10 Questions to Ask Before Investing in a Sector

Barbara Friedberg

Have you considered investing in a particular sector?

Maybe you believe technology is a good bet, but don't want to invest in only one technology stock, such as Intel, Apple, Microsoft or Facebook. Sector investing eliminates the decision of which stock within a sector you should invest in.

Here is what you need to know to decide which sector to invest in, if you should invest in a sector at all.

1. What is a sector? Investopedia defines a sector as, "An industry or market sharing common characteristics. Investors use sectors to place stocks and other investments into categories like technology, health care, energy, utilities and telecommunications. Each sector has unique characteristics and a different risk profile."

On the risk ladder, a sector fund investment is less risky than an individual stock investment, but riskier than a diversified investment in a total market index fund such as a Fidelity, Charles Schwab, or Vanguard total U.S. market index fund.

There are many ways to slice and dice the sectors. To keep this discussion manageable, let's use the Dow Jones U.S. Total Stock Market Sectors as our proxy for sector investing. The Dow Jones Company breaks the U.S. stock market into 10 basic categories which represent approximately 95 percent of the U.S. market capitalization.

These sectors are:

-- Dow Jones U.S. Basic Materials Index

-- Dow Jones U.S. Consumer Goods Index

-- Dow Jones U.S. Consumer Services Index

-- Dow Jones U.S. Financials Index

-- Dow Jones U.S. Health Care Index

-- Dow Jones U.S. Industrials Index

-- Dow Jones U.S. Oil & Gas Index

-- Dow Jones U.S. Technology Index

-- Dow Jones U.S. Telecommunications Index

-- Dow Jones U.S. Utilities Index

2. What's the point of investing in a sector fund? Many people believe that if you pick the fastest growing sector or sectors in which to invest, you get a leg up on the investing competition and can outperform the general markets.

We will explore sector investing and give you some information to help you decide for yourself whether to tilt your investment portfolio towards certain sectors or maintain a broad based investing approach.

3. How have sectors performed recently? The week of July 17, 2014, all sectors were down except technology and telecommunications. Yet, the sector performance for the previous month tells a different story. Only four sectors were down: consumer goods, financials, industrials and utilities. The oil and gas sector growth was even or zero. The remaining five sectors were up: basic materials, consumer services, health care, technology and telecommunications, with a whopping 2.26 percent surge last month.

So what does this tell the investor?

In the short run, stocks as well as sectors go up and down.

4. What can you learn from specific sector performance? Over the long haul, you can expect sectors to move based upon the strength of the revenue growth and the demand for the products and services sold by the companies within a sector. When technology companies are experiencing new product launches and growing demand, it's likely that the technology sector will experience robust growth.

5. How do you determine which sectors will advance in the future? The investor would go about choosing a sector in which to invest in a similar way to choosing an individual stock. First, start with a particular sector of interest. Let's do a quick case study to see how you would go about analyzing and choosing a sector fund.

For example, let's look at the financials sector. A proxy for the unmanaged financials sector is the iShares Dow Jones US Financial ETF. According to Morningstar, the top holdings in this ETF financial sector fund are Wells Fargo & Co, Berkshire Hathaway Inc., JP Morgan Chase & Co, Bank of America Corporation, and Citigroup Inc. You probably recognize all of these financial companies.

Growth factors in sector analysis. You need to think about what will drive the future revenues of these companies. Financials are particularly sensitive to the overall economy. Even minor changes in unemployment and consumer confidence can have a great impact on consumers' willingness to borrow or their repayment rates. When the economic growth slows, it's likely this sector will slow as well.

As an investor, do you expect the economy to expand in the future? It's possible that when interest rates rise, so will the profitability of the financial sector. At present, housing seems to be growing nicely with strong demand for both new mortgages and refinancing of the older loans.

6. Is this a sign to invest in financials? To determine the future growth of financial companies you need to do some economic forecasting as well as valuation analysis.

Valuation factors in sector analysis. Let's assume you have researched the future direction of the economy and believe the U.S. is poised for growth and interest rates will slowly rise. And you conclude financials may be a good place to invest.

The next question to consider is, "How is the valuation of the financial sector?" As with individual stocks, even if a particular stock is a strong company, it may not be a good investment if it's overpriced.

The iShares US Financials fund's price/prospective earnings ratio or P/E ratio is 15.63, according to Morningstar. This means that you're paying $15.63 for one dollar of future earnings growth (of the companies within the fund).

7. Is this P/E ratio cheap or expensive? Well, it's a bit more expensive than the historical P/E ratio of the U.S. stock market of 14. Although comparing the financial sector P/E ratio with the U.S. stock market P/E ratio is helpful, it's better to look at the past P/E ratio of the financials in order to make a more precise comparison.

Another important ratio for financials is the price-to-book ratio. The financial sector price-to-book ratio is 1.37, a bit higher than the fairly valued 1.0 price-to-book ratio would be. On these two valuation measures, the financial sector is looking a bit frothy.

8. What are the potential risks of investing in this sector? Morningstar analyst Robert Goldsborough doesn't expect banks to rev up growth any time soon. High unemployment or tepid growth might sink this industry. If interest rates rise, the investment banks may suffer from a slowdown in underwriting growth. The continuing European sovereign debt problems could also hurt the U.S. banking sector.

9. What sector should I invest in now? As the previous analysis illustrates, choosing a sector is just as challenging as researching an individual stock. It requires economic and valuation analysis. If you are interested in tilting your portfolio towards a particular sector, do your homework first. Be an informed consumer and educate yourself about the factors influencing the growth and future profits of a sector.

10. Does all this seem like a bit too much work? A simple index fund portfolio, aligned with your risk tolerance, can perform quite well. Personally, I haven't invested in any sector funds and prefer broader diversification across asset classes.

Barbara Friedberg, MBA, MS , is a portfolio manager, consultant, website CEO and author of "How to Get Rich; Wealth Building Guide for the Financially Illiterate." Learn more about money and pick up her newest free investing book at Barbara Friedberg Personal Finance.com .