Recession-beating sectors

How we got here

Financial stocks, the mother and father of the global downturn in equity values, are weak and getting weaker. And the contagion resulting from a rush to achieve high returns in a world of low inflation and low interest rates that prevailed 18 months ago has now spread to outside the banking sector. Banks have no money after writing off billions of pounds on exotic and dubious credit packages, financial instruments and profligate lending, and so they are unwilling or unable to raise money in the wholesale market. At the same time, they remain hard pressed to oil the wheels of commerce by making funds readily available for companies to invest. As a result, the bad apple has affected the rest of the bunch. Consumers, already over their heads in easily available and cheap debt, have compounded their woes by remortaging their houses, whose values were rising at unsustainable rates.

So the economy is in trouble. Banks won't lend money, consumers can't afford to repay what they already owe, house prices are falling and consumer spending is drying up. So it's not looking good for most companies that reside in the financial, retailing, advertising, media, construction, housebuilding, leisure and entertainment sectors. However, it is not all gloom. For investors, the stock market provides a wonderful conduit to invest money now to take advantage of what is expected to happen some way down the line. After all, share prices are supposed to reflect what seems likely to be the trend some way ahead. By the same token, it is a moot point as to whether current valuations have priced in the extent of the downturn in corporate earnings before the next recovery begins.

But which sectors and companies can you rely on going forward? In '', John Hughman finds out which sectors perform best and worst at different stages of the economic cycle. But generally, chart patterns can help as can any measure of financial performance such as price-earnings (PE) ratios, cash generation and, of course, profits. Gut feeling and common sense play an extremely useful part, too. For example, housebuilders trading on PE ratios of three are supposed to be cheap, but are they? Sure, the share price has fallen from 900p to 90p, but that doesn't mean to say that it cannot fall to 9p before recovering, or even going bust.

For the investor with a portfolio of shares spread across the full spectrum of high-risk/high-growth all the way to lower-risk/lower-return, the events of the past six months have proved to be chaotic. Investing heavily in ‘safe’ high-street banks has turned out to be a disaster, while taking a gamble on a mining company with assets of little more than a map and two shovels has turned out to be a spectacular success. Taken one step further, demand for oil and food has not doubled in the last year, but commodity prices have, as the fashionable rationale is that China and Brazil will gobble up any spare capacity in raw materials for the foreseeable future. Not many people have given much thought to the fact that rising prices will ultimately make the western world less reliant on these commodities, while the emerging nations are building empires at phenomenal speed that are entirely reliant on diminishing assets that are commanding ever higher prices.

So the bad news is that there will be a global slump, with high inflation. The better news is that when all the analysts, market watchers and armchair punters agree on a set course of events, it is almost certain that they will not happen.

Hedge funds and asset managers have to make money in tough times otherwise they lose customers, their money and ultimately their jobs. And in these troubled times, flexibility is the key. Stepping outside the equity market can deliver spectacular results. For example, a lot of money has been made this year buying agricultural land. Prices have gone through the roof since the drive for biofuel has driven up the cost of food materials. Farmers in predominantly sheep-rearing areas are even getting in on the act by ploughing up pasture to plant crops. For the average investor, though, these avenues are not readily open – although Aim-traded Landkom is busy buying up chunks of land in western Ukraine with a view to having 350,000 hectares under cultivation by 2011.

Winners and losers

Valuing potential investment opportunities sector by sector has some merit, but there remains a broad divergence of performances within each sector. By and large, the usual ground rules apply, whereby the companies most likely to best survive the economic downturn will have a low level of financial and operational gearing, reliable cash flows and – perhaps most important of all – a progressive and sustainable dividend policy. If shareholders have to resign themselves to watching share prices underperform as a result of macroeconomic downward pressures, they should at least be able to take some comfort from a decent dividend payout.

Taking the battered banks as an example, the sector continues to suffer from the effects of the credit crunch. Most worrying is the pressure on future earnings as highly indebted consumers are hit by rising unemployment and falling house values. Most of the big names have been obliged to go cap in hand to their shareholders for funds to prop up balance sheets ravaged by write-offs. But some are much better placed to ride out the storm. So, while Bradford & Bingley is probably best avoided, a bank such as HSBC, with its broader geographical diversity of revenue streams, offers the most defensive qualities.

This strategy of trying to pick up the stocks that are most likely to rise strongly from the ashes of recession has advantages over the more conventional ploy of switching into classic defensive stocks such as utilities. Yes, we'll always need water and electricity, but a lot of money has already found its way into this sector, and there must be a question mark over how much longer utility providers can continue to pass on double-digit price increases to financially hard-pressed customers.

