Anyone beginning to learn to invest in sector or general investment will soon hear the phrase “sector rotation.” Different types of industries perform better during specific stages in the economic cycle. For example, some industries take off when the economy is expanding, while others actually profit more when the economy is in a slump. That means that investors can always find a way to profit in the markets, as long as they know where to look. To capitalize on sector rotation, you first need to get a handle on the sectors themselves. Essentially, a sector is a unique industry group.
A lot of people—including financial professionals—use the terms sector and industry interchangeably, but they aren’t really the same. The industry describes a specific set of businesses, while the sector is a broader term. In fact, a sector is technically a broad section of the overall economy and can include more than one industry. For example, the financial sector includes banking, investment banking, mortgages, accounting, insurance, and asset management—six distinct industries. Where in the cycle are we?
Next, you’ll need to know at which point in the cycle the economy currently stands: downturn, recession, upturn, or recovery. You can find current economic analyses in most of the big financial newspapers, such as the Wall Street Journal. You can also find detailed information on the state of the U.S. economy from the Bureau of Economic Analysis at www.bea.gov. Once you know where the economy is, you can better predict where it’s going to go from there, even if you can’t predict the timing. That’s because the economic cycle follows a very definite pattern. For example, when the economy is in a deep recession, the next phase of the cycle will be an upturn, a very good time to begin investing more actively. That knowledge, combined with a grasp of sector rotation, can help you profit regardless of the prevailing economic state.
Invest in Sector
You can diversify your portfolio and take advantage of sector rotation by investing in sector funds. These mutual funds invest in single economic sectors (like technology or healthcare), and sometimes even more focused sector subsets (like electronics or pharmaceuticals). While sector funds expose investors to more risk than more broad-based mutual funds, they can also bring higher re- turns. We’ll discuss this more in the section on mutual funds. Sector rotation describes the movement of profitability through different sectors as the economy goes through its cycles. Different sectors thrive in different portions of the cycle.
The basic sectors are highly predictable, following the economic cycle like clockwork. For example, the utilities and services sectors tend to perform well during an economic downturn; and as that downturn segues into a full recession, the technology, cyclicals, and industrial sectors will start to flourish. As the economy begins to turn toward recovery, basic materials and energy perform best. In a full thriving economy, the consumer staples sector will really take off. So if you know what stage the economy is in now, you know where in the cycle it will be going next, and you can reasonably predict which sectors will prosper.
An Index for Everything
Financial professionals look to benchmarks to measure just how well (or how poorly) their investments are doing. These benchmarks are known as indexes, and they cover every sector of the financial markets, from small-cap stocks to emerging nation bonds. Most of these indexes consist of a group or sample of representative investments that indicate how the overall market or a segment of the market is performing. Some widely used indexes track thousands of individual securities, while others look at fewer than fifty.
The Dow Jones Industrial Average (DJIA, also called the Dow) is the most prominent stock index in the world. It was named after Charles H. Dow, the first editor of the Wall Street Journal, and his one-time partner Edward Jones, although Jones was not instrumental in creating the index. Dow’s creation revolutionized investing, as it was the first publicly published gauge of the market.
The thirty stocks on the Dow, which are all part of the New York Stock Exchange (NYSE), are all those of established blue-chip companies like McDonald’s, Coca-Cola, DuPont, and Eastman Kodak. The Dow was created to mimic the U.S. stock market as a whole, and its companies represent a variety of market segments such as entertainment, automotive, healthcare products, and financial services.
GE and DJ
General Electric is the only company that was included in the original Dow Jones Industrial Average, created in 1896, that is still part of its makeup today. However, it hasn’t been there the entire time. General Electric was dropped in 1898, restored in 1899, taken out again in 1901, and then put back on the list in 1907.
The thirty stocks of the Dow Jones Industrial Average companies are weighted by stock price, rather than market capitalization, which is how most indexes are weighted. Basically, the Dow number is calculated by adding up the prices of all the stocks, then dividing by the number of stocks included in the index, adjusted for stock splits. The important point to remember is that each company carries equal weight.
