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Investing in Different Industry Sectors

Different industry sectors each display some key characteristics that may either attract or repel equity investors

Alanna Petroff 19 February, 2013 | 6:00AM

This article is part of Morningstar.co.uk's Equity Investing Week.

When people look at investing in equity markets, they may focus on investing in specific sectors because they believe these sectors will help them reach their financial goals. For example, some sectors may typically be less volatile, which would appeal to investors who are focused on predictability and capital preservation. Meanwhile, other sectors that have more growth prospects and higher volatility may appeal to investors with a higher risk tolerance.

Many fund managers also focus on sector-specific investments. In some cases, fund managers may only focus on investing in one sector, such as the technology sector or the healthcare sector. Additionally, some fund managers may invest in a range of sectors and companies, but veer away from certain sectors (i.e. the financial services sector) if they don’t like the current prospects for that sector.

Morningstar has split up and categorised all equities into 11 unique sectors. Below is a list of the sectors and there is also information about the key characteristics for each of these sectors.

Industry Sectors:

- Basic Materials
- Communication Services
- Consumer Cyclical
- Consumer Defensive
- Energy
- Financial Services
- Healthcare
- Industrials
- Real Estate
- Technology
- Utilities

Key Characteristics and Information

Basic Materials
Take a glance at the periodic table of elements and you will get a quick sense for the products that basic materials companies sell. If a company doesn't produce one of the elements listed, chances are it is manufacturing a compound or alloy from a combination of various elements. Basic materials companies are, by definition, commodity producers, and customers' decisions are made primarily on price. (Of course, there are a few exceptions in this sector, such as seed and specialty chemical companies.)

Commodity prices, driven by the intersection of supply and demand, are a key determinant of these companies' earnings. For the most part, basic materials companies have been riding a wave of robust demand for commodities from developing countries. Important exceptions include North American and European producers of building materials, which have been facing a multi-year downturn in construction activity, and paper producers in the same areas, which have been facing declining demand driven by the rise of electronic media.

Competitive advantages in the basic materials sector are based largely on low-cost production. Ownership of world-class mineral deposits, access to low-cost feedstocks, or highly efficient production methods are the most common ingredients for success. Alas, many of these advantages can eventually be replicated by competitors so relatively few companies in the basic materials space have economic moats (aka sustainable competitive advantages).

Basic materials markets are deeply cyclical. In boom times, producers mint money but in downturns, many players can go bankrupt. All feel the pain of bear markets, but high-cost producers and those with high fixed cost structures are the most likely to feel serious pain when times are bad. An eye toward macroeconomic conditions is necessary when investing in this space.

Examples of companies in the basic materials sector: BHP Billiton (BLT) and Rio Tinto (RIO).

Communication Services
The communications services sector is mainly comprised of telephone companies, but also includes pay television providers as the two sectors increasingly compete against each other. Telephony can include traditional fixed-line as well as wireless services. Most fixed-line providers also offer Internet access or broadband services as well as some kind of television service. Frequently, fixed-line, broadband and television services are sold in bundles that are cheaper than buying the services separately. A customer that subscribes to all three services is referred to as a triple play customer. If they also subscribe to wireless services from the same company, they are dubbed quad play customers.

Historically, the telephone business was considered a safe, conservative industry that grew regardless of the economy. However, competition has greatly intensified as pay television operators have increasingly bundled telephone and broadband services with their television product. Meanwhile, other telecom operators have entered the business by re-selling capacity from existing telephone operators. This competitive trend has been exacerbated by regulators cutting prices for transferring calls to other operators and the weak economy. In today’s environment, telecom operators are no longer exempt from pullbacks in the economy, which has caused many companies, particularly in Europe, to cut their dividends, though many still have high yields.

Examples of companies in the communication services sector: Vodafone (VOD) and Virgin Media (VMED).

Consumer Cyclical
The consumer cyclical sector is comprised of companies that deliver products and services to consumers and operate in industries such as entertainment, retail, gambling, publishing, auto manufacturing and housing. These companies deliver goods and services that are luxuries instead of absolute necessities.

