In the search for stock ideas and new market trends, it’s worth paying attention to the biggest moves at an industry sector level. Targeting sector leaders with positive price strength, hitting new highs on rising trading volume could put you on the trail of the market’s rising stars.

When it comes to using sectors in stock research, it’s worth considering how the classifications work and the ways investors can use them.

World stock markets and data suppliers classify equities by industry sector. Grouping stocks like this makes it easier to understand what they do, and makes comparisons between them more meaningful. There are 10 high level sector groups (11 in many parts of the world) which together account for more than 200 industry classifications.

Modern portfolio theory will tell you that diversification helps to manage risk - and industry groupings are one way of doing that. Holding stocks across a range of industries can balance your exposure to different areas of the economy. Those groupings can guide you on the nature of the businesses - and how you might expect your holdings to behave in different economic and market conditions.

Generally, cyclical sectors do well in strong economic periods but suffer first and fastest when uncertainty reigns. Defensive sectors hold up better in spells of volatility and heightened uncertainty but can lag when the mood brightens.

But of course, not everyone puts the same value in diversification, often for good reason. At the other end of the spectrum are those who intentionally focus on very specific industry areas. They may have expertise or have worked in certain industries. They may have extensive research experience or just a particular interest. It may be that they’re just attracted to the returns that stocks in a sector have achieved in the past.

Indeed, many investors may not pay any attention at all to industry sectors when they pick stocks - and nothing says you have to. But one feature that’s common in the strategies of influential investors is that looking at what’s going on at a sector level can be useful…

How the investing greats think about sectors

For some famous investors - especially those chasing growth stocks - industry leadership is a must. Bill O’Neil, the American investor and publisher, devised a strategy he called CAN SLIM. The ‘L’ in that acronym stands for Leader or Laggard? In other words, O’Neil’s growth-focused approach insists on knowing whether a stock is a leader in its industry group. His strategy looks for fast and accelerating earnings growth, but strong one-year price momentum relative to the market is also vital.

In popular, fast moving sectors, growth strategies like O’Neil’s could mean that you’re looking at shares with expensive valuations. This may not be a worry if the momentum remains strong, but value-focused investors will be wary. As Mark Minervini, the well-known US trader, notes… hot stocks in hot sectors are sometimes only apparent when they’ve already re-rated sharply upwards.

But using sectors in stock research doesn’t necessarily just mean finding the hottest sectors. Peter Lynch, another well known US investor who enjoyed long-run success with a value-oriented growth strategy, says that industry leaders in out-of-favour sectors hold a lot of appeal.

In his book, Beating the Street, Lynch wrote: “Avoid hot stocks in hot industries. Great companies in cold, non-growth industries are consistent big winners.”

How to find stocks on the move

How can you begin the search for strong performance at the sector level?

One of the go-to measures of recent price performance is Relative Price Strength. This tells you how a stock price has performed relative to the movement of the market over time. On its own, it won’t give you a view of how the stock has performed at an sector level, but there is flexibility in the Stockopedia Screener to help you do that:

• On the Screener page, Click “Add Rule”
• On the pop-up Rule Picker select Momentum > Relative Strength (shown below)
• Select the time frame (in this case 1 year (1y))
• Click “Add Advanced Rule” and select Average Rule
• Finish by clicking “Add Rule

Back in the Screener, the rule will give you the option of looking for stocks with one-year relative price strength greater than a multiple of either the industry, sector or market average:

Here we’ve looked for relative price strength that is greater than two times the stock’s industry average.

Next, to find stocks that could be breaking out, or at least showing signs of strong momentum, you can use the 52 week high.

Research shows that investors have a habit of under-reacting to positive news from stocks at one-year highs (this is called anchoring). But as they absorb the new information and adjust their views, the momentum in these stocks simply continues.

Some research shows that 52 week high momentum is even punchier at the industry level than just the general market level. Evidence suggests that the ‘new high’ is driven more by investor under-reaction to positive news about particular industries than it is about specific stocks. So at times when market trends are shifting, and out of favour industries are bouncing back, new highs could be a useful signal.

In the Screener, the Price vs 52w High rule works by inputting a percentage range within which the stock should be trading versus its 52 week high. By inputting -5%, you’ll be looking for stocks trading within 5% of their one-year highs.

Finally, investors with experience of charts will know that recent increases in trading activity can be a confirmatory sign of support for a share. With the the Screener you can build on price strength rules with a volume rule that specifically looks for a recent “volume surge”.

Volume surge is measured with the 10 Day to 3 Month Volume Ratio. It compares the average daily volume over the last 10 trading days with the average daily volume over the last 3 months.

You can set this to a percentage increase - in this case 10% - to refine the list of stocks to those that have seen a rise in near-term average share trading volumes. In practice, the percentage can be set much higher in order to find stocks where trading volumes are genuinely surging.

You can find, copy and save this screen here: Industry Leaders - New Highs and Volume Surge

Tracking down industry leaders

Keeping an eye on leading stocks across sectors can be a useful way of getting an idea about where investor interest is focused. Trends in price action and share trading volumes are a couple of ways of detecting which stocks are finding favour. Indeed, recent increases in trading volumes can sometimes be a sign of accumulation by funds and other institutions.

This kind of approach may also reveal signals about which sectors and industries the market thinks will benefit from the current and near-term economic conditions. When the outlook is changing and the market focus is rotating, new highs and accelerating price momentum could be worth watching.