INVESTMENT STRATEGIES - SECTOR BASICS A GLOBAL VIEW

Sector basics

1. It's the economy, stupid

• Over the long run, economic growth and stock market returns have actually
been negatively correlated. What really matter are turning points.
• Over time, the economy moves through stages where it expands and contracts
at changing speeds. Financial experts commonly refer to this as the 'economic
cycle', and typically switch between different sectors according to which stage
of the 'cycle' it is. As the economy picks up, the idea is to move into
economically sensitive industries. When it falters, investors move into those
that are less sensitive.
• Talking about a 'cycle' makes it sound as though the economy follows a
smooth and predictable pattern. While contractions and expansions do happen
in turn, the intervals are seldom, if ever, regular. And supposed sub-phases of
this 'cycle' often repeat themselves or get missed out altogether.
• Financial markets aren't concerned with what is going on today, but with what
is likely to happen tomorrow. It is all about anticipating economic
developments. Waiting for confirmation that recovery has taken place is
another way of saying 'missed opportunity'.
• Leading indicators of economic activity provide clues to turning points in the
economy before they happen, as well as the strength or weakness of
tomorrow's growth e.g. the OECD's leading indicator. Sectors often do react to
changing economic conditions as expected. Shares in 'cyclical' industries such
as mining and chemicals do indeed perform better when the leading indicator
points to an improving economy. Likewise, 'defensive' sectors - tobacco and
food producers, for example - have recorded their best results when the
indicator was signalling a slowdown.
• However, not everything follows the textbook.

For example, sectors that are
supposed to fare better during the later stages of an economic 'cycle' often
performed well during its early stages, too. The same is equally true of so-
called 'earlier cyclicals' during the latter stages of an expansion. Now and
again, certain defensive sectors thrive in upswings, while particular cyclical
ones do badly during downswings.
• Identifying sectors' behaviour is one thing, explaining it is more difficult. The
conventional story is based on profits. In this view, cyclical firms have
cyclical earnings. When those earnings peak, it is best to switch into defensive
sectors, where earnings are much steadier. Thanks to cyclical companies' high
operational and financial gearing, they subsequently enjoy a strong profits
recovery, and investors should exploit this early.
• In reality, there's no need to complicate the situation by introducing earnings.
Investors' attitudes to risk provide a neater explanation. During hard times,
sensible investors want to hold assets that are uncorrelated with their own
incomes or their homes. This could well involve selling volatile shares, such
as those in cyclical sectors. During a recovery, they regain confidence and
enter risky areas, which may well have been oversold in the downturn.

2. Pack animal or lone wolf?

• While looking at sectors is an efficient way to seek out potential investments,
individual shares should not be ignored. A share I in a certain sector will not
necessarily move the same way as that sector. Therefore, you need to know
how a sector's members behave in relation to the group as a whole.
• When a sector consists of very similar companies, the behaviour of the
individual shares tends to be more predictable. For example, the three
members of the UK tobacco sector - whose businesses are almost identical -
have all been around 90 per cent correlated with the overall sector in the past
10 years.
• On the other hand, the leisure sector shows little such conformity. Three of the
four hoteliers are fairly highly correlated with the sector as a whole. A number
of its pub members are somewhat less correlated, while First Choice Holidays,
a tour operator, has only a weak relationship with the group as a whole.
• The situation is even less coherent within support services. This ragbag of a
sector comprises numerous firms, many of which have no obvious link to the
others. Three of its members have been negatively correlated with the sector.
• This diversity has obvious implications for investors wanting to mimic
exposure to an entire sector using 'bellwether' stocks. Based on historical
trends, ICI's shares would replicate the chemicals sector. But Rexam would be
inappropriate in the support services sector.
• Watch out for cases where a company is more highly correlated with a sector
than its members. Life assurer Aviva enjoys a stronger relationship with the
food retail sector than does Wm Morrison a supermarket chain. Likewise,
British Airways moves more closely with the engineering sector than its
constituent members.

