Passive investors may be in for a tough 2018. The longest bull market in history has slowed to a crawl and become a stock-picker’s market this year.

With the S&P 500 up just 2% through almost half the year, investors can no longer dump their money in passive index funds and ride the market higher. This late in the cycle, investing has become about finding industries with the potential to outperform on waves of strength.

#-ad_banner-#And one industry may be starting a wave to last the rest of the year.

The industry underperformed last year and in the first quarter but has outperformed the broader market this quarter and could be gaining momentum. While first quarter earnings surprised to the upside and brought investors back to the space, the industry could still be undervalued by as much as 16% versus a generally overvalued market.

Leisure & Entertainment Stocks Haven’t Been So Entertaining For Investors
The nine-year bull market has been a bumpy one for companies in the leisure & entertainment space. The industry rebounded quickly after the recession but then underperformed the broader market for years. Growth picked up again in 2016 but hit a rough patch last year.

The industry broadly underperformed during the first quarter with the PowerShares Dynamic Leisure & Entertainment ETF (NYSE: PEJ) falling by 4.2% in the first quarter against a gain of 0.8% on the S&P 500.

The underperformance was a continuation of last year when the industry fund lagged the broader market by nearly 10% with much of the weakness in the second half.

A combination of economic factors began to weigh on investor sentiment for stocks in the space last year, including rising rates and higher prices at the pump. That potential for higher prices and rates conflicted with stagnant wage growth that had barely budged since 2010 and investor enthusiasm plunged ahead of what was sure to be a weak period for the group.

But that weakness hasn’t come. In fact, leisure & entertainment stocks could be setting up for another run at outperformance.

Investors have become more bullish on the group lately with the industry fund posting a gain of 9.1% since the end of the first quarter, outperforming the broader market by nearly two percent.

This Could Be Just the Beginning of a Wave for the Industry
While gasoline prices have continued higher and the Fed is expected to hike rates at least two more times this year, wages have shown signs of growing and the consumer is spending again. Average hourly earnings grew 2.7% in May for three consecutive months of solid wage growth and the unemployment rate dropped to 3.8%, its lowest since early 2000.

Last year’s weakness left the group undervalued by 16%, according to Morningstar analysis, one of the largest discounts by industry. This could turn quickly as investors return to the space and as second- and third-quarter earnings surprise on the upside.

Brand strength and economies of scale are even bigger drivers in Leisure & Entertainment than they are in other industries. Larger companies with the balance sheet strength to take advantage of slow periods to gain market share should rebound quickly as customers come back this year.

Tripadvisor Inc (Nasdaq: TRIP) draws the largest travel audience among online booking sites with 455 million monthly visitors reported in the first quarter. The site’s 630 million user-generated reviews of travel destinations drives its position in search rankings to support website traffic with limited marketing.

The company surprised on the upside in both its hotel and non-hotel segment in the first quarter, increasing non-GAAP earnings by 20% from the prior year. A recovery in hotel segment sales could help the company deliver on expectations for 31% earnings growth this year to $1.36 per share.

Royal Caribbean Cruises (NYSE: RCL) has a history of beating expectations but strong bookings in a typically weak quarter helped blow threw expectations by 12% and could be on track to exceed analyst expectations for 17% earnings growth for the year. With over 90% of the North American cruise market controlled by just three companies, Royal Caribbean benefits from limited discounting and competition in the industry.

Beyond the potential for a near-term increase in bookings, demographics and an expansion into Asian markets should drive topline growth for years to come. An increase in operating expenses decreased profitability to a nine-quarter low in Q1, but management plans around cost-savings could drive margins and earnings on top of higher sales this year.

Six Flags Entertainment (NYSE: SIX) is the world’s largest regional theme park with 20 parks across the United States, Mexico and Canada, serving more than 31 million guests annually. Revenue growth slowed last year to 3% from a pace of 5% over the last three years but lower operating expenses helped the company deliver a 46% increase in operating earnings. Nearly two-thirds (63%) of 2017 attendance was from season pass holders, up from 30% in 2009.

Six Flags has started licensing the brand internationally with partners in Dubai, China and Saudi Arabia. The company announced its 11th park in China and its first in Saudi Arabia this year. A return to growth in North America sales this year could help the company beat expectations for 26% earnings growth this year.

Risks To Consider: Rising rates and broader geo-political risks could eventually slow consumer spending and slowing the momentum in leisure stocks.

Action To Take: Front-run the potential for strong summer sales in leisure and entertainment stocks with best of breed names ready to run.

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