And it would be wise not to be seduced by the soothing words offered by some about a particular sector's undervaluation at current prices. Conventional valuation measures are sometimes of little use. Take a company that offers a 30 per cent dividend yield and trades on a PE ratio of less than one. Does this make it undervalued? Worth buying? Well, in the case of Barratt Developments, where these valuations apply, the answer is probably no. If unemployment continues to rise at the same time as lenders pull up the drawbridge on mortgages, then housebuilders will operate at a loss. There will be no PE ratio and, more likely than not, no dividend either. The trick is to pick those that will still be here in the long term.

So, which other sectors look like offering some sort of shelter? On current form there is very little reason to expect any material improvement in the overall market. Of the 31 FTSE 350 sub-sectors, only seven have shown a rise over the past 12 months. Over the past six months, this came down to six and, in the past month, we’re down to just five.

Electricity suppliers

The top-performing sector was electricity suppliers, which is not surprising given the wall of money that has found its way into the sector. But, even without that, the dramatic rise in oil and gas prices has focused attention on future energy sources and, despite some dragging of feet, the government has finally conceded that nuclear power has a significant part to play in electricity generation. So, regardless of its collection of clapped-out power stations and persistent disruptions to output, British Energy has been attracting a lot of attention from potential bidders. The main reason behind this is that the company owns some of the really plum sites for potential construction of nuclear power stations and, once the government can convince private investors of its commitment to a long-term investment programme, British Energy should benefit nicely.

Chemicals

The chemical sector is another winning area, although there should be a note of caution here. Its performance in the past 12, six and one months has been plus 36 per cent, plus 16 per cent and plus 6 per cent. And analysts at Charles Stanley are cutting back their earnings estimates in the face of rising input cost pressures and slowing global demand, particularly in the US and Europe. So Croda is perhaps the star performer in a sector now reduced to just three major players – it has performed well, especially in the wake of its Uniqema acquisition from ICI.

Industrial engineering

Industrial engineering companies have risen in the past one and six months but for medium-sized engineering companies such as IMI, Weir and Bodycote, the economic outlook is making life more difficult by the day and, if the possibility of takeover activity were taken out of the equation, there would probably be little positive performance to talk about.

One of our preferred plays in this sector is marine engineer Hamworthy, which provides equipment for the liquefied natural gas market.

Healthcare equipment and services

Healthcare equipment and services is an interesting sector, too, because having underperformed over the past 12 and six months, it showed positive progress in the past month. But there is a catch. The sector is dominated by Smith & Nephew which, ironically, has been having a rather torrid time of things lately after admitting to unacceptable sales practices at Plus Orthopedics, a Swiss company purchased last year. The upshot is that it will lose around £50m in sales this year. That said, the shares have moved higher recently on rumours that there could be some interest from private equity in financing a bid for the company. For more on the healthcare sector, see article ''.

Other utilities

And last but not least come the other utilities such as gas and water. These have only featured as outperformers quite recently, although with revenues linked to inflation there is a comforting level of earnings visibility. The downside is that regulator Ofgem has launched an enquiry into rising gas and electricity prices, and the government has commissioned a new study into whether it would be feasible to open up household water supplies to competition.

The best of the rest

So that leaves plenty of sectors that have lost ground but could provide an investment opportunity. The most obvious absentee from the outperformers is the miners. These shares are the top performers over the past 12 months and have also risen over the past six months. Since then, the wheels have come off the trolley.

Take Rio Tinto, for example, which was the subject of a hostile approach from rival BHP Billiton. Having secured a near-doubling in ore prices the outlook should be rosy, but since peaking at £71 in May the shares have collapsed 24 per cent to around £54. Part of this can be put down to rising resistance to the merger and the real possibility of one of the many regulatory bodies involved vetoing the deal. There is also some concern that even this buoyant sector will be unable to shrug off the effects of a global economic slowdown. True, we appear to be short of all the important elements dug out of the ground, but the sector has had a spectacular run and, while there may be some mileage yet, commodities are cyclical.

Tobacco companies are also a good defensive option. Good performers over the past 12 and six months, their shares have been hit more recently to some extent by further calls for measures to curb youth smoking. But tobacco producers can make up for resistance in developed countries by increasing sales in emerging nations where there are fewer laws on smoking. As long as cigarettes remain legal, tobacco companies will offer good defensive qualities.

Finally, shares in aerospace and defence companies should hold up well in a recession. Although the civil aerospace market might suffer, the defence market is protected by long-term government contracts. The situation this time around is clouded by the forthcoming US presidential election, the winner of which might be less interested in defence spending. Nevertheless, companies with a good global spread or a strong market niche should prosper. Our favourites in this sector include defence technology specialist Qinetiq and countermeasures maker Chemring.

The deteriorating macroeconomic picture – made worse by the inability or reluctance of monetary authorities to cut interest rates in the face of rising inflation – suggests that earnings downgrades will be the norm rather than the exception for the rest of this year. And growth projections for 2009 may well have to be scaled back as well. Some companies will outperform, but there won't be many of them.