Is sector investing sensible?

“If you are in the right sector at the right time, you can make a lot of money very fast”, Peter Lynch.

A timeless principle, but something truly difficult to prepare and strategize for. During the past 2 decades, we’ve witnessed the simultaneous rise and fall of different sectors; most notably being the dot com bubble and the real estate bubble. Regardless of how intense and widespread the damage was, the gains that were made during a short-lived period of time were tremendous.

A common strategy that investors apply is sector analysis. As the name implies, sector analysis involves the assessment of the prospects and viability of a particular sector in an economy. However, the challenge of choosing the right sector and making sure that it aligns with the movement of the economy is a seemingly impossible task, even for the most seasoned investor.

They are also impacted by different micro and macro factors, political instability, changes in policy, etc. are things that can’t be controlled and could have an adverse effect on one sector with the other sector highly benefitting from the very same change. Contrary to popular belief, different sectors perform in different stages of the economic cycle. Some sectors outperform others during a recession and others during an expansionary phase. But as stated, to isolate and target those sectors is an extremely difficult task because it involves so many variables that simply can’t be predicted; mainly the human psyche.

Certain principles can be ascertained during the different fluctuations in the economic cycle:

During a recessionary period when businesses are contracting, sectors such as FMCG, utilities, pharma would generally outperform as compared to other sectors. During an expansionary or recovery phase, interest rates will be low and growth would begin to pick up. Sectors like lifestyle and financial services would profit during this phase.

Some investors to help predict where the next boom is using a “Top-down approach” to focus on environmental conditions that would benefit companies to outperform or underperform; factors like demand, employment, inflation, unemployment, etc. that would affect a large part of the population. Using these factors, they isolate companies that would perform well with such factors.

Another approach is the “Sector Rotation approach”, where investors buy and sell investments according to the cyclical changes in the economy.

A common form of investment in sectors can be through Exchange Traded Funds (ETF’s) or Mutual Funds (MF). They focus on a particular sector and invest a minimum of 80% of their corpus there. The remaining is probably into highly liquid investments or those that generate a steady return so as to provide a scapegoat in case things go south with the sector, they’ve invested in.

Sectors that usually have sector funds associated with it are (1) Financials (2) Energy (3) Health Care (4) Energy (5) Real Estate.

Sector funds are focused and do not provide any form of diversification so as to mitigate any unforeseeable risk. They are generally invested for a medium- or long-term period since sectors have cyclic investments. It would be advised to join a scheme that gives the investor the freedom of exit like an open-ended mutual fund, in order to leave with his investment and interest earned once a sector reaches its peak.

A good way to minimize is risk is to follow the path of institutional investors and using the trends in the economic cycle to predict one’s move, whilst generally sticking to income-producing sectors. A good way to analyze the headwind of a particular sector could be the behavior of the interest rates – as discussed in the previous article interest rates are inversely proportional to the changes in the stock market.

To draw an analogy, investing in a sector is like putting all your eggs in one basket. It’s not bad, and if timed perfectly the returns that can be earned will be multifold. It also provides more exposure to an investor as compared to focusing on just one stock in that particular sector. Regardless, they are extremely volatile and any inaccurate calculations or predictions could result in mammoth losses.

Written by Rohann