Buy Financials, Resources and Value for 2017

It can be tricky to make 'quantitative' comparisons between sectors because it is rarely a case of comparing like with like. Indeed, more often than not it's a case of apples and pears. Some sectors tend to command valuations that seem stingy at first sight. However, this is often because the industry in question has unattractive characteristics. Classic reasons for low sector valuations include: low returns; high capital requirements; low long-term growth potential; and cyclicality. And many cosmetically low sector valuations are weighed upon by several of these 'cheap for a reason' factors. Likewise, those sectors that superficially look perennially expensive usually command their lofty valuations to reflect very desirable industry characteristics, such as a strong defensive, long-term growth story and high returns.

While it is important for investors to acknowledge the distinct investment propositions of different sectors, it is also important to acknowledge that over a cycle the market can be very changeable about how it views and values the risks and rewards associated with different sectors. Indeed, companies with bloated balance sheets and returns that are highly sensitive to the economic cycle often trade at their most fulsome valuations just before markets top out (when such sectors offer most downside) and change hands on miniscule valuations as the cycle bottoms (when such sectors offer the most upside). Something of a cruel irony, but a big opportunity for contrarians.

Given the difficulty of comparing sectors - and the difficulty I've had finding solid historic fundamental sector data for FTSE 350 sectors - the parameters of this screen are fairly straight forward. It focuses on two well established investment principles: value and momentum. On this basis, I've screened the sector breakdown of the FTSE 350 as provided by Thomson Datastream.

HOW THE SCREEN WORKS

Value is assessed by the screen based on where each sector's dividend yield lies within its own 10-year range. The 10-year range itself is based on quarterly dividend yield data. Effectively, the first step in the screening process is to ask whether a sector is cheap by its own historic standards rather than by the standards of other sectors. This measure of historic value is then used by the screen as a basis for making comparisons between sectors - ie, a sector with a yield in the top 10 per cent of its historic range will be deemed far more attractive than a sector with a yield in the bottom 10 per cent of the range regardless of whether or not it has a lower yield in absolute terms.

Dividend yield seems to me to be a good a cross-sector valuation measures as dividends are reasonably relevant to all sectors. Indeed, arguably the next most far reaching valuation ratio is price-to-earnings (PE). But despite how ubiquitous the PE ratio is in investment analysis, there are some sectors where it is has limited relevance. For example, real estate stocks tend to be valued against net asset value (NAV), and their year-on-year earnings tend to jump around wildly depending on revaluation gains or losses and the profit or losses booked on disposals. Dividend yields on the other hand are a tangible return to shareholders that all sectors offer, even if yield characteristics vary significantly between sectors.

My measure of momentum, meanwhile, is based on the three-month capital return from each sector. Many academic studies have found momentum (past share price performance) is a very good predictor of future price movements (there is a tendency to see more of the same). Indeed, the consensus on this subject among students of stock market performance is so great that the momentum 'factor' has earned itself the tag of 'the premier anomaly'. Intuitively, the idea holds allure, too. It can often be hard to be convinced by thematic ideas early on when they have few supporters, but as more and more people accept an idea and more evidence is gathered to back it up, it becomes progressively easier for investors to be won over and get on board.

The danger of following momentum is arriving at the party late: when valuations have already been pushed up to outlandish levels; only good news is expected for evermore; and the risk of a painful derating is high. The idea of combining the attractions of 'value' with 'momentum' is that it may give investors a chance of moving into a promising part of the market before the stampede has really begun. That in theory creates the potential for big rerating gains while avoiding the dangers of buying into a very expensive part of the market.

BRINGING IT ALL TOGETHER

To combine the two factors I've turned to a ranking system that regular readers of this column will be familiar with. This is the simple system used by hedge fund manager Joel Greenblatt to rank stocks for his two-factor "Magic Formula" (this screen only uses Mr Greenblatt's ranking system and not the Magic Formula criteria). The ranking system, as used by this screen, simply ranks sectors by their relative cheapness or expensiveness compared with their historic range and then separately ranks sectors by their three-month momentum compared with each other. The two rankings are then added together and a final ranking is then based on this.