3. Club versus country

• As an investment style, allocating money to different industries is steadily
advancing at the expense of doing so across different countries. Economic
globalisation is the most likely reason behind this shift. As economic policies
internationally follow a similar course and economies become more
synchronised, individual industry issues matter more than country ones.
• Academic studies of several stock markets have confirmed that correlations
between countries' returns have slightly increased in recent times, whereas
those between sectors have declined strongly.
• However, other approaches still matter. Even though cross-country investing
has lost ground to sector strategies, researchers stress that countries can play a
useful role in diversifying a portfolio. In addition, there are important choices
to be made between growth and value, as well as between large and small
companies.

4. Where to find out about sectors

• The Financial Times' Companies & Markets section carries a daily FTSE
sectors table containing price, dividend and earnings information.
• Yahoo’s finance pages are easy to use and have some nifty features. As well
as breaking down each sector into its constituent companies, the pages also
enable users to plot charts, including technical analysis graphs. Go to:
http://uk.biz.yahoo.com/sectors/
• A similar package is offered on the sector pages of Selftrade, including
advanced technical analysis and Japanese candlestick graphs.

The main sector drivers

According to the capital asset pricing model, the only systematic risk affecting sector
returns was market risk. Here are some of the other risks:

Real interest rates

• Many sectors are sensitive to changes in real interest rates, as measured by
index-linked gilt yields. This is especially true for telecoms. A one percentage
point rise in index-linked yields is associated with a 49 per cent fall in the
sector. Changes in index-linked yields alone can explain two-fifths of the
variation in telecoms' annual returns since 1990. Such a rise is also associated
with 20 per cent-plus falls in the insurance and IT sectors. However, rising
real interest rates are associated with good returns on mining, chemicals and
paper stocks.
• There's a simple reason for these links. Telecoms and IT stocks are supposed
to offer plenty of cash flows in the distant future, being 'growth stocks'. A rise
in real interest rates increases the rate at which investors discount future cash
flows, which impacts negatively.

Retail sales and house prices

• General retailing stocks are not badly hit by slower retail sales. Since 1990,
the correlation between retail sales volumes and general retailers has been
slightly negative.
• Instead, falling retail sales matter for real estate (a 1 per cent drop in retail
sales is associated with a 4.1 per cent fall), pharmaceuticals and telecoms
stocks (where a 1 per cent fall in sales is associated with 5 per cent higher
returns for both sectors). For most sectors, however, the impact is
insignificant.
• The same is true for house prices. There's not a single FTSE sector that moves
by more than 2 per cent (up or down) with a 1 per cent drop in house prices.
Even the construction sector, on average, falls only 4 per cent when house
prices drop 10 per cent.

Leading indicators

• The OECD's index of leading indicators for the world economy matters. A 1
per cent rise in this over 12 months is associated with returns of 3.5 per cent or
more on the general industrials, media, software and leisure sectors. For these
sectors, moves in the OECD's lead indicator alone can explain more than one-
fifth of the variance in annual returns. The reason is signs of better economic
times to come are good news for many sectors.
Oil prices

• The oil sector does not benefit most from rising oil prices; mining, media and
IT sectors have all been more sensitive to oil prices. The oil sector is
dominated by the diversified giants, BP and Royal Dutch Shell, whose prices
do not move much. A strong oil price is usually a sign of a strong global
economy, which benefits cyclical stocks.
• The main message is that sectors are not very sensitive to oil. Even a 50 per
cent rise in oil prices is associated, on average, with only a 15 per cent rise in
the mining sector, a 6.5 per cent rise in the oil sector and a 14 per cent drop in
tobacco, which is usually the hardest-hit sector.

Short-term interest rates

• A one percentage point rise in short-term rates is associated, on average, with
falls of 3-5 per cent in the general retailing, banks, mining and tobacco sectors,
but rises of just over 2 per cent in the pharmaceuticals, food retailing and
software sectors.

Sector behaviour

Sector reputations stem from their supposed relationships with the wider economy
and the stock market. They are typically labelled either 'defensive' or 'cyclical',
depending on how they are meant to behave under certain economic conditions and in
response to movements in the market.