The performance of consumer cyclical companies is heavily dependent on the business cycle and economic cycle. When times are good, consumers tend to make more discretionary purchases and these companies will benefit. However, in tough times, consumers will try to cut back on their spending and that will hurt these consumer-focused companies.

Examples of companies in the consumer cyclical sector: Burberry (BRBY) and Pearson (PSON).

Consumer Defensive
This sector includes companies that manufacture food, beverages, household products, personal products, packaging and tobacco. The sector also includes companies that provide services such as education and training. These goods and services are often called “consumer staples”.

Companies in this consumer defensive sector are considered to be non-cyclical, which means their products and services are in constant demand regardless of the economic cycle. Consumption also tends to sit at a relatively constant level, regardless of price.

This sector is considered a solid, reliable and less volatile sector for investors who are seeking slow and steady returns. When the economy is struggling and cyclical companies begin showing signs of weakness, investors often try to put their money into consumer defensive companies in an effort to protect their portfolio during a downturn.

Examples of companies in the consumer defensive sector: Unilever (ULVR) and Diageo (DGE).

Energy
The energy sector is made up of upstream, midstream, and downstream firms which handle a variety of activities within the oil and gas industry:

- Upstream companies (E&Ps, integrated majors) typically explore for and produce oil and gas.
- Midstream firms (mainly pipelines) handle the transportation, storage, and marketing activities.
- Downstream businesses (refiners) refine oil and process gas.

Oil and gas prices are key determinants for profitability within the industry, and the industry’s expectations around future prices drives capital expenditure levels. Given the industry’s dependence on commodity prices, the sector tends to be cyclical and profitability can be highly variable.

Examples of companies in the energy sector: BP (BP.) and Tullow Oil (TLW).

Financial Services
The financial services sector includes banks, asset managers (aka fund companies), insurance firms, brokerages and exchanges. All serve different, but important, roles in the economy. Banks essentially take short-term deposits and transform them into long-term loans, using their expertise in judging credit risk. Insurance companies also must carefully judge risk, but they generate most of their revenues by investing the premiums paid by their customers for a while before they must pay the money out in claims.

The fortunes of financial services companies often follow that of the broader economy. In good times, they report steady profits and many pay attractive dividends. However, downturns can hit financial services companies hard as net interest margins shrink and credit losses grow. During downturns, financial services companies are often forced to cut their dividends and sometimes even sell new shares, which dilutes investors' shareholdings.

Examples of companies in the financial services sector: Aviva (AV.) and Barclays (BARC).

Healthcare
Healthcare is one of the few sectors of the economy that's directly linked to human survival, as new medical innovations can significantly improve or extend patients' lives. The vital importance of healthcare, combined with favourable demographic trends in the United States and Western Europe and a growing emphasis on individual well-being in the developing world, provides a strong secular tailwind (a.k.a. forward momentum) for the sector and offers the potential for above-average financial returns.

The healthcare sector, which includes drug companies, biotechs, medical device firms, and healthcare service organizations, has benefited from powerful growth trends over the past few decades, particularly in the US. Between 1980 and 2009, total healthcare spending increased from 9% of the total US economy to more than 17%, with $2.5 trillion in total expenditures. This growth rate decelerated significantly over the past few years as recessionary pressures suppressed demand in the developed world. Further, one of the goals of the US healthcare reform is to permanently alter the cost curve and, combined with the ongoing weakness in Europe, we anticipate the developed markets’ prominence in the global healthcare market will gradually decline. However, increasing consumption of healthcare products and services in emerging markets suggest demand should still stay strong over the long run.

The healthcare sector also has a higher prevalence of companies with sustainable competitive advantages (aka economic moats) compared to other sectors, which implies the sector will continue generating robust excess economic returns.

Examples of companies in the healthcare sector: GlaxoSmithKline (GSK) and Novartis (NOVN).

