Be wary of the corporate cheerleaders

There are many different schools of thought when it comes to investing. Some portfolio builders prefer to go with the flow and follow momentum in share prices, earnings forecasts or perhaps a combination of the two. Others are happier going against the crowd in search of value which they believe will emerge once a catalyst appears to change market perception of a company.

Not everyone has the time to research individual stocks in a detailed way. Picking the right sectors, or even just avoiding the wrong ones, can be easier than burrowing through companies' accounts and prove beneficial to portfolio returns. The old saying a “bad stock in a good sector will tend to outperform a good stock in a bad sector” has stood the test of time for a reason.

One method which could help investors identify areas which may be underloved and undervalued is to look at those sectors and industries where the big investment banks are paying little or no attention. There is surely more chance of valuation anomalies appearing here. Equally, there must be a greater chance of stocks being overhyped in the areas where the corporate cheerleaders are still banging the drum in the hope they can generate commission, either from share trading or, more likely, corporate activity such as new listings, secondary offerings of paper and merger and acquisition activity.

Encouraged by former colleagues from my investment banking days, this column has studied the FTSE 350, excluding investment trusts, and the number of analysts who cover each stock and then aggregated those figures by sector. In sum, there are 4,417 sets of estimates for the 315 firms, or 13.2 analysts per quoted company, and an average of one analyst for every £547 million of market cap.

If a stock has fewer than 13 analysts covering it and more than £547 million market cap per number cruncher, the research providers might be missing a trick in their neglect, as they chase fees from flashier sectors which have been lucrative in the past or are seen as potential fee generators in the future.

At first glance, the ten most underbroked, potentially most neglected areas include five of 2014's top ten performing sectors in the FTSE All Share, while four of the most excessively analysed areas feature in the sector performance listing's bottom ten for last year (these sectors are highlighted in bold in the tables).

Defensive sectors still look relatively neglected by analysts

Source: London Stock Exchange, Digital Look, www.brokerforecasts.com, AJ Bell Research

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term. Data as of 7 January 2015

...while Oil Equipment, Electronics and Industrial Metals look overbroked (and could still be overhyped)

Source: London Stock Exchange, Digital Look, www.brokerforecasts.com, AJ Bell Research

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term. Data as of 7 January 2015

This may not be a coincidence, especially as heavy coverage of Mining, Oil & Gas and Oil Equipment & Services implies the investment banks are yet to realise the commodity supercycle is history.

Noisy neighbours

At this point it is instructive to hark back to the technology, media and telecoms bubble of the late 1990s. In 1997, I was part of a research team of some five or six analysts who covered tech across the UK and Europe. By 2000 the team had grown to 60 - just in time for the smash to come.

Research from former research department colleagues at equity strategy boutique Mirabaud Securities reminds me how 56 analysts were at one stage covering Europe's Nokia, the one-time leader in mobile phone manufacturing. Such ardent coverage did not stop the Finnish firm from well and truly dropping off its perch and even now some 46 souls are trying in vain to find something interesting to say on a company whose best days are gone, despite its market cap of €23.9 billion.

Analyst hype and huge coverage could not save Nokia from crunching share price falls

Source: Thomson Reuters Datastream

For the record, the most widely covered stock in the FTSE 100 looks to be BP with 34 analysts hanging on its every word. In the FTSE 250 it is Afren, with 24 keen followers. Neither stock has covered itself in glory over the past five years and both hail from the Oil & Gas Producers sector, one of those areas which attracted plenty of hype amid talk of how the commodities would be stronger for longer and different this time around.

At least BP's bumper market valuation means it has one analyst for every £2.2 billion of market cap, which makes Nokia look terribly overbroked by comparison, let alone poor old Afren at £21 million of market cap per analyst.

In fact, ten resources and resource-related plays populate the 20 firms which have the lowest amount of market cap per analyst – and these figures were prepared on 7 January, before the latest plunge at Afren, which leaves its market cap at just £435 million.

Oils and miners still look suspiciously popular among the investment banking community

Source: Reuters Datastream, AJ Bell Research

The ongoing obsession with Software and Electronics suggests the investment banks have yet to get over the collapse of the tech bubble in 2000, let alone the implosion of the miners and oils, though again this may be the result of hopes for new floats, rather than the prospect of strong trading flows in the secondary market.

Sea of tranquillity

If history is any guide, investors may be better served by looking at areas where there is less hoopla. The table below ranks the FTSE All-Share sectors by their capital return over the period 2000 to 2014. In sum, the top ten sectors have an average of £801 million in market cap per analysts, well above the £547 million average, while the bottom ten come in at £476 million.

Sectors which were the subject of bubbly enthusiasm – such as technology between 1998 and 2000, financials in 2004-2007 and then miners and oil – have all failed to deliver in the long run.

Steady sectors where capital discipline is king and analysts are quieter have tended to do well since 2000...

Source: Reuters Datastream, AJ Bell Research

While hyped banks, financials and resources plays have let their cheerleaders down

Source: Reuters Datastream, AJ Bell Research

Perhaps it is the lack of relative volatility which deters the investment banks from getting too heavily involved in the best performing sectors. This may further skew the economics away from covering those areas which have provided solid and consistent capital returns and prompted them to focus on industries where there is more happening

But from an investors' perspective, excitement and expenses are the enemy, as Warren Buffett once put it. Over the last 15 years, 13 sectors out of the 33 areas to have a full trading history have risen in value at least ten times but only one – Chemicals – is one of the most intensively covered areas.

Note the single-digit rankings of such stalwart performers as Tobacco, Beverages and Food Producers, where there are juicy market caps but relatively few analysts. In Tobacco's case there is at least an excuse as the sector has consisted of just two stocks since Japan Tobacco's acquisition of Gallaher in 2007.

The most consistent performers since 2000 have high analyst-per-market cap scores

Source: Reuters Datastream, AJ Bell Research

The more consistent performers are sectors which tend to come with strong brands, cost-conscious management teams, relatively dependable demand and healthy cashflow. These are all characteristics which typify good long-term, dividend-paying investments for good measure, so capital returns will be supplemented by income.

Such attributes also mean companies in these sectors are not necessarily the type to pay investment banks fat fees for overseeing daft acquisitions or holding rescue rights issues to shore up balance sheets once the latest deal goes wrong.

Russ Mould, AJ Bell Investment Director.

With thanks to Nick Stevenson of Mirabaud Securities.