THE RESULTS

Source: Thomson Datatream

Some of the sectors highlighted as being particularly attractive in the table should perhaps be regarded as red herrings, or at best only part of a boarder theme. For example, for the forestry and paper sector readers should simply think Mondi, as that is the sector's one and only constituent. Likewise, autos and parts is GKN on its own, industrial metals and mining is Evraz (the mining sector is where the majority of the miners are to be found) and the high-ranking electricity sector comprises of just SSE and Drax. However, in terms of where the action is, there seem to broadly be three main themes, two of which are sector based and one of which is more general and more debatable. The themes I would point to are : resources, financials and a general fondness what can be broadly termed 'value'.

RESOURCES

One clear theme that has emerged is that resources stocks, along with sectors that serve the industry, look particularly attractive on the screen's rankings. Not only are oil and gas plays among the highest ranking stocks, but so are the oil equipment and services companies that provide the picks and shovels for exploration and production. Miners also do well and the presence of industrial engineers with a relatively high ranking (11th out of 37 FTSE 350 sectors) can be seen in no small part to reflect of the amount of business many constituents do in the resources sector.

The persistence of commodity price rises since early-2016 lows suggests the recovery we've seen in this part of the market has a good chance of proving sustainable. The signal from commodity price momentum is reinforced by the fact that there has been a significant retrenchment in capital expenditure by resources companies accompanied by a drop in production. In the oil and gas industry a drop in shale production from North American shale producers has been particularly of note.

The rebound in commodity prices could be supported by the fact that ramping up production can be a long-winded process for oil companies and miners. What's more, the torrid experience over several years for lenders to resources companies as well as investors means capital may be slow to return to the sector which would exacerbate any supply constraints.

FINANCIALS

The embattled banking sector comes out as one of the most attractive parts of the market based on the screen, and it definitely looks a contrarian call. There are a panoply of reasons to be negative about banks. Returns on equity are diabolical, revelations about past behaviour are repugnant, fines are everywhere and regulation has been getting ever more onerous. But the sector is potentially at a point where things are so bad it may be hard for them to get much worse. Indeed, the somewhat unguarded comment by Credit Suisse's boss, Tidjane Thiam, that European banks were "not really investable" as a sector, is the type of statement that suggests a sector may have found its nadir.

Such a view point is reinforced by the fact that the sector has rallied so hard off a relatively small piece of good news: the rise in bond yields from anaemic levels. The profits made by banks should benefit from recent yield increases which stand to push up the cost of borrowing by banks' clients over the longer term while keeping the banks' own cost of short-term borrowing (taking deposits) relatively low. The movement in yields feeds off expectations that we're soon to see a fiscal splurge, led by Mr Trump in the US, which will ultimately push up inflation and force central banks to raise interest rates. While this would be good for banks, it is worth remembering that, while the market is eagerly pricing the scenario in, we are definitely not there yet (it's still the old 'new normal' for now).

There are also reasons to be wary about the future for banks based on signs that the credit cycle could be close to turning: high levels of merger and acquisition activity; increased share buybacks; and debt-funded dividend increases are all classic signs of an approaching turn in the credit cycle and are currently on display. And if the cycle were to turn, banks would be expected to see more of their loans going bad. In this regard, some comfort can arguably be taken from the fact that for most of the big banks this has not been an normal credit cycle because regulation has forced them to focus on derisking their balance sheets rather than loading up with ever-riskier loans.

Meanwhile, life insurance companies are also highly rated by the screen and could also be major beneficiaries of higher bond yields should the recent trend in the bond market continue. That is because higher yields mean they are able to offer better returns on many of their products, such as annuities, and as major buyers of bonds, insurers' investment returns will benefit from being able to lock in higher yields. What's more, the fall in the prices of existing bond holdings (falling bond prices push up yields) should not be a major worry for insurers because they tend to hold bonds to maturity. That means what is really relevant to these businesses is the yield they are locking in when they originally make bond purchases rather than the market gyrations thereafter.

VALUE

The financial and resources sectors are two of the biggest constituents of the MSCI World Value index at the moment, and this focus on 'value' (stocks with high yields, low PEs and low price-to-book ratios) is also reflected in a number of the other top ranking sectors. Industrial transportation would be one such example along with some of the more esoteric high-ranking sectors such as chemicals (ranked eighth), forestry and paper (10th), and autos and parts (15th). Could this be a sign that after 10 years in the doldrums, value investing as a style is actually making a comeback (see Value Investing: After 10 years of inferior returns, is value investing coming back to life?).