Aerospace & defence: capital spending by firms on expensive equipment, such as
aircraft, generally waits until the economy has clearly taken off. Consequently,
investors have branded the sector a 'later' or 'industrial' cyclical. Its poor showing
during the early 1990s' recovery supports this notion.

Banks: the banks sector, despite its low beta, is not considered defensive. However,
the sector has frequently outperformed in anticipation of both improving and
worsening economic conditions. Interestingly, it has tended to beat the market more
often and more strongly as leading indicators deteriorate.
Beverages: a favourite defensive refuge in harder economic times. History bears this
out, with fairly consistent performance during downswings, matched by poor
showings during upswings. Rather insensitive to stock market gyrations, it also offers
low variation compared with its level of returns.

Chemicals: the chemicals sector is definitely considered cyclical and has performed
consistently well during upswings and poorly in weaker periods. Often spoken of as
an early cyclical, the sector did indeed achieve its greatest out-performance during the
recovery that followed the last UK recession.

Construction & building materials: this sector, cyclical by reputation, has had
mixed showings in both periods of economic strength and weakness. Although known
as an earlier cyclical, the pattern of its returns doesn't really bear this out. Property
market trends may have greater influence than international economic indicators.

Electricity: this is one sector that really does deserve its defensive tag, given its
excellent record during harder economic times. Oddly, it hasn't slumped back during
anticipated cyclical recoveries, as have many of its defensive peers.

Electronics: an obvious play on a strongly rising stock market, the high-beta
electronics sector supposedly does better once an economic recovery has really
developed. Its best recent showing actually occurred in the later stages of the 1990s'
boom, while the sector tends to do worse in downturns.

Engineering & machinery: the engineering and machinery sector is counted as a
later cyclical play, owing to its dependence on capital spending. Nevertheless, it did
well enough in the early stages of the last economic recovery. It is also a consistent
loser during downswings as investors' appetite for risk diminishes.

Food & drug retailers: unlike general retailers, food and drug sellers are seen as a
solid defensive sector. Consistently robust showings during cyclical downturns
support this, while the opposite is true when the economic outlook brightens.

Food producers: belief that 'everyone always needs to eat' underpins the sector's
reputation for defensiveness. When the economy moves from boom to bust food
shares prosper. Recently, they've been the worst performers when strength is forecast.

Forestry & paper: along with other basic materials, paper is classed as early cyclical.
It lived up to this tag coming out of the 1991 recession, but prospered towards the end
of the last stock market upswing. To be avoided when economic slowdown looms.

General retailing: as a consumer-dependent sector, general retail is reputed to
prosper some way into an economic recovery, as consumers benefit from employment
and wage growth. In truth, the sector has an inconsistent record.

Health: increasing demand for health-related products and services means the health
sector is known for combining the qualities of defensiveness and growth. In reality,
however, health has a poor record during harder times, when other defensives have
done well. Indeed, its performances during upswings are much better, which suggests
it has cyclical features.

Insurance: although insurance is not typically included in either cyclicals or
defensives, the sector has a definite tendency to beat the market in times of sliding
confidence and lag behind it when good times are forecast. This makes the sector look
relatively defensive, along with life assurance.

IT hardware: since businesses tend to invest in new technology after an upswing has
got well under way, investors count IT hardware as a later cyclical. During the 1990s,
this was broadly so, with weakness in the early recovery contrasted with strength in
its latter stages. The biggest loser of all, however, when leading indicators deteriorate.

Leisure and hotels: a beta close to the market and a moderately low coefficient of
variation do not immediately suggest a 'late cyclical' sector. In fact, leisure and hotels
has prospered during almost as many downturns as upturns. That said, its overall
performances have been stronger during the good times.

Life assurance: because they hold large amounts of equities, life assurers are
considered by investors to be a geared play on the stock market. In terms of the
economy, though, the sector has often done much better during expected slowdowns
than it has during forecast pick-ups, much as a defensive industry might behave.