Some indexes are capitalization weighted, giving greater weight to stocks with greater market value. For example, consider Standard & Poor’s (S&P) Composite Index of 500 stocks. The Standard & Poor’s 500 Index, commonly known as the S&P 500, is a benchmark that is widely used by professional stock investors. The S&P 500 represents 500 stocks—400 industrial stocks, twenty transportation stocks, forty utility stocks, and forty financial stocks. This index consists primarily of stocks listed on the NYSE, although it also features some over-the-counter (OTC) stocks.
The Russell 2000 index covers the small-cap equities market, so it tracks corporations that fall into the small-cap segment of the market, those with market capitalization falling between $300 million and $2 billion. The Russell 2000 is a subset of the Russell 3000 index, following the performance of only the 2,000 smallest companies in the Russell 3000. Other indexes treat each stock equally.
The Value Line Index tracks 1,700 equally weighted stocks from the NYSE, the National Association of Securities Dealers Automated Quotations (NASDAQ), and OTC markets. It acts as a market barometer, widely held to be the best measure of the overall market and a crucial monitoring tool for any investor.
Watchdogs of the Market
If you become seriously involved in investing, one organization you’re sure to hear about is the Securities and Exchange Commission (SEC). The SEC is part of the government regulatory apparatus that keeps an eye on the stock market. During the Great Depression, Congress passed the Securities Exchange Act of 1934, creating the U.S. Securities and Exchange Commission.
The 1934 Act was designed to restore confidence in capital markets, setting clear rules and giving the SEC power to regulate the securities industry. Basically, the SEC watches over the securities industry to make sure no illegal activity takes place. To help with that enormous task, the agency sets strict standards for brokers, investors, and publicly traded corporations. Every corporation whose stock trades on a U.S. exchange must be registered with the SEC. The agency’s main goal is to protect investors by making sure the securities markets remain honest and fair. One way the SEC meets this goal is by making sure publicly traded companies disclose enough accurate information for investors to make informed decisions.
There’s a slew of ongoing paperwork required of all companies whose stocks trade on the public markets, including annual audited financial statements. In addition to keeping close tabs on publicly traded companies, the SEC also regulates any companies involved with trading and any professionals who offer investment advice. Insider trading is one of the most widely known issues covered by the SEC.
Insider trading, or insider information, refers to buying and selling publicly traded securities based on confidential information that has not been released to the general public. Because such information is not available to everyone, those insiders have an unfair advantage. And though it makes for splashy headlines—think Martha Stewart, Enron, and WorldCom—a good story does nothing to help investors recoup their losses.
Division of Enforcement
The SEC’s Division of Enforcement does just what the name suggests; it makes sure federal securities laws are followed to the letter. This division investigates possible legal violations, and when it finds that laws haven’t been followed, it recommends ways to remedy the situation. Most important, though, the SEC is all about you: protecting you from swindles, providing reliable information, and keeping your broker in line.
On its website, you can visit a special section called EDGAR (Electronic Data Gathering, Analysis, and Retrieval), a complete database of all corporate reports (such as 10-Ks and 10-Qs) filed by public companies—all the way back to 1994! It’s very easy to search EDGAR for information on any company you plan to invest in, so make this your first stop.
For More Information
On its website (www.sec.gov), the SEC offers everyone the opportunity to inves- tigate any questionable activities. They also make available a wide range of public services, including free investment information, up-to-date complaint tracking, and a toll-free information line at 1-800-SEC-0330.
The Market on a Grand Scale
During the past twenty or thirty years, one of the most important things that’s happened has been the information revolution. The speed at which information now circles the world has meant that international boundaries have virtually been erased. As Thomas Friedman wrote in his well-known book, “The world is flat.” All this affects investments and the investment climate in which you operate. In- vestments don’t exist in a vacuum. What happens on the U.S. stock markets has global consequences.