Industrials
Companies in the industrials sector operate in some of the following areas: diversified manufacturing, freight transportation, heavy equipment, autos, distribution, aerospace, waste and business services. The industrial sector in general is characterized by a wide variety of markets, with companies spanning the quality spectrum in terms of competitive advantage, growth prospects, and exposure to economic cycles.

Most industrial names suffer relatively high cyclicality, with those catering to the capital spending and durable goods arena by far the most cyclical and companies producing consumer durables a close second. As such, the position a company has relative to the economic cycle and to what degree it’s affected by economic volatility is of paramount importance when thinking about industrial names.

Examples of companies in the industrials sector: Caterpillar (CAT) and Rolls-Royce Holdings(RR.).

Real Estate
This sector includes companies that own, manage, operate, develop, service and invest in real estate properties. This includes companies that work in commercial, corporate, industrial, retail and residential real estate. The sector also includes real estate investment trusts, which are publicly traded funds that own and manage a portfolio of properties.

Performance in the real estate sector tends to follow the overall economy; during periods of economic growth and inflation, real estate investments will usually post strong returns. But during difficult economic times, real estate investments will deliver lacklustre performance.

When investing in real estate, just like investing in a house, you should consider “location, location, location”. Companies that operate in desirable areas will likely have different risks and deliver different returns compared to companies operating in undesirable areas.

Examples of companies in the real estate sector: Land Securities Group (LAND) and Savills (SVS).

Technology
This sector consists of companies that focus on the research, development and distribution of technology-based goods and services. This sector includes hardware, soft­ware, and semiconductor industries. Businesses that manufacture electronics, design computer programs and provide information technology services are all included in this sector. Technology products and services are used by both businesses and individual consumers.

The technology sector is generally characterised as a sector that is full of innovation, competition and growth. This sector is known to be highly cyclical and volatile.

The relentless forward march of technological progress makes it difficult for companies to create sustainable competitive advantages in the technology sector. Examples such as Dell (DELL) and Nokia (NOK1V) are only the latest in a long series of companies that once led their respective industries but were relegated to also-ran status within a few years. How­ever, the companies that do build economic moats are ex­ceptionally profitable because many technology industries tend to produce natural monopolies or oligopolies.

The technology sector has experienced a multi-decade run of secular growth as the myriad benefits of technology were adopted by the global population. While growth has recently moderated in developed economies, many emerging economies are still in the relatively early stages of technology adoption, which is expected to drive future growth.

Examples of companies in the technology sector: ARM Holdings (ARM) and Apple (AAPL).

Utilities
Utilities typically are local monopolies that own transmission and distribution networks that deliver electricity, natural gas, water or other energy sources to customers in a given service territory.

In most developed countries, state and federal regulators typically set customer rates for utilities. This ensures utilities investors recover a fair return on capital while ensuring the utilities businesses keep their systems well maintained.

Regulated distribution utilities are among the most defensive investments available with solid cash flow, high dividend pay-out ratios, and low cyclicality. Morningstar utilities analysts typically expect total annual equity returns near 10% for regulated utilities through all economic cycles. 

Diversified utilities typically are holding companies with businesses that could include traditional regulated T&D operations, wholesale power generation, retail supply or infrastructure. They are still defensive investments but carry more risk than their fully regulated peers.

Independent power producers, although officially within the utilities sector, are fundamentally very different from their regulated peers. Independent power producers are highly cyclical, volatile, closely tied to commodity markets, typically have no economic moat, and rarely pay dividends. Traditional income-seeking utility investors should steer well clear of these companies. But Morningstar analysts believe that independent power producers are a compelling option for investors seeking deep cyclicals that can outperform during an economic recovery and expansion.

Examples of companies in the utilities sector: National Grid (NG.) and SSE (SSE).

This article was written with significant contributions from the following Morningstar analysts: Elizabeth Collins, Allan Nichols, Stephen Ellis, Erin Davis, Alex Morozov, Keith Schoonmaker, Travis Miller and Grady Burkett.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Alanna Petroff

Alanna Petroff  is a financial journalist with Morningstar UK.