Finding the strongest and weakest stocks in various sectors can be a highly profitable endeavor for traders and investors. At the very least, it lets investors know which stocks are leaders and which ones to avoid. Aggressive traders will often buy the strong and short the weak, potentially increasing their profits as a result.
The top-down approach is another way of describing fundamental analysis. Pillars of this type of stock analysis include earnings and revenue growth, the debt/equity ratio, price-to-sales growth, payout ratio, dividend sustainability, book value, margins and other metrics. With top-down analysis, the investor will want to use the same metrics with several stocks within the same sector. Obvious divergences in metrics such as profit growth and debt/equity will be important tells regarding the best and worst stocks in that group. For example, investors can use the payout ratio to discern a company's ability to sustain and grow its dividend. A company with a high payout ratio and high debt burden in a sector full of rivals with low debt and low payout ratios could prove to be one of that sector's weaker members.
Find which sector are in favor and which are out of favor. This strategy works best in markets that are trending higher. By identifying sector leaders, investors have already won part of the battle because they inevitably find some of the stocks that are truly contributing to broader market strength. Additionally, the laggards in a strong sector usually have a reason for lagging. For example, assume that energy is a sector leader at a particular time and nearly all of the large-cap oil stocks, except ABC Inc., are soaring. By identifying a leader, the investor found not only stocks to go long, but also a possible opportunity to sell short ABC.
Use Relative Strength
Specifically, use what is referred to as the relative strength index, or RSI, an easy-to-use technical analysis tool that most new traders think measures overbought and oversold stocks. RSI does do that, but it pays to go a step further. That means some stocks that remain overbought based on RSI for long periods of time would be billed as "strong." Likewise, stocks that remain oversold for lengthy periods of time are apt to be laggards.
Many online brokers and other websites offer free stock screeners, in which investors can sort stocks according to a variety of parameters. Using a combination of fundamental traits such as those in the top-down approach in unison with technical analysis such as RSI can help investors screen for the best and worst of a sector’s offerings.
Todd Shriber is a financial writer who started covering financial markets in 2000. He worked for three years with Bloomberg News and specializes in analysis of stocks, sectors and exchange-traded funds. Shriber has a Bachelor of Science in broadcast journalism from Texas Christian University.