, up and up?
One way is to consider undervalued sectors at any given time. Like for example, the construction, finance, basic materials, oil-energy, consumer staples and utilities sectors that are all attractively valued at this time.
After that, we could try to figure out if there’s a good reason for the undervaluation-
The Construction sector is booming at the moment, as the pandemic and historically low mortgage rates further built on favorable demographic trends. Inventories remain low and builders are busy securing land. So prices aren’t keeping up with earnings estimates at the moment.
Finance is another sector that does well in an expanding economy although low interest rates directly impact earnings. The pandemic and the resultant impact on interest rates pushed down prospects and valuations in this segment. However, with economic activity picking up, things are beginning to look good. At the same time, valuations are still attractive.
The Basic Materials sector consists of mining, paper, chemicals, non-ferrous metals, steel and agribusiness companies. It stands to reason then that they are likely to do better in expanding economies with robust manufacturing operations. So the vaccination of the population and the opening up of the economy should spur growth in this sector this year. So this is another example of relatively low valuations for the right reasons.
The Oil-Energy sector has turned up over the last few months mainly because of stronger pricing. On the one hand, the vaccine announcement spurred expectations about travel while on the other, environmental factors kept the lid on production. If travel does pick up as expected, there would be an inventory issue, which would further drive prices. So analysts are expecting earnings growth, but there’s more of a risk here.
The Consumer Staples sector represents companies that sell products with inelastic demand. Food, beverages, everyday household supplies are things we couldn’t stop consuming even in difficult economic conditions. This means that companies in the sector experience more or less steady demand and slow growth over several years.
So they are more favored in down markets and recessionary conditions because their demand will remain steady. In bull markets (such as now), they are usually not favored because the market will grow stronger. However, some of these players are large and pay an attractive dividend, so they are worth adding to your portfolio when valuations are attractive.
Like the Finance sector, the Utilities sector is heavily regulated because it provides basic public services like electricity, gas, etc. And like the Consumer Staples sector, demand is relatively inelastic. Therefore, the companies generate relatively steady revenue and grow gradually over time. They usually pay dividends that encourage investors to stick with their heavily capital intensive and therefore, debt-ridden businesses.
This is another sector that offers defensive options in a recession and limited opportunity in an expanding economy, which again keeps valuation down. If you’re looking for income, this could be just the right time to add some attractively valued utilities to your portfolio.
The next step is to find winning stocks and for that it’s best to stick to the basics. Find some top-ranked industries within these sectors and some top-ranked stocks within these industries. Add a Value Score A for good measure. My search revealed the following-
In Construction – BCC, BZH, CCS, KBH, MHO
In Finance – There are too many here, I’m just mentioning a few: AMG, AMP, COWN, ENVA, JEF
In Basic Materials – CLW, GGB, MT, NGLOY, X
In Oil-Energy – ARLP, CEO, HPR, SNP, SSL
In Consumer Staples – IBA, MATW, NUS, PPC
In Utilities – MDU, TDS
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