Media: considered a cyclical, and deservedly so. Since advertising tends to pick up
some way into an economic recovery, investors rightly believe media to be a late
cyclical. But it can perform early on, as during the upswing at the start of the 1990s.

Mining: more so than any other sector, mining has outperformed the market strongly
during upswings. But its historic performance during periods of weakness is not as
bad as one might expect. Despite a sharp economic slowdown recently, mining has
belied its 'cyclical' tag by continuing to boom, suggesting every 'cycle' is different.

Oil and gas: the sector is widely considered cyclical, and it does outperform more
often and more strongly when leading indicators head up. But the sector has
outperformed just as many times during downturns over recent years, albeit not by the
same degree. The low beta is also untypical of a cyclical sector. It could be that the
combined weight of BP and Royal Dutch Shell makes up such a large part of the
FTSE that outperforming the market is mathematically more unlikely.

Personal care: while notably strong when the economic omens are poor, personal
care, surprisingly, has the capability to beat the market even when things are looking
up - although much of this is based on the sector's largest company, Reckitt
Benckiser, which has undergone a successful restructuring over the past six years.

Pharmaceuticals and biotech: a very low beta and a marked tendency to do well
following peaks in the cyclical leading indicator have earned the sector a rightful
reputation for defensiveness. Conversely, pharmaceuticals tend to disappoint during
times of rising optimism about the economy.

Real estate: its relatively low sensitivity to the stock market smacks of defensiveness,
but this is contradicted by the real estate sector's unspectacular performances during
hard times. This is partly offset by its tendency to do better when economic prospects
improve, making it a cyclical sector of sorts.

Software: since companies tend to invest in new software when their balance sheets
are healthy, software has a 'later cycle' label. A disastrous showing at the beginning of
the 1990s' recovery would tend to support this idea, followed by its strength later in
the decade. Although not a consistent winner during the good times, when it does do
well, it does so spectacularly.

Speciality finance: a collection of firms that are not easily categorised with other
financials such as banks, speciality finance does not have an obvious reputation
among investors. It has cyclical qualities, though, having done markedly well when
economic growth is on the horizon.

Support services: given the highly differing characteristics of the companies making
up this sector, there is confusion among investors as to its identity. Experience shows
it to be strongly 'cyclical', gaining and losing alongside the leading indicator.

Steel: the sector is rightly considered cyclical, although the 'early' tag is unhelpful.
That said, steel has not always outperformed during periods when the leading
indicator has gained. When it has, though, it has often done so impressively. In true
cyclical fashion, it almost always loses during the downswings.

Telecom services: the advent of mobile telephony meant that the perception of the
telecom services sector changed from that of a utility to that of a growth sector.
Although it did disastrously during the bursting of the technology bubble, the sector's
longer-term success during such times merits its defensive tag. Still, it shows that
sectors' reputations are liable to sudden change.

Tobacco: known as the classic defensive sector, tobacco has indeed done
exceptionally well during every one of the past seven major declines in the leading
indicator. It is important not to confuse the late maturity of the industry with its
investment potential, though, as the excellent sector share price growth in recent years
emphasises.

Transport: both people and goods move around most when the economy is in full
swing, which may account for transport's 'late cyclical' badge. In fact, it achieved one
of its best showings during the early 1990s' recovery. Overall, however, it has actually
disappointed during cyclical upturns, doing slightly less badly in downturns.

Utilities (other): with their steadily flowing businesses, water companies are
regarded as defensives. The excellent performance of other utilities when the leading
indicator has turned down supports this, while they have done poorly during the good
times.

Sector recommendations - late 2007

Aerospace & defence: airlines continue to struggle with bloated costs and rocketing
fuel prices but the high oil price has proved good news for the UK's aerospace sector.
New planes have generated orders on the promise of greater fuel efficiencies. The
soaring oil price means that cash-rich Middle Eastern flag-carriers have been ordering
new planes. Boeing and Airbus expect to increase aircraft deliveries by around 10%
this year, and analysts predict an extended super-cycle. Meanwhile, defence markets
are also offering solid prospects, with new military aircraft and a wider shift to
technology-led warfare prompting huge increases in budgets. Buy.

