How to Find Sectors That Will Outperform

I was intrigued by this Investopedia Article on valuing industry sectors. 
In an analysis of industry sectors it makes sense to use the same criteria we use for individual companies. This being said, it doesn't make sense to compare every multiple across sectors (mining operations and tech firms are going to have very different 'norms'). We can however narrow our analysis to 3 universal criteria: Price to Earnings (P/E), Price to Earnings Growth (PEG), and Net Profit Margin. This will show us which sectors are undervalued, expected to grow, and their ability to turn sales into profit.

What i've done here is ranked each sector (including the S&P 500) in each category from 1-11, then averaged the scores across the 3 criteria. Here we're assuming the lower the P/E and PEG the better, and the higher the profit margin the better. And of course the lower the average score the better.

The results show why fund managers consistently cannot beat the S&P, it ranked 3rd overall meaning only Energy and Healthcare are better positioned to outperform the index. I've highlighted the Consumer Discretionary sector because it is what is currently being advocated the most, yet on average it ranked the worst. With extremely low profit margins and expected earnings growth to be minimal over the next 5 years perhaps we should ignore our better judgement and avoid this sector. Often in a recession fund managers advise to stay with companies that provide consistent returns on simple products, but the numbers don't lie.

While I didn't highlight it, both tech and financials scored well. Financials are of particular interest considering they're what receive the most press (good or bad). I think it's likely that the sector has been punished to a point where financials have no where to go but up; that is if we choose stable institutions as opposed to speculating on Citigroup (C) for example.

Bottom line: Energy and healthcare look ready to outperform. Tech and financials are also attractive. If you can't stomach the risk, buy the S&P, simple as that.

Companies with Stability, Profitability, and Dividends

I'm a big fan of the google stock screener; it's simple and allows you to quickly screen companies based on desired fundamentals. For this screen I was looking for dividend plays with the potential for modest outperformance in the future. These are large caps that provide necessary products/services, aren't going to drop 10% tomorrow, and have a healthy dividend.

Screener Results

I've set a debt/equity ratio of 50% and minimum interest coverage of 2x to weed out unstable businesses. There is also a max 20 P/E to ensure our companies aren't significantly over-valued and a minimum net profit margin of 10% to demonstrate they are profitable.

When looking through the list you should first recognize the 'house hold' names. These would include 3M, Johnson and Johnson (JNJ), Mastercard (MA), and Procter and Gamble (PG). Their average dividend yield is 2.27%, without Mastercard it's closer to 3%. This may not seem like much but it beats inflation and the potential upside for these businesses is still something to consider.

Of the above mentioned my pick is Johnson and Johnson (JNJ). Compared to Mastercard, 3M, and Procter and Gamble it's got the highest net profit margin and the lowest P/E. It's also a classic Buffet holding.

Good luck on the hunt for those safe blue chips, its not as hard as you may think.