The sectors leading the charge into 2019

It could prove a particularly interesting time to look at sector themes should recent market volatility be symptomatic of a longer-term changing of the guard in the markets. For some time, there has been speculation about how much longer growth plays – especially technology stocks – can continue their strong run. This was a question posed last year in my brief précis of the 'capital-light technology' sub-sector, which came up as having the strongest momentum of all the 38 sub-sectors screened. Tech took a battering when markets turned in October and on a one-year view the unweighted average performance of the 13 stocks in this sub-sector was a 13.1 per cent drop.

If it is a case of out with the old – not that a recovery of the old order can be ruled out – what sectors could represent the in-with-the-new? Many value investors have been waiting for over a decade to see their favoured investment style reassert its long-term outperformance of the growth style of investing. For value diehards, some comfort can be found in some sectors' performance over the past year. Indeed, the seven stocks from last year’s cheapest sub-sector, car dealers, managed to beat the average FTSE All-Share stock with a 6.0 per cent fall compared with a FTSE All-Share average drop of 6.8 per cent. The data this screen runs off is based only on capital returns, so the relatively high yields of car dealers will have meant a better total return.

Many classic defensive sectors stand out as having performed reasonably well. To an extent this also plays to the value-come-back theme. Three classic defensive plays among the top-performing sectors were biotechnology and pharmaceuticals, aerospace and defence, and utilities. That said, sector-specific problems whacked the share prices of companies in some other defensive industries, such as tobacco and food retail.

Last year’s real sector star, healthcare, was the one least favoured by the 2017 screen: it looked expensive and showed weak momentum. But this may tell us more about the inherent problems with trying to analyse sector data than anything else. That’s because last year the healthcare sector was represented by a single stock. Tobacco, capital-intensive technology, airlines and airports, and paper are also sectors with very few constituents. Meanwhile, the only company now representing the healthcare 'sector' does not have a long enough valuation history to qualify for the screen.

How the sectors fared last year

Source: S&P CapitalIQ

How the screen works

The screen assesses every FTSE All-Share stock based on its valuation compared with its long-term history as well as recent (3-month) share price momentum. For 'long-term' the screen takes 12 years of valuation data (enough time to capture a full cycle), but will settle for six years of data as a minimum. The valuation metric the screen looks at is each company’s value compared with its source of earnings. For most companies this means a comparison of enterprise value with sales, but with more asset-centric industries, such as banks and property companies, the screen looks at price compared with tangible net asset value (NAV) per share. The screen measures the number of standard deviations the valuation is compared with the long-term average to create something I pompously call the ZEUS ratio (you can read a more long-winded explanation of my Z-score of Earnings Ultimate Source ratio here). 

For each of the 38 sectors I split the FTSE All-Share into, the screen looks at the unweighted average for both ZEUS ratio and three-month momentum of all sector constituents. The sectors are then ranked by how attractive they look based on a combination of the two factors. The hope is, this may provide some clues to what will prove interesting sector themes for the coming 12 months.

The results from this year’s screen are presented from top to bottom ranking sector in the table below. I’ve also provided write-ups of the top-ranking sector, the cheapest ranked sector and the raciest sector based on three-month momentum. There is considerable deja-vu when it comes to the top-ranking and cheapest sector as they are both the same as last year.

Source: S&P CapitalIQ

TOP RANKING

Pubs and restaurants

The sector screen is doubling down on the beleaguered pubs and restaurant sector as its top pick for 2019. This was the highest ranking sector from last year’s screen, too, but the performance from the sector has hardly been inspiring: a 9.0 per cent fall compared with negative 6.8 per cent from the average All-Share stock.

Many of the headwinds I highlighted last year for pub and restaurant companies have persisted over the 12 months, with the sector still facing issues of oversupply, rising costs and wobbly consumer confidence. What’s more, while there were tentative signs this time last year that broker downgrades were abating for some more troubled companies, this proved only a temporary hiatus. What’s more, some erstwhile stars of the sector have succumbed to the industry’s wider malaise during the past year. From this perspective, the poor performance from Domino’s Pizza (DOM) is of particular note.

