"Buy what you know" is the linchpin of investing guru Peter Lynch's philosophy. Yet if you're like most people, then this limits you to one or two sectors, most likely consumer goods and tech. This could cause you to miss out on many profitable sectors.
It can take a lot of homework to feel comfortable with a sector outside your wheelhouse. But if you don't get out of that comfort zone, your portfolio could be dangerously unbalanced.
Best of breed
Consider easing into a new sector by buying "best of breed" companies. These are companies at the top of their industry thanks to growth, good corporate governance, and experience. They are generally shareholder-friendly, offering a sustainable dividend.
Three sectors that can be daunting at first are energy, utilities, and telecommunications. But these industries have plenty of growth potential going forward, as they are the backbone of the economy.
Major integrated oil company Chevron (NYSE: CVX ) stands out in the oil patch. The main reason is that a relatively large percentage of Chevron's revenue comes from higher-margin exploration and production, also known as the "upstream," at 85% compared to 64% for giant rival ExxonMobil.
Chevron has the No. 1 spot among the integrated oil companies for upstream adjusted earnings per barrel, besting rivals Royal Dutch Shell, BP, Total, and ExxonMobil. Among its integrated-oil cohort, Chevron also has the highest production ratio of liquids (i.e., oil) to natural gas, as well as the highest net margin per barrel of oil equivalent, as detailed by fellow Fool Tyler Crowe.
ExxonMobil trades at a higher trailing earnings multiple of 11, as opposed to Chevron's 9.7. Chevron also offers a higher yield of 3.3% compared to ExxonMobil's 2.9%. Chevron's net profit margin of 10.7% is also higher than ExxonMobil's 8.3%.
Chevron also has mining interests in coal and molybdenum. It even has some financing and insurance assets, as well as 11 power assets. .
Growth in gas
Consolidated Edison (NYSE: ED ) , more familiarly known as Con Ed to its 4.8 million customers across three states, pays a dividend yielding 4.3%. In the S&P 500 it's the only utility with 30-plus years of consecutive dividend raises. And yet if you limit yourself to "buy what you know" and aren't a customer of either Consolidated Edison of New York or Orange & Rockland Utilities, you might ignore this name entirely.
Con Ed trades at a reasonable forward earnings multiple of 14.8. This gas, electric, and steam utility has a net profit margin of 8.2% -- higher than the industry average.
One risk factor is that the New York City-based company is in a regulated industry. This month, New York Governor Andrew Cuomo told the state's Public Service Commission that it should deny Con Ed's proposed 2014 rate increase (a ruling is expected in December).
And, like most utilities, Con Ed is not a fast grower: It has a five-year compound annual growth rate of 5.95%. Its main growth prospect is the ever-increasing conversion from heating oil to natural gas. New York has the highest rate of homes heated by heating oil in the nation at 29%. NYC mayor Michael Bloomberg is supportive of these conversions, and the state is considering lifting its ban on natural-gas hydraulic fracturing (a.k.a. "fracking").
Growth through spectrum
Finally, AT&T (NYSE: T ) , the giant telecom, offers a whopping dividend yield of 5.1% and trades at a trailing earnings multiple of 26.1, which makes it look more fairly valued than competitor Verizon, priced at 65.7 times trailing earning, and about equivalent to smaller wireless contender Sprint.
AT&T recently agreed to lease 9,100 cell phone towers and sell 600 more to Crown Castle International for $4.85 billion. The ongoing leases will monetize those towers yet still maintain accessibility for AT&T. The company plans to increase its networks' density through innovative small cells, as well as these traditional towers, as part of its growth strategy. The company is creating growth by increasing its spectrum, which it managed to expand by a third in 2012.
AT&T has the lowest net profit margin of the three "best of breeds" I've covered, at 5.9%, and its margin falls far short of Verizon's 11.5%. However, free cash flow grew significantly in 2012 to $19.4 billion from $14.5 billion in 2011.
The limits of Lynch
"During a lifetime of buying cars or cameras, you develop a sense of what's good and what's bad, what sells and what doesn't," wrote Lynch in One Up on Wall Street. "That's true," you might say to yourself, "but what do I know about upstream oil or natural-gas conversion in NYC or small cells and wireless spectrum?"
It's not as easy as scoping out the mall, but when retail or tech tanks, you might regret not having a best-of-breed integrated oil company, utility, or telecom with a decent yield. Of these three, consider Chevron first for its upstream business, higher dividend growth, and highest net profit margin.
Once you've found your investment of choice, keep up with your homework (trade magazines, earnings transcripts, annual reports, online company presentations, etc.) to make sure your best of breed stays top dog.
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