Changes in the interest rates on U.S. Treasury securities can impact bond markets across the ocean. A downturn in the U.S. economy hits the rest of the world almost immediately. And the reverse is also true. Major shakeups around the world affect stock prices, bond prices, commodities, and currencies.
At the same time, the breadth of the world markets practically ensures that there’s always a profit to be made somewhere. When major economies are tanking, emerging economies may begin to thrive. A natural disaster in one part of the world can cause the economies in other parts of the world to go into overdrive—or it can cause shortages and slowdowns, depending on the type and extent of damage.
In addition, the Internet has made the world a much smaller place. We now know instantly when something happens in the farthest corners of the earth. We know the second a stock exchange in Asia or Europe goes up or down a few points. Extensive international trade means the dollar can be affected when another country’s currency strengthens or weakens. All of this affects investors. Whether you invest in individual stocks, fixed-income securities, mutual funds, real estate, or more exotic financial instruments, your investments will feel the impact of world events—sometimes immediately, other times slowly.
It used to be that only investors in foreign securities had to pay close attention to foreign and global economies. Now every investor needs to know and understand what’s going on around the world, because every investor is impacted by what goes on in the rest of the world.
Foreign Owned or American Owned?
One of the questions to investigate when buying stock in a company is, is the company owned in the United States or abroad? There’s nothing wrong with investing in a foreign-owned company, but generally that can increase the level of risk to your investment, depending on who owns the company and where they’re located.
How To Choose Companies To Invest
Looking at the ABCs
When you buy stock in a company, you’re buying a part of that company. Just as you would do if you were making any other purchase, you have to know what you’re buying and why. This means doing research. Many people don’t like this aspect of investing; it sounds too much like work. But it’s an essential and rewarding aspect of building your investment portfolio. Most educators will tell you that 75 percent of all learning is gained by doing home- work; this is true of investing as well.
When you are interested in investing, it’s important that you do your homework, including research, analysis, and investigation. Look up the stock you own on the Internet and find any company news listings. Read the company newsletter, its annual or semiannual reports, and ask your broker for any updated news about the company. An educated investor is more likely to be a patient and relaxed investor.
Know What You’re Buying, Buy What You Know
One of the benefits of being a consumer is that you are called on to evaluate products and services every day. You have learned that you can get the best results by thoroughly researching your options before you make a purchasing decision. Maybe you’ve recently purchased some new electronics that you just can’t put down, switched cereal brands to cut some of the sugar out of your kids’ diet, or started a new medication that actually made you feel better without any side effects.
These are experiences you can put to work when you’re making your investment decisions. Your observations are another way to gain valuable insight. During your recent trip to Japan, did you notice people consuming huge quantities of a new CocaCola product? While waiting to pay for dinner at your favorite restaurant, did you notice that many of the patrons pulled out American Express cards? Part of doing your homework as an investor is noticing the companies whose products and services are prominently displayed and used by the people around you.
Avoid Hot Tips
Putting serious thought into your investments early on will most likely pay off in the long run. Unfortunately, many people are introduced to the world of investing through a hot stock tip from their barber, buddy, or bellman. There’s really no way to make an easy buck, and by jumping into a stock because of a random tip, you’ll probably end up losing money. Whichever style of investing you choose, you need a place to get the information on which you can base your decision. These days, there’s no better starting point than the Internet.
On the web, you can easily find the best investment information in real time, mostly for free. More and more, investors both young and old are turning to websites to limit their reliance on expensive financial advisors. In addition to the prospect company’s web page, there are dozens of sites that provide in-depth company data and even more that offer real-time stock quotes. There is no shortage of good market research available to you as an investor. Part of your job is to determine which sources work best for your needs.
Read the Annual Report
When it comes to reading financial documents, most people would rather walk over hot coals then peruse endless rows of numbers. Corporations count on that and fill their annual reports with glossy color photos and colorful commentary; a lot of people assume that a heavy, glossy report means a successful year. The numbers inside, though, may tell a completely different story. It’s up to you to get comfortable with the numbers; when you do, you’ll find a wealth of information about the company’s current success.
