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Searching by sectors: looking at the economy for good buys

A sector-by-sector analysis of the economy can help you identify good stocks to buy, says this Canadian advisory, but it’s only a first step.

Here’s an investment argument that never seems to run out of gas. Do you look first at the big picture? Or just at individual stocks?

Are you better off looking to see which parts of the economy are bound to do well and picking stocks accordingly? Or is it preferable to just search for good individual stocks that look like they’re going to grow?

Let’s put it a slightly different way: you like a natural gas company, but it looks as though the price of natural gas will stay soft. Are you willing to hold the stock, collect the dividends and wait for the capital gains to pile up later? Or would you rather dump that one and buy an engineering stock because it looks like that industry is in for a rich payoff with projects piling up around the globe? Or, are you willing to do both?

There’s no right or wrong answer (although you could probably walk into a Bay Street watering hole and start a fight on the subject pretty quickly). The only right answer to any investment question is that the stocks you picked did good and made money.

Either way, it certainly doesn’t hurt to know what’s going on in the various sectors of the economy, especially in times like these. That’s what we’ll do today with the help of one of Canada’s most venerable advisories, The Investment Reporter.

Once it has dissected the different sectors of the economy, the advisory turns to a specific area to offer some buys — and a hold.

Don’t ignore any of them

Studying sectors isn’t just a way to see where good stocks might be, but a way to sort them according to your own concerns.

“If you’re a conservative, income-seeking investor, focus on banks and utilities,” says this advisory. “If you’re an aggressive investor, include more manufacturing and resource stocks.”

But don’t overload on one or two sectors, and don’t ignore any of them. The advisory believes investors should keep at least 10 per cent, but no more than 30 per cent, in each of the five main economic sectors: Financial, Utilities, Manufacturing, Consumer and Resources.

Always keep in mind that stocks can perform pretty raggedly even within a favoured sector. Last year, for instance, when the price of gold went on a record rip, the natural expectation was that gold stocks would take off. A few large firms obliged, but many more chugged along at a very disappointing pace.

The Investment Reporter gives us a quick overview of each of the five sectors, and their sub-sectors, and then elaborates.

The whole economy

Here’s the quick overview of the whole economy for the next six to twelve months.

In the Financial sector, two groups — banks and trusts and investment and fund companies — are expected to underperform the market in the wake of the credit crisis. Insurance companies should do better, and match the market.

All three Utilities groups — gas and electrical, pipelines and telephones — should outperform the market.

Among Manufacturing stocks, two — chemicals and engineering stocks — get the full thumbs up as outperformers. Transportation and steel stocks should match the market. But building materials, fabricators and technology stocks all look like underperformers.

The so-called consumer staples stocks — food, beverages and tobacco — should outperform the market. But other Consumer stocks don’t get quite the same rating: merchandising stocks (retail stores) should match the market, but communications and health care are due to underperform.

Three Resource groups — gold and precious metals, oil and gas, and metals and minerals — should all outperform. The last group, paper and forest products, appears to be in for another year of underperformance.

The reasons why

Now let’s see the reasons why these things should come to pass.

The banks, of course, are still digging out from under the mess left by the subprime mortgage crisis in the U.S. and the other unpleasant affects of collateralized debt obligations. Lower interest rates and a steeper yield curve can’t offset these problems entirely.

Insurance companies have suffered fewer investment losses, and they’re expanding rapidly in developing countries. They’re in better shape.

The advisory’s overview on utilities does have one caveat. “We now expect gas, electricity and telephone utilities plus pipelines to beat the market. Lower rates raise profits. And they give investors safety and solid dividends. This assumes that BCE gets taken over.”

Among manufacturers, building materials face the spectre of continued trouble in the U.S. housing market. Chemical stocks, on the other hand, have one big advantage — the worldwide demand for fertilizer.

Many fabricating stocks (that bit of jargon basically stands for factories that make stuff) are still facing high commodity prices. But some are due to prosper, as we will see a little later.

Roads, bridges, airports

Engineering stocks are in a strong position, as roads, bridges, airports, stadiums and other pieces of infrastructure get built and re-built around the world. For much the same reason, steel stocks should match the market, although they suffer more from the affects of the high loonie. Even as the economy slows down, exports are still due to rise, so transportation stocks should also do O.K.

Most technology stocks just don’t do well in troubled markets. Costs are high and a retrenching market presents stiff challenges for stocks that are still building market share.

Communications stocks will suffer because ad revenue sags during a weaker economy. What the advisory calls “unproven health care stocks” should slip back, too. Retailers in general will do well to match the market. But the old saw that everyone has to eat and drink should help food, beverage and tobacco stocks beat the market (everyone doesn’t have to smoke, of course, but tobacco stocks generally do well in times like these).