Banks: an uncertain housing market and a massive consumer debt pile do not make
for an ideal banking backdrop. But given that it would take an economic recession of
early 1990s proportions to seriously hit the banking sector, the outlook is not so bad.
However, some banks are better placed than others. Two camps at present: slow
growth, costly players such as Lloyds TSB, which are overly focused on slow-moving
UK retail business; and those with efficient structures and more diversified earnings
bases, such as HBOS or RBS. Yet, despite the quality differences, there's not much
difference in bank share price ratings, making the sector good value overall.

Beverages: consolidation hopes should help support shares prices over the coming
year. The two international brewers - Scottish & Newcastle and SABMiller - are the
most likely participants in any takeover action. Given their solid reputation, beverages
companies could benefit if investors' appetite for economically sensitive industries
wanes. But slowing consumption of alcohol - particularly of expensive spirits - is
always a risk during harder times. The possibility of further value-creating deals,
combined with modest valuations, make the sector worth buying.

Chemicals: the sector is groaning under rising costs and potentially onerous new
European legislation. Record oil prices mean many raw material prices are rapidly
increasing, and companies have also had to absorb energy price hikes of around 40 %
in the past year, with more to come. Fortunately, so far most companies have passed
on these costs to customers. But new draft European legislation, known as REACH,
could increase the amount of testing required before new chemicals are introduced
into the marketplace and add to costs. For now, the sector looks fairly priced.

Construction & building materials: spending on schools, hospitals, utilities and
transport is keeping construction companies busy, with several boasting record order
books. The house builders have had to start providing lower-cost units to help first-
time buyers reach the first rung of the housing ladder. Some profit margin erosion has
obviously occurred, but nothing to warrant the rather lowly rating on which the
builders trade. With house-price inflation levelling off, builders and builders'
merchants should see demand starting to accelerate, while there is little sign of any
slowdown in infrastructure spending. Against this background, good value.

Electricity: surging power prices are certainly proving beneficial for share prices in
the electricity sector - since the start of the year, they have gained a whopping 26 per
cent on average. It's true that the cost of producing electricity has also risen due to
higher fossil fuel prices and new carbon emission targets, but those electricity
generators that have extensive and flexible generating assets are powering ahead. The
outlook for electricity prices remains buoyant, underpinned by the tight margin
between generating capacity and demand. What's more, US electricity prices are
showing signs of recovery after several dull years, making the sector worth buying.

Electronic & electrical equipment: a quick glance at valuations across the electronic
and electrical equipment sector suggests there is little short-term value to be found
here. Share prices have climbed sharply over the past 12 months on the back of
burgeoning demand, driven by the US and China, and the average sector multiple is
now a whopping 17 times this year's forecast earnings. This fails to discount the risk
of an economic slowdown in these key markets. Although, so far, there are few signs
that demand is abating, there is little room for error. But, like the engineering sector,
electricals consists of a number of high-quality, high-margin niche businesses that
may be attractive as takeover targets for global engineers. Good value.

Engineering & machinery: the UK engineering sector is a ragbag collection of
highly focused niche businesses, so searching for common threads is almost a fruitless
task. But, as the takeovers of Kidde and Domnick Hunter highlight, global
engineering conglomerates are prepared to pay a premium for these high profit
margin-making specialists. Some analysts believe there may be further consolidation
in the coming months, although they largely shy away from picking potential takeover
candidates. But this likelihood is already reflected in shares prices across the sector,
which trades at a premium to the stock market. And although there could still be value
to be found in companies with exposure to late-cycle capital expenditure-reliant
markets, such as oil & gas and utilities, against a mixed economic backdrop, the
sector is fairly priced.

