Sectors: 2007's Comeback Kids

A few of last year's worst-performing groups could present tempting opportunities for this year's nimble investors

As 2007 gets under way, value-oriented investors have what you might call a "good problem." Simply put, it's a tricky time to pick winners from last year's neglected stocks, because most industries performed quite well in 2006 (see, 1/2/06, "Best and Worst Stocks of 2006"). Bargain hunters might have to search harder this year to find overlooked gems.

That's not to say every sector was a winner in 2006. Steel was the year's best-performing industry in the Standard & Poor's 500, gaining 75.8%, but other stock groups weren't so fortunate. The education services industry, for example, trailed the S&P 500 with a 35.5% annual loss, and it wasn't the only area going through a weak patch.

Still, lucky and resourceful investors may be able to find some opportunities among the laggards of 2006. This Five for the Money focuses on five of the worst-performing industries of 2006—and their chances for a comeback.

1. Airlines

Major carriers' stock might be in the midst of taking off, some market pros say. In 2006, the airline industry was one of the S&P 500's 10 weakest performers. As a group, the stocks shed 6.8% in a year when the broader index logged a 13.6% rise.

However, many airline stocks rallied late in 2006 as merger talk swirled. Continental Airlines (CAL) and United Airlines (UAL) have reportedly been holding talks on a possible combination. Meanwhile, US Airways has proposed a hostile takeover of Delta Air Lines (DALRQ).

The industry might also benefit from lower fuel costs this year, adds Joe Battipaglia, chief investment officer at Ryan Beck. "That's a group I think can perform well in '07," Battipaglia says.

Continental's stock price went on to finish the year up 93.7%, while US Airways' (LCC) added 45%. "They've been doing pretty well for the second half of the year, and we don't see any reason why that wouldn't continue," Barry Ritholtz, chief market strategist at Ritholtz Research & Analytics, says of the group.

2. Semiconductors

Chip stocks were a beleaguered group in 2006. The semiconductor industry was the S&P 500's seventh-weakest performer, losing 9.9% on the year. The largest chipmaker by sales, Intel (INTC), was the Dow Jones industrial average's biggest loser in 2006. Shares of the company fell 19%.

Better times may be ahead. For one thing, chip stocks could prove to be attractively priced relative to the rest of the market, some analysts say. "If you have satisfactory domestic economic growth, global economic growth, and domestic and global expenditure in the tech arena, which seems to be unfolding, then they may be cheap," says Rob Brown, chief investment officer at Genworth Financial Asset Management (GNW).

The tech world is also making a shift from 32-bit to 64-bit processing. Microsoft's (MSFT) Xbox and Nintendo's (NTDOY) Wii have already made the shift. Meanwhile, Microsoft's new Vista operating system comes in both 32-bit and 64-bit versions.

"The whole technology industry is going to have a tailwind behind it as this new technology is adopted," says Barbara Walchli, who manages the Aquila Rocky Mountain Equity Fund (ROCAX). "It's going to be a slow adoption, because it's such a big shift, but still I think it's going to improve demand generally for semiconductors."

Citigroup (C) upgraded its outlook on the semi and semi equipment groups from market weight to overweight on Nov. 10. The rate of growth in chip equipment orders is soon expected to go negative, a trend that has historically been linked with rising share prices, according to Tobias Levkovich, chief U.S. equities strategist at Citigroup. "We think that investors should be looking more aggressively at the chip stocks," Levkovich says in a Dec. 29 report.

3. Homebuilders

Homebuilder shares got hammered in 2006, as the extent of the housing slowdown became apparent (see, 12/25/06, "Housing: Curb Your Enthusiasm About a Recovery"). The homebuilding industry was the second-weakest performer in the S&P 500, tumbling 20.9% on the year. But the stocks have recovered from their lows in recent months amid hopes the housing market already hit bottom.

Despite their end-of-year uptick, homebuilders continue to trade near historic low price-to-book value ratios, says David Chalupnik, head of equities at First American Funds. Chalupnik is looking for the Federal Reserve to cut interest rates in the first half of 2007, which has historically tended to give homebuilding stocks a boost. "There's not a lot of downside to the homebuilders," he says. "It's more of a waiting game for us than anything else."

The housing market has shown some signs of life in recent data reports, a disappointing preannouncement from Lennar (LEN) notwithstanding (see, 1/2/07, "A Nasty Hangover for Homebuilders"). "Currently, the signals are hopeful but faint," says Goldman Sachs (GS) economist Ed McKelvey in a Dec. 26 report. Mortgage rates have slipped in recent months, McKelvey notes, while the months' supply of unsold homes has also inched lower.

4. Managed health care

Health-care stocks started 2006 under the weather. Aetna (AET) plunged more than 20% one day in April on a weak earnings report. UnitedHealth Group (UNH) faced a stock-options probe. Overall, the managed health-care industry was another of the S&P 500's 10 worst performers last year, dipping 6.6%.

Fortunately, the industry's problems weren't terminal. Several managed-care stocks bounced back in the second half of the year. In fact, the sector may be well on the road to recovery, some analysts say.

A combination of favorable valuation and company-specific factors could bode well for some managed care stocks in 2007, according to S&P analyst Phillip Seligman. "When Aetna was hurt, it hurt the whole industry," he says. Seligman has strong buy recommendations on UnitedHealth and Coventry Health Group (CVH).

Looking ahead, demographic factors should work in managed care's favor, others observe. "As an aging baby boomer myself, in the long term I'm bullish on managed health care," says Lincoln Anderson, chief economist and chief investment officer at LPL Financial Services. "I would expect it to do better in '07."

5. Education services

After a disastrous 2006, Wall Street may be ready to go back to school in the new year. Education services was the worst-performing industry in the S&P 500 over the last 12 months, sliding 35.5%. Apollo Group (APG) weighed on the sector following a disappointing earnings report and a stock-options probe (see, 10/18/06, "A Harsh Lesson for Apollo Group").

The sector may not get a failing grade again in 2007. One possible teacher's pet is ITT Educational Services (ESI), a Carmel (Ind.) post-secondary degree program provider, according to Bank of America (BAC) analyst Howard Block. He has a buy rating on the stock, saying the market has not yet priced in the company's impressive 150% return on invested capital. "Ongoing evidence of accelerating enrollment trends and strong execution on key corporate initiatives should drive outperformance in 2007," Block wrote in a Dec. 1 report.

Most investors will remember 2006 for all the industries that did well. Still, taking a moment to study last year's losers might be a useful way to identify future winners—before everyone else does.

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