Sector selection: Beating uncertainty

In uncertain markets it is important that investors consider all the tools at their disposal. Stock selection has been a tough job in recent times, and many investors worry that recently successful tactics of chasing yield and hiding in bonds have run their course.

In the equity universe I feel that sector selection is a misunderstood and underutilised strategy that can offer alpha regardless of market conditions.

If done properly, a sector selection strategy offers many benefits to the investor. Eliminating the stock-specific idiosyncratic risk through diversification within a sector reduces volatility. At the same time, using a broad basket of stocks from the same sector maintains the fundamental industry alpha. Underlying sector trends are more predictable and reliable than pure stock selection, due to a higher signal-to-noise ratio. By this I mean that for a sector the signal (the fundamental trend in an industry), is easier to identify and more reliable than a stock-specific trend. At the same time the noise, or volatility, around this trend is lower. Forecasting is more reliable when the signal-to-noise ratio is higher.

A simplistic version of sector selection relies on regular investment cycles, with predictable rotation through the cyclicals and into the defensives in a regular cycle. We think a more sophisticated approach is required, involving valuation analysis and potential return drivers over the medium and long-term. In effect, a lot of the cyclical rotation is actually matching betas to the market cycle, as opposed to sector alphas. While matching betas to investment outlook is important, two sectors with similar betas can have completely different alpha drivers, such as financials and materials.

At the moment, it makes sense to go underweight in sectors with high political risk. Specifically financials, healthcare and utilities. Financials are vulnerable to further punitive regulation and taxation, as well as having equity directly owned by governments. Healthcare relies on government subsidies from stretched budgets, and utilities have regulated pricing and profits that we expect to be squeezed for the foreseeable future.

On the other hand, I am more bullish on sectors that will benefit from growing emerging market demand and the recovery of international trade. Although emerging market stocks took a percentage relative hit in 2011, I think that emerging market growth rates will be significantly higher than their developed counterparts for the next decade, with the emerging markets contributing the majority of global GDP growth. Consumer staples are a beneficiary of this, with increasing demand for western staples in emerging markets. Industrials cover a broad sector, but rely on international trade and emerging market demand for developed market knowledge, with companies like Caterpillar increasingly benefiting from emerging market demand. IT demand growth is being driven by Asia and Latin America, with increasing market penetration expected to continue for decades to come, as growth drivers shift from China to India and from Asia to Africa.