Food & drug retailers: the battle for market share will remain the main game in the
food retail sector. While Tesco is likely to dominate the industry for some time, the
ongoing challenge for the two other main listed players is to achieve consistent
positive underlying sales growth. And they will have to do so against a tough
background of deflation in selling prices. For Sainsburys, this involves continuing to
improve its competitiveness against its cheaper rivals, but without sacrificing quality.
For Morrison, the test is to complete the messy integration of Safeway. The
combination of defensiveness and individual recovery stories means buy.

Food processors: while food processors should always be able to count on steady
demand for their produce, the sector faces great uncertainties. The big supermarket
chains will continue to demand better terms from these companies. Makers of bog-
standard items - such as milk and supermarket own-label products - are most at risk
here. Owners of top food brands - such as ABF, RHM and Premier Foods - are best-
placed to deal with the pressure. Buying new brands or consolidation is a distinct
possibility. Spikes in energy, packaging and raw material costs also threaten to choke
profitability. But food processing's robust credentials and reasonable rating make it
worth buying.

Forestry & paper: high energy costs and low selling prices for paper products will
continue to dog the forestry & paper sector, otherwise known as DS Smith. Unlike
other basic materials industries, such as mining and steel, paper hasn't benefited from
Chinese economic growth. Having just issued a profit warning induced by the harsh
conditions, Smith has few fans among investors. Self-help measures - such as closing
less efficient mills - could boost the UK sector. Also, a forecast reduction in European
capacity may be on the cards. Ultimately, though, paper needs a recovery in demand
to restore its profits. Based on its low valuation, the sector is nonetheless a buy.

General retail: a disposable income-sapping combination of faltering house prices,
rising interest rates and dwindling remortgaging activity has already triggered
underperformance by the general retail sector in recent months. This pressure hasn't
gone away by any means, so it's hard not to see this gloomy picture continuing to
darken. Furthermore, general retailers continue to increase their number of outlets
precisely at a time when underlying sales are falling. Overall, then, they are
expanding into a weak market, and investors should sell the sector.

Health: changes afoot in the structure of government funding will challenge the
business models of healthcare companies that service the NHS. From next April, NHS
hospitals will no longer be paid upfront, but by results or how many patients they
treat. This means already stingy NHS managers will be counting their pennies even
more carefully. Capital equipment suppliers, such as mattress manufacturer
Huntleigh, are already feeling the effects. But industry experts say the new regime, an
attempt to make the NHS more commercial, should be beneficial for the sector,
although it may take time to implement. Therefore, the sector offers good value.

Insurance: the soaring premium rates achieved following the attacks on the World
Trade Center (WTC) are now a distant memory, but the insurance market refuses to
weaken substantially. Granted, premium rates in plenty of business lines are falling.
But plenty more sectors are still delivering rate increases and, overall, the market
looks stable and next year is likely to see solid underwriting profits. That rating
stability largely reflects a need to rebuild reserves following a stream of costly post-
WTC disasters. These included last year's hurricanes, while August's Hurricane
Katrina should also help keep rates higher for longer than they otherwise would have
been. The sector is fairly priced.

IT hardware: the exponential growth of consumer electronics should be great news
for the companies in the UK's IT hardware sector. Many of its constituents design the
semiconductors that power these devices, which range from mobile phones to MP3
players and, in 2004, the industry sold more chips than ever. But an inventory glut
curtailed sales throughout the first quarter of the year and sent shivers through the
market, which saw shares drop to 12-month lows. The industry has demonstrated
new-found resilience, though, working through the excess stock in just three months.
And the industry's forecasting body, the Semiconductor Industry Association, has
revised its delivery forecasts upwards on evidence that the consumer-led boom shows
no signs of letting up. Good value.

Leisure & hotels: legal changes are to pose opportunities and threats to the gambling
and drinking parts of the leisure sector. Relaxation of entry rules and an increase in
the number of jackpot machines should boost casinos from this autumn. The
introduction of a smoking ban in Scotland's pubs next spring could hurt their owner's
earnings, though, and will guide investors as to the effects of a future English ban.
International travel patterns - particularly business trips - will determine the fortunes
of major hoteliers. But the likely further shift away from property ownership towards
management and franchising could support valuations. Overall, the sector is a sell.