For pub companies, trading problems are being exacerbated by the extremely high levels of debt many carry, although most have stuck by their dividend payments. If there is little let-up in tough conditions, these payments could start to become more precarious as 2019 progresses. Property leases could also prove an issue in 2019. Long-term rental agreements are very debt-like from the perspective of shareholders (landlords get paid before shareholders as do lenders). These liabilities are due to come onto companies' balance sheets from next year and, while this accounting change is well known, the increased visibilities of these commitments may have an impact on sentiment.

The big reason for betting on the sector is essentially a contrarian one. Valuations look very low, which means good news is not expected and could have a significant positive impact on shares. Positive developments in the Brexit saga and any impact on consumer confidence represents a potential trigger. However, the high borrowings of some companies and litany of trading headwinds means it is easy to see the potential of the sector as a value trap, too.

Source: S&P CapitalIQ

CHEAP

Car dealers

At the best of times there are reasons to feel wary of shares in car dealers. These companies are low-margin, highly cyclical and have significant capital requirements. Car dealer shares change hands at low multiples of sales and earnings, for good reason. However, even by its own standards, the car dealer sector looks cheap. Equally, by its own standards, the sector looks risky and a number of companies have experienced noteworthy broker forecast downgrades recently. So, as with pubs and restaurants, this sector is probably only of interest to contrarians. 

The pain being felt by the sector has been most evident in new car sales. The industry body, the Society of Motor Manufacturers and Traders (SMMT), forecasts that new car registrations will fall 6.3 per cent this year from 2017 highs of 2.54m. Another year of decline is pencilled in for 2019 but at the more modest rate of 2.4 per cent followed by a 1 per cent drop in 2020. Of particular note is a near-30 per cent forecast fall in diesel vehicle sales this year as demand has been decimated by the diesel test-rigging scandal.

New EU emissions regulations are also complicating life for car dealers, while consumers are demanding more environmentally-friendly vehicles, which is being reflected in the make-up of used car sales. Monthly used car sales have also broadly been in decline since midway through last year, although this market looks more solid than that for new cars. The third quarter of the year showed a 2.1 per cent used car sales decline.

Two big uncertainties hang over the sector. The ubiquitous issue of Brexit and its influence on consumer spending – especially on big-ticket items such as cars – is a major source of uncertainty. Meanwhile, there is uncertainty about the future of the generous financing packages that helped fuel growth up until 2017. What’s more, should lending over recent years be found to be imprudent, there could be wider reverberations for industry players.

The low valuation of car dealers' shares means it is possible to argue the bad news is all in the price, but it would nevertheless take a brave investor to have a punt.

Source: S&P CapitalIQ

STRONGEST MOMENTUM

Precious metals

This time last year all the talk was of “synchronised global growth”, a truly intoxicating and rare backdrop for investors – albeit a backdrop that never lasts for that long. But can things have really got so bad that it is now time to seek solace in precious metals, an asset class that is often characterised as a nuclear-bunker investment. For those subscribing to the 'everything bubble' view of markets, the answer may be yes. Some fear that quantitative easing has lifted almost all assets into bubble territory and the reversal of these policies now under way, will have widespread and far-reaching consequences.

Miners are often regarded as a geared play on the metals they dig for, and over the past three months (the period looked at by this screen to measure momentum) the sector has benefited from a recovery in the gold price following a slip below $1,200 while other parts of the market were falling off a cliff. The strong momentum showing by the sector has also been influenced by a few outsized gains. The merger of Randgold Resources with Barrick Gold has helped the former’s shares. The merger has also had a knock-on effect for Acacia’s share price as Barrick is a majority shareholder. The hope is that with the merger out of the way, a major impasse between Acacia and the Tanzanian government can now be rectified.

Acacia is not the only sector play with significant company-specific issues to contend with. Indeed, the individual struggles of several precious metal miners helps explain why average valuations remain cheap. Among the issues faced by individual companies are: a new government in Mexico threatening the interests of Fresnillo; Centamin struggling to meet forecasts; and Polymetal’s high debt.

source: S&P CapitalIQ