Make an Investment Checklist
Every investor should use a research checklist to evaluate stock under consideration. Look for annual reports, financial statements, industry comparisons, and current news items. Analyze your findings before making investment decisions. Once you become a shareholder, you will find that your main information needs are filled with press releases, ongoing financial statements, and judicious stock price monitoring. If you’re already a shareholder, you’ll automatically get a copy of the annual report every year; if you’re not yet invested in the company, you can simply call and ask for one or look at it online. Every company’s report looks different, and they may be assembled in different orders. However, every publicly traded company’s annual report contains the same basic items:
- Letter from the chairman of the board (expect a big pile of spin here)
- A description of the company’s products and services (more spin)
- Financial statements (read the footnotes carefully; they contain some of the
- Management discussion (sort of a big-picture look at the company, with a little spin)
- CPA opinion letter (read this to make sure the company’s financial position is
- accurately represented)
- Company information (locations, officer names, and contact information)
- Historical stock data (including dividend history and dividend reinvestment
- plan program information)
Two Proven Ways to Analyze Stocks
Investors generally favor one of two stock-picking techniques: technical analysis or fundamental analysis. Technical analysis is all about stock prices and how they move, and it relies on charts and graphs to determine patterns. Fundamental analysis, more common among beginning investors, involves studying the company
itself, with a focus on financial statements and performance. For optimum results, many savvy investors combine both techniques when making trade decisions. For example, a stock with great fundamentals and sagging price trends could indicate trouble on the horizon. Technical analysis focuses on charts and graphs showing past stock price and volume patterns.
There are a number of patterns technical analysts recognize to be historically recurring. The trick is to identify the pattern before it is completed, then buy or sell according to where the pattern indicates the stock is headed. Those who use this technique believe you can forecast future stock prices by studying past price trends. They make trades based primarily on stock price movements. Technical analysts tend to do much more buying and selling than fundamental analysts.
Fundamental analysis is a long-used, common way to review stocks. The technique involves an analysis of the company’s ability to generate earnings and an examination of the value of the company’s total assets. Value investing and growth in- vesting are two subdivisions of fundamental analysis. Proponents of fundamental analysis believe that stock prices will rise as a result of growth. Earnings, dividends, and book values are all examined, and a buy-and-hold approach is usually followed. Fundamental analysis advocates maintain that stock in well-run, high- quality companies will become more valuable over time.
5 Characteristics of Great Companies
Once you’ve narrowed your focus to a handful of companies, you need to fine-tune your research even more. One of the primary reasons to buy a particular stock is because of its future outlook. It’s wise to buy and hold onto a stock for the long term, so quality is an important part of your investment strategy. Among other factors, you want to purchase stock in a company that you believe has the following traits:
- Sound business model. You want to single out a company that has a solid business plan and a good grasp of where it wants to be in the years ahead, and a plan to get there. A company with a clear focus has a better chance of reaching its goals and succeeding than a company that just rolls along without a concrete plan.
- Superior management. An experienced, innovative, and progressive management team has the best chance of leading a company into the future. Star managers have had a major impact on their prospective companies, and a company will often witness dramatic changes when a new management team comes onboard. When key management leaves an organization, you will often see major changes in the way a company operates.
- Significant market share. When a majority of individuals rely upon the products and/or services of a designated company, odds are the company has good insight into consumer preferences. Industry market leaders usually have a well-thought-out vision. However, the strongest company performance doesn’t always indicate the best stock to buy. Be careful and look more closely at markets with a glut of competitors; sometimes the second- best company makes the best stock investment.
- Competitive advantages. A company that is ahead of the pack will often be on top of cutting-edge trends and industry changes in areas like marketing and technology. You want to single out those companies that are—and are likely to stay—one step ahead of the competition.
- New developments. If a company places a high priority on research and development, it’s likely to roll out successful introductions. If the product or service takes off, the stock price may very well follow. If the future outlook for a particular company appears promising—that is, as long as a company continues to exhibit these traits and act upon them—owning a portion of that company might make good business sense.