Life assurance: UK life assurers are beginning to reap the benefits of an upturn in
demand for pensions and other savings products. Further government incentives are
expected next April when a big change in pension rules comes in. The position at the
moment is simple: the number of people drawing a pension is growing all the time as
life expectancy improves, and the state pension alone will not be enough for a
comfortable retirement. Consumers are also starting to regain confidence and their
appetite for equity and bond-based investments after a torrid time of falling equities
and product mis-selling. The sector is worth buying.

Media: the advertising downturn will remain the dominant theme, with almost all
stocks affected. There is no sign of a recovery, particularly in the badly performing
employment advertising market. Mainstream players are also dealing with the threat
that internet sites pose to their advertising revenue, which is even starting to affect
local newspaper publishers. To combat that, there are likely to be more acquisitions of
internet businesses by traditional operators and new website launches. Investors
should avoid the sector in the short term, but start looking for value in beaten-down
media stocks when signs of an advertising recovery emerge. Sell.

Mining: few would dispute that, over the long term, commodity prices tend to mirror
the marginal cost of production. But, from time to time, prices can remain high for
extended periods, because it takes so long to bring new capacity on stream. Mining
bulls argue that, courtesy of Chinese demand, we are in just such a 'stronger for
longer' phase now. Bears point out that a supply-side response is already building,
especially in base metals. If some commodity prices start to weaken, diversified
miners, such as Rio and BHP Billiton are more defensive than single-commodity
plays, such as Antofagasta and Lonmin. As with oils, cash-generation is impressive
across the sector. Some select opportunities but overall is high enough.

Oil & gas: cash is what it's about. High oil prices mean major producers are drowning
in money and, even after heavy capital spending, there is plenty left for shareholders.
Mergers and acquisitions would appear unlikely at current valuations but, if heavy
exploration spending does not start to yield results, that could change. Smaller
exploration and production companies have driven the oil price higher, but their
recent record at finding hydrocarbons has been patchy. The market could start to fret
about this should oil prices weaken. The service companies are making the most of
higher spending, but share prices have raced ahead and the sector is richly rated.
Fairly priced.

Personal care: with demand for personal care and household cleaning products
growing at a modest rate in developed markets, further innovation will remain the
name of the game in the sector. As far and away the biggest player in the UK sector,
Reckitt Benckiser is well-placed to achieve such innovation, especially given its
excellent track record of creativity. However, high ingredient and packaging costs
will continue to threaten profit margins. Following the Procter & Gamble takeover of
Gillette, further industry consolidation could boost the sector's outlook. Fairly priced.

Pharmaceuticals & biotech: the future of this sector depends on how the industry
and regulators respond to the fallout from the Vioxx scandal. US company Merck's
painkiller was withdrawn last year after it was linked with heart attacks, and the
company is now embroiled in class-action lawsuits, the first of which Merck lost to
the tune of £140m in damages. GlaxoSmithKline and AstraZeneca have come in for
criticism, too, with both companies now posting clinical trial data on the internet to
increase transparency. And analysts fear there may be fewer drug approvals in the
future and increased regulation. But the bad news is well-known and the reaction has
been overdone. Good value.

Real estate: commercial property is showing signs of strain. Share prices in
commercial property groups are linked to the value of their property portfolios. These
values have been rising, driven by huge investor appetite for this asset class. But
prices are now so high that rental yields, according to the Investment Property
Databank's July data, are at record lows of 4.1 per cent. Also, commercial property
has underperformed equities by around 5 per cent this year. The quoted sector is being
buoyed up by the prospect of UK real estate investment trusts (Reits). But Reits may
not be introduced until 2007. The property Bull Run is reversing, so sell.

Software: in the absence of any real recovery in corporate IT investment, public-
sector spending looks to remain a vital component of the software sector's growth
prospects for some time. Companies such as Xansa, Northgate IS and iSOFT should
continue to produce steady cashflows from long-term government contracts, while
more commercially facing companies, such as Computacenter, face difficult markets
as product replacement cycles lengthen and IT services become a commodity.
Technology's reputation as a growth sector has been battered in recent years, and
many are turning to acquisitions to boost flagging growth. So, with the sector trading
at a massive premium to the market, it looks fairly priced at best.

