Retail investors can get above normal returns by adopting a sector specific approach to their investments in equities. Secondary markets offer opportunities with sectoral fundamentally sound picks and out-performers.
Technically called the top down approach, here the sectors expected to outperform the market are determined before stock picking. Stocks within a sector tend to move together because companies within the same industry group are affected in similar ways by market and economic conditions. No matter what the overall markets are doing, some industry groups move up, and others head down.
Some sectors, like the stock markets, move in cycles and are hence called cyclicals. Profits and share prices of cyclical companies tend to follow the up and downs of the economy. When the economy booms, sales of things like cars, plane tickets and luxury goods tend to thrive. In economic downturns the demand for these evaporate leading to heavy losses. Automobile manufacturers, airlines, steel, paper, heavy machinery and hotels are the best examples of cyclical sectors. Successful cyclical investing requires careful timing. It is possible to get substantial return on investment if investments are made close to the cyclical bottom.
Contrary to cyclicals are defensive stocks. Defensive stocks remain stable during the various phases of the business cycle. Defensive stocks experience profit regardless of economic gyrations because they produce or distribute goods and services always needed such as food, power, water and energy. Share prices of stocks within defensive industries tend to grow at a relatively stable rate that can often be predicted with some degree of accuracy, based on historical trends. The utility industry is an example of defensive stock as people need electricity during all phases of the business cycle. Investors can invest in defensive stocks when a downturn is expected. These stocks tend to perform better during recessions. They, however, tend to under-perform during an expansion phase.
All sectors go through what is called the “industry life cycle”. An industry goes through emergence, growth, maturity and finally decline. In the growth phase a sector gives enormous returns. Companies in this phase manage to give increased earnings year after year. Even during a downturn in the economy, growth for these companies may be slower than their long-term average, but their earnings still endure. Microsoft is an excellent example of a company that became very large in a growth industry (software) over a period of years, increasing its earnings all the while and, most importantly, maintaining its expectations. Retail and real estate are sectors where substantial growth is expected in near future.
Selecting the right sector also depends upon the investors’ risk profile. Investors with higher appetite for risk can go for cyclical stocks. Growth stocks suits an investor with a lesser risk taking ability, whereas a highly risk averse investor can choose defensive stocks. Allocating the investment corpus to different sectors also helps in diversifying risk. In case a particular sector does under-perform, only a portion of the total investment is exposed to the vagaries of the sector. Further, by investing in sectors which counterbalance each other investors can reduce the risk of the total portfolio substantially e.g. steel and automobile sector.
Sector investing, however requires extensive research to identify the right type of stocks. Investors will find their extra effort rewarded by higher returns on their investment.