In a general sense, fundamental screens offer a top-down approach to help you identify presumably strong sectors that are geared for growth, versus those sectors that seem to be stuck in the mud.
We tapped the minds at BlackRock, parent company of iShares, for their thoughts on what they look for when evaluating sector strength. Heidi Richardson, head of investment strategy for U.S., said, “We always look at valuations, cyclicality of markets and balance sheets. Put these three together and you’ll have a solid base for analyzing any sector or company.”
BlackRock’s investment professionals pay close attention to three main fundamentals when evaluating a sector’s worthiness:
What’s cheap? What’s expensive? How do price-tobook (P/B) and price-to-earnings (P/E) ratios compare with other sectors? These ratios might help you gauge what $1 in share price actually delivers. Keep in mind each sector has unique drivers. And you’ll want to compare current numbers to history. Generally, P/B is a measure of how much investors are paying for each dollar of total assets, while P/E reveals what the company earns from business operations. For example, the S&P 500 trades at roughly 18 P/E and 3 P/B. A lower ratio could mean that the sector is undervalued compared to the broad market. However, it could also mean that something is fundamentally wrong. Ratios vary by sector, so be sure to consider other factors.
2. The market cycle
How’s the economy? Is GDP growing? Is job creation healthy? During economic expansion, people spend more. So “cyclical” sectors like consumer discretionary, energy, financials, industrials, and information technology can benefit from increased activity.
During a recession, consider playing defense. Sectors that tend to outperform during slowdowns include healthcare, consumer staples, utilities, and telecommunications.
3. Balance sheets
Who’s got cash on hand and who’s servicing debt? As the Federal Reserve begins to normalize interest rates, monetary policy will continue to be influential.
Sectors with cash-heavy balance sheets, like technology, will be less vulnerable to rising rates than those carrying large amounts of debt, like utilities. What’s more, cash will continue to benefit shareholder-friendly policies like rising dividends, share repurchases, and M&A activity. An asset-to-liability ratio can also help shine a light on a balance-sheet outlook. BlackRock professionals analyze this sector metric as an aggregate of all the companies within the sector. A ratio reading under 1 suggests a company has more liabilities than assets.
In combing the three factors, areas like financials and technology, for example, may offer interesting opportunities in an environment of economic recovery and as we enter a new era of rising rates. The point is, traders have a wealth of fundamental data at their disposal, which can tell you things about sector strength your charts might not be able to.