Zero in on 7 hot sectors

By Harry Domash

"Stocks, like sheep, move in herds. If you want your sheep to move north, you'd better pick a sheep in a herd moving north."

That pithy advice from technical analyst John Bollinger illustrates why many professional money managers believe investing success depends more on picking the right industry than the right stock.

The other side of that coin is equally true. A great company won't be a great stock if the market has soured on its industry.

The trick, of course, is figuring out which industries are heating up, and which are cooling, before they've made their move.

Doing that doesn't have to be rocket science. Here's why: Many growth and momentum investors rely on Wall Street analysts' earnings-forecast trends and recent earnings surprises to predict future stock-price action. It seems to me there's no reason you can't do the same thing on an industry basis.

First, some background on what's so important about forecast trends and surprise history.

The lemmings of Wall Street

Changes in analysts' forecasts are probably the biggest single stock-price mover. What's interesting is that analysts' consensus forecasts tend to move in trends. That is, once the forecasts move, either up or down, they often continue on that same path.

Why? Probably because when one analyst makes a significant forecast change, other analysts fire up their spreadsheets to see if they've missed something. Often, they'll find they have and revise their estimates in the same direction.

Surprise, surprise

An earnings surprise is the difference between analysts' consensus forecasts and a company's reported earnings. It's a positive surprise when reported earnings come in above the forecasts and a negative surprise when they come in below forecasts.

All else equal, significant positive surprises usually move share prices up on announcement day, and vice versa. But there's more. Several researchers have found that stocks with recent positive earnings surprises continue to outperform the market for a period of several weeks. Those with recent negative surprises continue to underperform.

Since earnings-forecast trends and recent surprise history are useful for predicting individual stock-price action, it stands to reason that they would be useful for predicting industry trends as well.

My premise for applying those principles to industries is simple.

Industries with the most stocks showing positive earnings-forecast trends and recent positive surprises are likely to outperform the market. Conversely, industries that have a preponderance of stocks with negative forecast trends and negative surprises are likely to underperform.

You can compile lists of industries in both categories using MSN Money's Deluxe Screener.

First, I built two simple screens, one for finding hot stocks and another for spotting stocks that are probably headed down.

Hot-stock screen

I used two screening parameters that are found in a relatively obscure location on the screener.

Find them by selecting Advisor FYI under the Field Name and then select Analyst Projections.

Increased earnings forecasts

I look for stocks whose forecasts have moved up within the last week. You can increase the number of stocks your screen turns up by changing the time frame to the "last month" or the "last quarter." You can also enter a specific start date such as "5/1/2005."

• Screening Parameter: Earnings Estimate Increased Since

Recent surprises

I require a 10% minimum recent quarterly surprise, for instance 5 cents for a 50-cent-per-share earnings forecast. Many companies report one- or two-cent surprises, which the market discounts because they are so common. So, while you can increase the required percentage to cut the number of stocks your screen turns up, I don't advise reducing it.

• Screening Parameter: Recent Qtr Surprise % >= 10

Cold-stock screen

My screen for pinpointing potential losers is a mirror image of my hot-stock screen.

• Screening Parameter: Earnings Estimate Decreased Since

• Screening Parameter: Recent Qtr Surprise % <= 10

My hot-stock screen listed 165 stocks. My cold-stock screen turned up 140 stocks. The system works best if the numbers of stocks listed by each screen are in the same ballpark. If they're not -- say, the hot screen lists 300 stocks and the cold screen lists 100 -- adjust one or both of the "surprise" percentage parameters until you get roughly the same number of stocks on each screen.

I used the "Customize Column Set" feature to add an "Industry Name" column to the screen results and sorted each screen's stock list by industry name.

Then I printed each screen's list and tabulated how many times each industry turned up on each list. I counted hot-screen listings as positive numbers and cold-screen listings as negative. For example, Aerospace/Defense turned up four times on the hot list (+4) and one time on the cold list (-1), so its score was +3. To save time, I ignored industries that didn't show up at least three times on one of the lists. I added industries with scores of three or more to my hot list, and those with scores of minus three or lower to the cold list.

Hot

• Oil and gas equipment and services: +7

• Residential construction: +4

• Oil and gas drilling and exploration: +4

• Property and casualty insurance: +3

• Aerospace/defense: +3

• Railroads: +3

• Science and tech instruments: +3

And not

• Gold (mining): -6

• Paper and paper products: -6

• Savings and loans: -5

• Asset management: -3

Given our preoccupation with oil prices, the fact that oil-and-gas equipment stocks topped the list was no surprise. Same for oil-and-gas drilling and exploration stocks. But given the rising interest rate environment, seeing residential construction on the hot list was a total surprise.

But the fact is, despite conventional wisdom that home sales have peaked, the four homebuilders, Centex (CTX, news, msgs), Pulte Homes (PHM, news, msgs), Standard Pacific (SPF, news, msgs) and Meritage Homes (MTH, news, msgs), all reported strong March quarter results. Meritage, for instance, reported March quarter earnings of $1.55 per share, a whopping 40% above the $1.11 the analysts were expecting.

In fact, except for energy-related stocks, all of the industries on the hot list surprised me. Who would have thought that railroads or property-and-casualty insurance companies would pop up on a hot-industries list.

Same thing with the cold list. Since rising interest rates have slowed the mortgage-refinance rate, I wasn't surprised to see savings and loans, an industry that specializes in home mortgages, on the list. But gold mining? Even though gold is off its recent highs, that's not an industry that I perceived to be on a downward slope.

I also thought cyclical stocks such as paper and paper products still had more upside in this economy. But the six paper stocks that showed up on the list, Avery Dennison (AVY, news, msgs), Bowater (BOW, news, msgs), Stora Enso (SEO, news, msgs), Caraustar Industries (CSAR, news, msgs), Pope & Talbot (POP, news, msgs) and MeadWestvaco (MWV, news, msgs), all reported disappointing March quarter results.

Due diligence still required

You'll find plenty of losing stocks in even the hottest industries. Usually, investors making an industry play try to pinpoint the strongest players in terms of stock-price performance (relative strength) and expected earnings growth. You can see relative strength (higher is better) for the last three, six and 12 months on the Company Report page, and the earnings growth forecasts on the Earnings Estimates report. As is the case with any strategy, the more you know about the stocks you buy, the better your results.

While, in my view, the strategy for picking hot industries is based on sound principles, it's a new idea and I haven't tracked its results. I'll update you after a few months on how it works in practice.

At the time of publication, Harry Domash did not own or control positions in any of the stocks mentioned in this article. Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. Harry has two investing books out, the most recent being "Fire Your Stock Analyst," published by Financial Times Prentice Hall.