Picking profitable sectors is a new game, post-crunch

BRITAIN is on the verge of economic recovery we heard last week, and investors&rsquo; confidence was boosted by improving data. The stock markets have been taking their cue from economics over recent weeks and further signs confirming a recovery could help lift the FTSE 100 above the current 4,500 resistance level that has proved somewhat of a sticking point for the index.<br /><br />If you are a spread better picking stocks and sectors to trade rather than indices, then the fundamental value of the companies and the overall sectors are integral parts of your trading decisions.<br /><br />A company&rsquo;s price-earnings (P/E) ratio and return on equity (ROE) are two key values that every investor considers when making the decision to trade. The P/E ratio essentially shows the relationship of share price to profit &ndash; this helps traders see whether a company is overvalued compared to its historical levels and also to compare it to its sectoral peers. ROE measures a corporation&rsquo;s profitability by revealing how much profit a company generates with shareholders&rsquo; investment.<br /><br />Historically, the average P/E multiple for UK stocks has been 13 and the ROE 14 per cent. Morgan Stanley analysts said that if we were to assume that the post-crisis world reverts to these averages, that would imply a further 18 per cent upside to fair value for stocks at current prices.<br /><br /><strong>LESS OPTIMISTIC</strong><br />However, a research update from MS&rsquo;s Graham Secker says a less optimistic outcome suggests that UK equities are in fact between zero and 20 per cent overvalued.<br /><br />&ldquo;In contrast to the last 35 years, the future is likely to involve slower economic growth, higher financing costs and increased regulation and taxation, which are likely to weigh on long-term corporate profitability,&rdquo; he writes.<br /><br />For Secker, the sectors with the greatest upside on this basis (all more than 50 per cent) are banks, real estate, telecoms and construction and materials. In contrast, basic resources, food and beverages and chemicals offer very modest upside, and utilities are actually trading around 10 per cent above fair value currently.<br /><br />UBS analyst Nick Nelson also thinks that this recovery will be slower than before. He has assumed the recovery in margins in 2010 to be half that of the recovery seen in previous cycles (55 basis points versus 110 basis points).<br /><br />He has looked at companies&rsquo; average earnings before interest and tax (Ebit) margins by sector over the last cycle and says that on the whole, he would be nervous of sectors &ndash; such as metals and mining &ndash; where the forecasted 2009 margin is in line with or above the last cycle average, as this might be too optimistic, .<br /><br /><strong>DECIMATED PRICES</strong><br />Spread betters looking for long plays should consider those stocks and sectors which have a decent upside potential such as the banks, whose share prices have been decimated.<br /><br />Barclays is looking particularly strong, particularly following the conclusion of the BGI deal last week, which Charles Stanley&rsquo;s Nic Clarke says substantially improves the group&rsquo;s capital position and adds that there is no doubt that the market is more favourably disposed to those banks with higher capital ratios given the current economic environment.<br /><br />However, according to Secker, the financial crisis is likely to means that it will take some time for banks to be able to return to prior ROE levels given their requirement to de-lever. But sectors like oil and gas could benefit from higher commodity and power prices.<br /><br />In contrast, utilities are currently overvalued by about 10 per cent, says Secker &ndash; they have been hit recently by the increase in energy prices &ndash; and these stocks could now be worth a short.<br /><br />However, choosing an individual stock on which to take a long position remains highly risky, given the continued uncertainty. This is where trading sectors rather than individual equities can help reduce your overall risk exposure and will allow you to take a broader view. But, choose the sectors with the most upside if you want your long positions to be profitable.