Speciality & other finance: speciality and other finance covers investment managers
and stockbrokers to buy-to-let lenders and inter-dealer brokers. Those companies with
exposure to mortgage and sub-prime lending have seen some slowdown as a result of
high debt levels and a weaker housing market, but bad debt levels have yet to create
problems. Stockbrokers are experiencing more favourable trading conditions, helped
by an increase in discretionary fund management. The recent cut in interest rates has
provided psychological support across the sector, and a steadily improving equity
market is underpinning investment performance, making the sector good value.

Steel: after decades of inept management, Frenchman Philippe Varin has put the UK's
only volume steel maker - Corus - back on a firm footing, cutting costs and
rationalising production. He was helped last year by a strong recovery in steel prices,
on the back of rampant demand from China. The steel industry is a lot better at
managing output these days, but the long-term issue for Corus - and all its OECD
peers - is whether they can compete with lower-cost economies. Innovation - such as
coloured steels for the construction industry - is one option. Vertical integration is
another, although now is hardly the time to be buying iron ore assets. Overall, though,
the steel sector represents good value.

Support services: support services, which contains recruiters, private finance
initiative (PFI) contractors, equipment hire firms and even an undertaker, is a real
hotchpotch of a sector. Continuing skill shortages in this country and expansion
opportunities in the rest of Europe make the recruiters worth buying. And heavy
government spending should keep supporting many contractors, making them worth
buying, too. But high oil prices and US airline trauma mean investors should sell
airline services. The 2012 Olympics will boost many in the sector, from plant-hire
groups to catering outsourcers to those who make money from public-sector
construction projects. Overall, the sector is a buy.

Telecom services: consolidation chatter has resounded in the telecommunications
industry since the implosion of the dot-com bubble. Now it is officially under way
with Cable & Wireless buying Energis, and Spanish national champion Telefonica
looking at 02. The prospect of further merger and acquisition activity will continue to
drive prices. Investors are also appreciating telecoms' stable cash flows, with the
added bonus of growing markets, including mobiles, broadband and data. That should
shrink the sector's discount, as the likes of private-equity investors and rivals look to
take out telecoms operators. The attractive combination of strong cash flow,
undervaluation and consolidation make the sector a buy.

Tobacco: with European governments on an anti-smoking crusade, the trading
environment in the UK tobacco companies' most lucrative markets is going to remain
demanding. However, from the experience to date, they should handle this well. Cost-
cutting will continue to offer a way to maintain and even boost profitability in
developed markets. Meanwhile, expansion into China represents a growth opportunity
- although BAT, Imperial Tobacco and Gallaher are all some way from making real
money there. Further consolidation is inevitable, but may not happen in the immediate
future, owing to the industry's high current valuations. A renewed bout of stock
market weakness could boost the sector's appeal but, otherwise, it is no more than
fairly priced.

Transport: although passenger growth trends are positive, record-busting oil prices
have been stalling growth prospects across the sector from airlines to bus operators.
So, with no respite from rocketing oil prices in sight, the only real excitement is likely
to come from takeover activity. For example, easyJet's shares have doubled in value
during the past year on bid rumours, while logistics companies are also ripe for
consolidation as they struggle to eke out decent margins. But aside from pockets of
bid action, the oil price will continue to be a drag on earnings. Consequently, the
sector's rating of 13 times forward earnings looks too high. Sell.

Utilities (other): having sailed through the recent regulatory review, the UK's water
companies are now looking forward to five years of agreed price rises. This
transparency of earnings is a major plus point for the sector, as is its chunky 5 per cent
average dividend yield. Merger mania has also recently hit the sector with a series of
takeover bids - water companies' reliable cash flows are a major draw for bidders.
But, following a long period of out performance, the sector is trading on a punchy 19
times forward earnings, leaving it worth holding for income. Fairly priced.