Stock Sectors

Stock sectors are a way of categorizing stocks into pre-defined groups that reflect the role that a company plays in the economy. Some sectors are consistent performers no matter what is happening in the economy. However, investors know that some sectors perform differently depending on the state of the economy and the consumer.

This article will provide an overview of the most common stock sectors and offer some basic principles that investors can use to be profitable sector investors.

What Are the Major Stock Sectors?

Communications Services (Telecommunications)

This sector features companies that enable global communication whether that is in audio or video formats. The sector includes industries such as: diversified telecommunication services; wireless telecommunication services; entertainment; media; and interactive media & services.

The growth in this sector has been fueled by wireless communication which has moved into the expansion of mobile services. The sector has companies that appeal to both growth and value income investors.

Consumer Discretionary

This sector features companies that make or provide what are considered “non-essential” products or services. The sector includes industries such as automobile components; automobiles; distributors; diversified consumer services; hotels, restaurants & leisure; household durables; leisure products; multiline retail; specialty retail; textile, apparel & luxury goods; and internet and direct marketing.

This sector tends to do better when the economy is doing well and consumers have more discretionary income. However, some companies in this sector such as Amazon (NASDAQ: AMZN) and even Nike (NYSE: NKE) may do well even in a poor economy.

Consumer Staples

This sector is the inverse of consumer discretionary companies. That means these companies provide essential goods and services – the kind of things consumers can’t live without. The sector includes industries such as: beverages; food & staples retailing; food products; household products; and personal products. Since 2000, the list has expanded to include sin stocks in areas such as alcohol and tobacco.

These stocks are considered defensive because consumers have to buy them no matter what. This does give the best-in-class companies pricing power and allows them to outpace the broader market in a downturn. However, these are also typically low-margin products that restrict the growth of these companies. For that reason, many of the companies on this list pay dividends to help increase shareholder value.

Energy

This sector features companies that either directly or indirectly provide and/or distribute power to our economy. The sector includes industries such as: energy equipment & services; oil, gas & consumable fuels.

For many years, this sector was dominated by non-renewable energy companies. While those companies are still listed in the sector, they take up a smaller percentage. That’s due to the emergence of renewable energy companies such as wind and solar companies that are commanding a larger share of this sector.

The performance of energy stocks is intrinsically tied to the performance of the underlying commodity. For example, when the price of oil is high oil and gas stocks tend to outperform the market. But the opposite is true when oil prices fall. This dynamic was seen at its extreme at the onset of the Covid-19 pandemic when, for a brief moment, the futures contract for crude oil turned negative due to the uncertainty surrounding future demand.

Financials

This sector features companies that provide financial services to individuals and businesses. The sector includes industries such as: banking; capital markets; consumer finance; diversified financial services; insurance; mortgage real estate investment trusts (REITs); and thrifts & mortgage finance.

For the most part, this is a sector that does better when the economy is strong. At first glance this is a paradox because banks derive a significant amount of income from the interest they receive on loans. And when interest rates are lower (as generally is a sign of a strong economy), banks have lower lending margins. However, as the decade after the financial crisis showed, lower interest rates can facilitate more demand for loans as consumers and businesses have easier access to capital.

Conversely, when the economy slows and interest rates rise a bank may profit more from a loan, but there is less lending activity as many consumers and businesses try to prevent themselves from being overleveraged.

In recent years, this sector has expanded to include financial technology (i.e. fintech) companies such as PayPal (NASDAQ: PYPL) and more recently SoFi Technologies (NASDAQ: SOFI).

Health Care

This sector features companies that provide medical services including insurance, medical equipment and pharmaceutical products. The sector includes industries such as: biotechnology; health care equipment & services; health care providers & services; health care technology; life sciences tools & services; and pharmaceuticals.

The health care sector can be a challenging one for investors to navigate. On the one hand, health care itself is an evergreen need. On the other hand, the sector is always under pressure to provide the best care at the lowest cost. The sector also is prone to demographic shifts. For example, the baby boomer generation is now retired and many are in need of more medical care.

However, there are other sectors such as pharmaceutical companies that are constantly trying to bring new drugs and therapeutics to market. If they’re successful, the company’s revenue and profits can go up for years. But if not, their revenue and earnings (and share price) are likely to drop.

