Investing in underperforming markets
By Jim Middlemiss • Bankrate.com

Every investor wants a portfolio of stocks that are out-performing. But while keeping your eye on high flyers is important, you shouldn't overlook underperforming sectors of the market, because they are where you could strike gold.

Because eventually, the high flyers come back down to earth and are replaced by the next market cycle. So, an out-of-favour company or foreign stock market that looks like an ugly duckling today could turn into swan in the not-too-distant future.

"Markets are always in some form of exaggeration, either too expensive or too cheap," says Terry DeVries, a financial adviser with RBC Dominion Securities in Toronto. It's the out-of-favour markets investors need to watch, he says, noting that's how value investing gurus such as Warren Buffett and Benjamin Graham made their millions. Value investors, he says, "are looking to buy assets that are cheap. You can't go wrong buying $1 for 40 cents."

Three stages to a market
DeVries says there are three stages to a market. There's the accumulation phase, in which astute investors start buying. That's followed by the public participation phase, in which the stock or market index begins to break out and attract mass appeal. Last is the distribution phase, in which the growth pendulum "swings too far" and people sell their holdings and move on to something else.

So, it's good risk management to use asset allocation and portfolio diversification strategies to stay invested in a range of markets, says Kim Dewar, a certified financial planner with Edward Jones in Vancouver. "It's impossible to pick the next winner," she says. However, by rebalancing and reducing your holdings in investments that have performed well and redirecting them to underperformers, "it's forcing you to sell high and buy low." That should be the mantra of every investor.

However, you have to be aware of the value trap when investing in out-of-favour stocks or sectors, says Gavin Graham, director of Investments at Guardian Group of Funds, or GGOF, in Toronto. "A stock may be cheap for a good reason," he says. For example, many airline stocks are currently underperforming, but that doesn't make them good investments.

Health care looks good
So where are the opportunities these days? "I think there's one big, liquid sector that no one loves, and it's called health care," says Graham, referring to stocks for drugs companies and medical device makers. Canada's segment is small on this front, he says, but globally, it's a huge industry. Graham says many of the big drug companies sell for 12 to 13 times earnings and pay a 3-per cent to 4-per cent dividend. Those numbers are similar to bank stocks.

Health care is being picked by many as the next wave. UBS Securities LLC, part of the global banking giant UBS AG, says in its 2006 U.S. outlook report that it is overweighting health care and sees it as an opportune area in which to invest. Some of the top UBS picks this year include Stryker Corp., Advanced Medical Devices and Endologix Inc.

Dewar notes that Edward Jones has a healthy 16 per cent weighting for health care, citing a company such as Pfizer as a great example. It is down 35 per cent since February 2004, but it has paid a dividend since 1901 and increased it for the past 37 consecutive years. Its yield is now almost 4 per cent, and it has a 10-year growth rate of 15.8 per cent.

Graham notes that "none of us are getting any younger," so demographics are favourable for health-care investments. If drug companies aren't your game, he says investing in drugstores poses less risk than individual pharmaceutical companies, which spend hundreds of million of dollars developing a single drug.

If individual stocks aren't your bag, there are 48 health-care mutual funds according to Globefund as well as half a dozen exchange traded funds, or ETFs, that invest in this sector listed on the American Stock Exchange.

Telcos are cheap
Health care isn't the only out-of-favour sector garnering attention -- the telecommunications industry is also lagging. According to BCA Research in Montreal, "telecom stocks are particularly notable -- they underperformed substantially last year and are cheap," based on a number of valuations.

Graham says it all depends on the stock. While Telus and Rogers Communications have done well, he says BCE and Manitoba Telecom Services have lagged and could be candidates for growth in 2006.

In terms of other slow sectors, Graham notes that banks lagged the TSX index in 2004, and if the markets get defensive in 2006, as some expect, then there will be a move toward financials as a safe haven. DeVries says investors should also look outside North America for opportunities.

On that front, BCA Research cites Argentina, Thailand, Indonesia, Taiwan and Italy as laggard markets that are cheap. Investors can buy into some of those markets directly using ETFs that trade on the American Stock Exchange.

So while energy and mining stocks currently have investors' attention, there are other money-making alternatives for patient investors who want to reduce their risk. As DeVries says, "it's important investors realize that when you start to hear about a sector that is in favour or gaining attention, they've missed the majority of the move."

The trick, he says, is to avoid "the herd mentality. You want to invest in sectors that are out of favour, when no one wants anything more to do with them."

Jim Middlemiss is a freelance writer and lawyer based in Toronto. He's a frequent contributor to the National Post, Investment Executive and Wall Street & Technology.