Rick Welch: Dollars and $ense

Sector Investing

There are many different ways to construct an equity or stock portfolio, including the more traditional approaches of market cap (large, medium or small) or style (growth or value).  The view of these approaches may be changing as recent long term studies of stock return differentials suggest that industry sectors may be a more important component of equity returns than market cap and style combined.  As defined and used in this context, a sector is an industry classification or grouping of companies sharing common characteristics.  The most common classification of industry sectors, the Global Industry Classification Standard or GICS, divides the equity universe into ten major sectors: Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunications and Utilities.

We think a focus on sector composition can provide a clearer understanding of where stock price returns are actually generated.  Sectors provide many benefits, including their static composition, clear patterns of volatility and low correlation to each other. While a company’s market cap or style groupings can change, its’ sector classification usually stays the same.  Since the development of GICS in 1999, there have been no changes to the number of sectors (ten) until the planned revision to the Financials sector this summer when Real Estate (a member category within Financials) will be removed and become a new eleventh sector.  Because sector performance is typically tied to the economic environment, sectors have clear patterns of volatility.  Some sectors, like Information Technology and Materials, are more volatile than the overall market and others (Utilities, Health Care and Consumer Staples) are less volatile.  As an economy moves through a cycle, sectors will often perform differently causing them to move out of sync with each other. For example, Information Technology and Consumer Staples have a low correlation (0.33), which means that their stock prices will move in the same direction (up or down), but, at much different speeds.  The construction of a portfolio with assets that have low correlation can potentially improve overall diversification.

A sector rotation strategy provides an efficient means to adjust equity weightings within a portfolio based on an understanding of where we are in the current business cycle.  A typical business cycle has four distinct stages: Early (a rebounding economy with strong earnings growth), Mid (credit expands, earnings are strong and economic growth peaks), Late (economic growth moderates, credit tightens and earnings decline) and Recession. History teaches us that sector performance can vary significantly depending on the stage of the business cycle. Early stage outperformance is often seen in Consumer Discretionary, Financials, Industrials and Information Technology. By the time we move through the Mid into the Late stage, we see that strong sector performance is expected more from Consumer Staples, Energy, Health Care and Materials. In Recession, we might expect above market returns from Consumer Staples, Health Care and Utilities.  

We think that the implementation of a sector rotation strategy within an equity allocation can bring precision to your portfolio. Sector investing eliminates the decision of which stock within a sector you should invest in.  If you believe that we are in the Late stage of the business cycle (that is our opinion), then you might want to increase your holdings in the Consumer Staples sector, instead of attempting to decide which individual stock within that sector (say, Procter & Gamble, Coca-Cola or Altria) would be the best choice.

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