Two Sectors that Deserve the Cold Shoulder

In a previous article I highlighted the best-performing sectors of the past five years and pointed investors to a few undervalued sectors. I also promised a column in which I'd discuss the worst-performing sectors of the past five years. Here it is, and not only will I tell you where you shouldn't have invested, I'll also point out a few sectors that you might want to ignore right now.

Of the 12 sectors that Morningstar actively tracks, none has performed worse over the past five years than hardware, which has dropped 17% per year over the past five years. This is a sector that is--and was--filled with some of the highest-flyers of the Internet bubble years, companies like  JDS Uniphase (JDSU),  Nortel Networks , and  Lucent Technologies . Each of these stocks has lost at least 35% of its value in each of the past five years. For example, JDS Uniphase traded for more than $120 five years ago and now trades for less than $2.

Morningstar Sector Performance (from Worst to Best) for the Past Five Years
Sector	YTD	1 month	3 month	1 year	3 year	5 year
Hardware	1.91	3.16	5.72	13.44	21.04	-18.13
Software	-0.92	2.16	5.57	14.52	17.02	-10.93
Media	-4.1	-0.66	1.73	8.09	11.95	-10.35
Telecom	-0.05	-0.43	6.76	15.35	15.24	-8.1
Health care	9.06	1.49	4.01	13.27	13.23	2
Business services	1.71	1.38	5.02	16.87	19.93	6.4
Financial services	1.64	0.74	5.09	12.5	17.57	6.03
Industrial Materials	2.96	1.38	5.02	16.87	19.93	6.4
Consumer goods	3.04	2.48	4.07	12.25	11.72	6.45
Utilities	17.09	4.61	8.02	36.26	25.54	7.64
Consumer Services	0.10	-1.62	-0.85	12.52	13.39	7.97
Energy	34.63	3.55	16.69	49.16	33.82	13.90
Data as of 09-14-05

The hardware sector was hit the hardest because it was the hottest hotbed for speculation in the late 1990s' bubble market. The promise of windfall profits led to hundreds of billions of dollars of capital being allocated to the sector, lifting share prices sky high. Once the market realized that hardware companies wouldn't be able to make economic profits from this capital, however, it reallocated the capital to other more productive areas of the economy, causing an enormous drop in the market value of businesses in the hardware sector.

The story was much the same in the software and media sectors, which both lost more than 10% annually over the past five years. These sectors were allocated more capital than they could use productively--which wouldn't have been as big a problem had they just kept the cash in the bank rather than mindlessly spending it on value-destroying projects--and their shares plummeted as investors figured this out.

So where are investors now allocating more capital than can possibly be used profitably? Using the Morningstar Rating for stocks as a guide, the clear answer is the energy sector. Of the 112 energy companies that Morningstar rates, 69 of them--or 62%--are currently trading at 1-star prices, while another seven--or 6%--are at 2-stars prices. Not a single energy stock that we cover right now trades in 5-star territory. That the energy sector would be so overvalued makes sense, given its outstanding performance over the past several years (as I discussed in my previous article).

Dispersion of Morningstar Rating for Stocks Across Sectors
Sector	1 Star	2 Stars	3 Stars	4 Stars	5 Stars
Software	34%	13%	40%	8%	6%
Hardware	43%	10%	38%	8%	2%
Media	24%	7%	52%	10%	7%
Telecom	26%	7%	26%	11%	0%
Health care	31%	13%	40%	13%	2%
Consumer services	16%	7%	53%	10%	14%
Business services	32%	17%	39%	9%	3%
Financial services	18%	14%	49%	15%	4%
Consumer goods	12%	15%	45%	25%	4%
Industrial materials	32%	12%	44%	11%	2%
Energy	62%	6%	29%	3%	0%
Utilities	8%	18%	69%	4%	0%
Total	28%	12%	45%	11%	4%
Data as of 09-14-05

Not everyone agrees with our take on the energy sector, which is based upon free cash-flow valuations that are predicated on oil returning to $35 per barrel by 2008. The market for oil has historically been very cyclical, and our analysts don't expect this to change, despite increased demand for oil from developing countries in Asia. High prices like those today--which are still well below the highs of the 70s after accounting for inflation--have always resulted in a market response that eventually leads to a significant decline in price.

At Morningstar, we fully expect the market to once again respond to today's high prices, leading to lower oil prices within two to three years and leading energy stocks down toward our fair value estimates. If we're wrong--and oil remains at these high prices forever--then our fair value estimates will prove to be way off the mark, and we'll look pretty dumb. If you're of the opinion that cycles rarely disappear and that oil prices are likely to tumble in the coming years, then you can probably ignore the energy sector for now.

Another sector you can probably skip is hardware. That's right, the same sector that's been the biggest loser over the past five years, still has relatively little to offer investors. Morningstar covers about 180 hardware companies, but our analysts only consider about 1% of them to be good buys right now. Conversely, 43% of the hardware companies we cover have 1-star ratings, while another 10% have 2-star ratings.

The story with software is similar, so it looks like, for now, you can skip the technology primer, since there isn't much opportunity for long-term investors in that market right now. Neither should you spend precious time figuring out whether we've reached Hubbert's Peak, the point at which worldwide production of crude begins its long, inevitable decline. If you're working on building your circle of competence--which is essential to long-term investment prowess--I'd pass on technology and energy and instead focus on consumer and financial services, where opportunities abound.