3 Secrets to Picking a Winning Sector for Your Portfolio

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One of the most important parts of selecting stocks for your portfolio is choosing which sectors of the economy you want exposure to. While the different companies in a given sector have various attributes, the fact remains that most of the exogenous economic and social events that will impact a given company will impact other companies in that particular sector. If the price of oil goes up, it benefits all oil-producing companies, although it will benefit those companies that have the highest leverage to the oil price the most. Similarly, a rising oil price will hurt all trucking companies.

We can find innumerable examples of such phenomena that illustrate the importance of sector selection. Several sectors are appealing because they have strong macroeconomic tailwinds, and other are unappealing because of economic headwinds. It is for this reason that we can make decisions regarding the performance of entire sectors based on economic assumptions — again, a rising oil price benefits oil-producing companies and hurts trucking companies.

However, there are some sectors of the economy that make for appealing investments based on more “common-sense” reasoning rather than from macroeconomic deductions. I think every portfolio needs to include some of these sectors, especially since our macroeconomic deductions can be wrong. In what follows, I outline some tips for picking winning sectors.

1. Find sectors with minimal competition

Source: Thinkstock

Source: Thinkstock

If a company has very few competitors, chances are that it is in a sector worth investing in, whereas if it has several competitors, it may be a sector worth avoiding. For instance, I think that the electronic payment sector, which includes the credit card companies [e.g., Mastercard (NYSE:MA), Visa (NYSE:V), and American Express (NYSE:AXP)] is an excellent sector to invest in. While it is true that these companies will compete with one another, one would rather survive with its competitors than sacrifice its profits by undercutting them. While price fixing is technically illegal, it happens, as is evidenced by the double-digit profit margins we see from these companies.

On the other hand, I think the restaurant sector is one worth avoiding except in unusual circumstances. Restaurant companies have to face incredible competition: restaurants are everywhere, and they often have to cut prices or offer some other sort of incentive to draw customers, who often have dozens of choices. Restaurants also have to compete with grocery stores, as consumers can cook their own meals, as opposed to eating out.

While dozens, if not hundreds, of restaurants in a big city are splitting the consumers among themselves, chances are that these consumers are using their Mastercard, Visa, or American Express credit card or debit card to make their payment. So while your favorite restaurant may have great food at a reasonable price, from an investment standpoint, it is not very appetizing.

2. Invest in sectors that meet people’s needs

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Source: Thinkstock

If you are looking for stocks that are going to continue to give you returns for a long period of time, then you’ll want to invest in companies that provide things that people need — housing, clothing, food, energy, cleaning supplies, toiletries, and so on. While Six Flags Entertainment Corp. (NYSE:SIX) or even Disney (NYSE:DIS) provide products that people like and want, if there is a recession or if consumers start to cut back, these are companies that will suffer.

Meanwhile, unless things get incredibly bad, consumers won’t turn off the lights in their homes or stop driving their cars to work. So while Disney has great brand power and while it is generating profits for shareholders, you’re probably better off investing in an electric utility or in a company that supplies this utility with the natural gas, coal, or uranium that it uses to generate electricity. You could also, for instance, invest in the natural gas pipeline that ships the gas from the point of production to the power plant.

3. Find sectors with recurring revenues

Source: Thinkstock

Source: Thinkstock

While there are many products that we buy multiple times, I think from an investment standpoint, we should focus on companies that provide a regular product or service for which we pay on a regular basis. Subscription services such as those offered by Netflix (NASDAQ:NFLX) or Comcast (NASDAQ:CMCSA) come to mind. However, these companies don’t fit my second rule of investing in things we need. We need to get a little creative.

Take healthcare, for instance, and then divide healthcare companies into those that provide products and services regularly and those that don’t. If you break your leg, you only need a few X-rays, and so X-ray machine producers aren’t the way to go. But if you get diabetes, you have the disease for life, and you have to take medicine for it regularly. So a company that makes diabetes medicine would be a good investment [e.g., Novo Nordisk (NYSE:NVO)].

Conclusion

While these rules are pretty straightforward, they are not so easy to follow. They also suggest that we can’t just think of the term “sector” as we normally do. For instance, thinking about “healthcare” as a sector wasn’t very helpful, because while healthcare is useful, some healthcare companies don’t have recurring revenues. While it didn’t come up, some healthcare companies also face a lot of competition, while others don’t.

But when we narrowed down the sector to “diabetes medicine producer,” the rules fit much better, and we were able to come up with a grouping that isn’t formally a market sector but from which we can pick any one of a number of stocks and end up with a winner. While it takes more effort to narrow down sectors into groupings that fit specified investment criteria (e.g., credit card companies, diabetes medicine producers) it is ultimately worthwhile to do so.

Disclosure: Ben Kramer-Miller is long Visa.

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