Industrials

This sector features companies that manufacture products or provide services that are used in the manufacturing and/or construction industries. The sector includes industries such as: aerospace & defense; air freight & logistics; airlines; building products; commercial services & supplies; construction & engineering; electrical equipment; industrial conglomerates; machinery; marine; professional services; road & rail; trading companies & distributors; and transportation infrastructure.

Industrial stocks tend to be a leading indicator of the overall economy. When the economy is strong, industrial stocks tend to lead the way as orders for the company’s products increases along with strong building demand.  However, when the economy is contracting, consumers and businesses will cut back on these purchases which directly affect the revenue and earnings of these companies (along with their stock).

Information Technology

This sector features companies that research, develop or distribute technology goods and services. The sector includes industries such as: communications equipment; electronic equipment, instruments & components; IT services; semiconductors & semiconductor equipment; software; and technology hardware, storage & peripherals.

The “tech sector” features high-growth stocks that tend to trade at a premium to the overall market. Some of these companies will have fundamentals that would be considered unhealthy in other sectors. For example, the average price-to-earnings (P/E) ratio of companies in the sector tends to be much higher. And some of these companies are not yet profitable with some of the smaller companies not yet even generating revenue.

Materials

This sector features companies that are engaged in discovering, developing and processing of raw materials. The sector includes industries such as: chemicals; construction materials; containers & packaging; metals & mining; and paper & forest products.

This sector is also considered a leading indicator for the economy because the businesses that provide these services are providing their products and services on the front end of the production cycle. Therefore, slowdown in material ordering signals weaker economic growth. Conversely, higher demand for materials can signify increased economic activity.

Real Estate

This sector features companies engaged in the buying and selling of properties that are used to build homes and businesses. The sector features companies in industries such as: equity real estate investment trusts; and real estate management & development. The sector is generally divided into three categories: residential, commercial, and industrial.

The real estate sector is highly cyclical and is often a leading indicator of strength or weakness in the economy.

Utilities

This sector features companies that provide the basic services that are needed in society including natural gas, water, sewage services, electricity, and dams. The sector features companies in industries such as: electric utilities; gas utilities; independent power and renewable electricity producers; multi-utilities; and water utilities.

The utility sector is highly regulated. This is both good and bad for investors. It’s good because the companies have predictable revenue and earnings and usually provide regular dividends. It’s bad because these are not companies that show strong growth.

However, due to the revenue they provide in good and bad economies, investors may find these stocks attractive when the market is weak because they help to preserve capital.

Strategies for Successful Sector Investing

Once you become familiar with the different market sectors, you’ll begin to see why investors may choose to shift into one sector or another at various times in the economic cycle. Here are some basic strategies that investors can employ:

• The Trend is Your Friend – Market timing is challenging for even the most experienced investor. And unless you’re a committed day trader it’s not a viable investing strategy. However, you don’t have to buy at the perfect market bottom or sell at the perfect market top to observe trends.

Every stock chart tells a story, and investors today have a wealth of free resources that can help them learn the basics of technical analysis. In many cases, unless you are taking a long position or have a compelling reason to hold a stock that is experiencing a significant move in one way or the other it can be a good idea to take some profit or to cut your losses.

• Get Defensive When the Economy is Weakening – Defensive stocks tend to outperform the broader market when the economy is slowing down. This doesn’t mean that these stocks won’t post a loss. But it does mean that they typically perform “less bad” than growth-oriented stocks.

Getting defensive however, doesn’t necessarily mean avoiding growth altogether. That’s because many defensive stocks pay dividends. And if you have a longer time horizon, this could be a time to pick up quality dividend stocks at significantly lower prices. The income you earn or reinvest from the dividend can boost your total return and set you up for strong gains when the market reverses course.

• Skate Where the Puck is Moving – The stock market is always looking ahead. While some stocks are evergreen, the list is not as long as some investors would like to believe. And in any event, a portfolio that consists exclusively of evergreen stocks is not likely to provide the reward for growth-minded investors.
  
  That’s why it’s so critical for investors to allow themselves the flexibility to reallocate portions of their portfolio to the sectors that are outperforming, or likely to outperform, the broader market. For example, when Congress is considering legislation on an infrastructure bill that would be a good time to look at stocks that benefit from infrastructure spending.