Sector Rotation in 2013 - Part 3

by Wayne Ferbert on December 11th, 2012

Sectors are broad collections of stocks that compete in similar markets to facilitate similar client needs. As a collection of stocks, we need to understand the components within the sector to assess where we think the best value exists going in to 2013.
Every sector is a collection of thousands of companies. And each sector has several hundred companies that are publicly traded and large enough to invest in. We focused on these companies to determine whether any sector has a concentration of companies that are poised to break out in 2013. 
We screened for all publicly traded companies with a market cap greater than $250 million that trade on a US exchange and are US-based. The screen yielded 2,600 companies.
Being defensive investors by nature (remember, we are the Buy & Hedge guys), we further analyzed the companies using our Value bias (vs. a Growth bias). We used a scoring schema that brackets every company into a quintile based on four key valuation metrics: Price to Earnings, Price to Sales, Price to Cash Flow, and Price to Book Value.
Each company received a 1 to 5 score based on which of those quintiles they sat in across the 2,600 companies. The 1 score went to the stocks in the quintile with the discount valuation while the 5 went to the stocks with the premium valuation.
We then added the quintile score across the 4 categories to yield a total score anywhere between 4 (best values) to 20 (worst values). We further excluded Utilities from the analysis as they are best treated as fixed income masquerading as stocks.
The result was interesting. Financials stand out as a significantly under-valued sector. Meanwhile, Real Estate, Technology, and Healthcare all stand out as particularly over-valued on these metrics.
When you further break down the results and only focus on the companies with a market cap of at least $1 billion, we find that Financials and Energy are the only two sectors that stand out as having a disproportionate number of companies trading at a discount when you examine the top rated companies on these metrics. Meanwhile, Real Estate, Technology, HealthCare, and Consumer Discretionary all look to have the least number of firms among the most discounted on a valuation basis.

Across all 1500 stocks that had a market cap over $1 billion, on average, 12% of these firms scored a 4, 5, 6, or 7 on their schema score. But energy and financials had 18% and 28% of the companies in their sector score a 7 or below. Only industrial were also above the 12% average (at 15%). Further encouraging was the average market capitalization of these highly rated firms in Energy & Financials was above average. 
We like to focus on firms with a market cap over $1 billion because these firms most often have options that trade on the stock which enable a hedging strategy.
So far, this analysis confirms what the Morningstar valuations pointed out: Financials and Energy continue to trade at the best discount to fair value.
But now we need to consider the investing vehicles that represent each sector. We like to use sector ETFs that have options that have a healthy trading volume. All of these kinds of ETFs are concentrated only in the largest market cap companies.
In part I & II, we looked at the SPDR Select ETFs. In our part 4, we’ll cross-compare our ratings for these 2600 companies with the top positions that make up 80% of each of these ETFs. We’ll look to see how many of the companies with the highest discount valuation appear in these top ETFs. That approach should help us affirm which sector is positioned to actually deliver the best returns in 2013.
So far so good – Financials and Energy are continuing to look like a logical investment in 2013.

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