Setting aside the disappointments of last year, gold stocks should do well. This is not simply related to a flight to gold for safety. Gold is much prized for jewellery and decoration in China, India and the Middle East, and as the middle class grows, so does the demand.

Oil and gas stocks will reap the rewards of high prices and no perceptible fall-off in world demand. Mining stocks are bound to do well, too: supplies are tightening and demand in developing countries is not letting up. Forestry stocks are due to trail the market yet again: demand is low and declining. Neither low share prices nor consolidation within the industry can turn these stocks into bargains.

So now you know what every industry in Canada will do in the next year. Now if you knew that every stock in the industry was going to follow suit, it would be child’s play to rake in incredible profits in the months ahead.

But stocks in a particular industry are a bit like kids: they may all be raised in the same conditions, but some of them turn out better than others.

The Investment Reporter illustrates with stocks from the metals industry. The stocks in question actually cover two sectors, Manufacturing and Resources.

Starting with steel

The advisory takes a close look at steel and mining stocks. So we’re looking at those who get the metals out of the ground and those who turn finished steel into structural metal and platework. But not so much the middlemen: as Stelco and Dofasco have disappeared, independent steelmakers have virtually retreated from the Canadian stage.

Let’s start at the end, with the finished products. The so-called infrastructure revolution is generally held to be a boon for the companies that oversee the building or re-building (engineering firms) and those who make the materials required (steel fabricators, among others).

Sure enough, this advisory has two buys among steel firms: Canam Group (TSX-CAM) and Gerdau Ameristeel (TSX-GNA). But not all fabricators get the same shining review.

Samuel Manu-Tech (TSX-SMT), one of Canada’s best-known steel firms, is a hold. It was hurt by the fall in U.S. housing market. It was hurt by the rising loonie. Its debt is too high for the advisory’s liking, and it failed to raise its dividend this year. The company does trade at less than book value, which is one bright spot.

But no matter how much infrastructure gets built in the months ahead, this stock remains a hold for conservative investors, says the advisory.

One more steel note: as the big Canadian steel makers have faded from the scene, two American steelmakers, US Steel (NYSE-X) and Nucor Corp. (NYSE-NUE) have earned a place on this advisory’s buy list.

The prospects for base metals

In the mining industry, there has been a mini-crisis. After a long bull market in commodities, base metal prices have slackened. But it looks like a short-term setback, says the advisory. The general demand for commodities has not petered out.

With these prospects in mind, the advisory has added a new buy to its mining list. Lundin Mining (TSX-LUN) produces copper, lead, nickel and silver. Up to now, it has chugged along nicely with mines in stable corners of the globe: one in Ireland, two in Portugal, one in Spain and two in Sweden.

Now it’s moving into less stable, but potentially very lucrative territory. It has a stake in a big copper and cobalt project in the mining-rich Democratic Republic of Congo. It’s also getting involved in a zinc project in Russia. Production at Lundin’s existing mines is forging ahead: in 2008 it should produce 92,000 tonnes of copper, 202,000 tonnes of zinc, 6,800 tonnes of nickel and 47,000 tonnes of lead. And the Congo should start producing in 2009.

The company has plenty of cash (it pays no dividends, so it saves there) and it has bought back almost 20 million of its own shares. The advisory fully expects Lundin’s sales and profits to rise in the years ahead.

Two standbys are also on the buy list. One is Teck Cominco (TSX-TCK.B), now Canada’s largest mining company. Besides price worries, Teck has had a few other setbacks of late, including the much-discussed suspension of activities at the Galore Creek copper and gold project. But it is an obvious winner as long as demand for commodities stays high.

HudBay Minerals (TSX-HBM) has fallen some 26 per cent over the last six months. But, says the advisory, “demand is rising as industrializing nations increase their consumption of base metals.” Like Teck, HudBay digs a variety of minerals out of the ground, including zinc, copper, gold and silver. And like Teck, it’s due to prosper in the long run. And since this issue was published, HudBay’s new CEO has been promising a more aggressive stance with the company’s cash, including possible takeovers.

So when you look at this corner of the economy, ignore what has happened in the past few months and look ahead, says The Investment Reporter. “Industrialized countries in Asia such as China and India are a large source of new demand for base metals. Their growing exports to the U.S. require base metals. When domestic demand in the U.S. recovers, base metals should jump. Particularly since supply is unlikely to keep up with demand.”

We’re not going to settle any big-picture vs. individual stock arguments here. But it certainly doesn’t seem like a bad idea to know which sectors are liable to do best in the months ahead. If you can then identify the best stocks in those sectors, you’re probably headed in the right direction.