How Do I Choose a Sector of the Market to Invest In?
What is a sector? Sectors are categories like energy and healthcare. Or Utilities and Real Estate. The equity markets use eleven distinct sectors.
The Global Industry Classification Standard also known as GICS is the primary financial industry standard for defining sector classifications.
Sectors are used to help diversify your portfolio. Ideally you should have every sector represented in your portfolio.
One reason to diversify your investments across sectors is that at each stage of the business cycle, some sectors will outperform other sectors.
Another reason to diversify sectors is to avoid having too much money committed to any one sector.
The dotcom bubble of 2000-2002 is a good example of investors over allocating to the technology sector.
Over allocating is a nice way of saying “took huge bets believing in the overnight get rich promise of internet-based companies.”
Amazon was one of the few that survived. Of course, there was no way of knowing then what the future of Amazon would be.
As startups quickly failed, price contagion spread through the technology sector. Amazon’s stock price dropped to a low of $7.00, losing over 90% of its value.
Investors looked at “the technology sector” and lumped all companies into a sell bucket.
I will never forget a meeting I had with a well-known media company at the height of the bubble. I was meeting with several members of the pension committee who had just met Mary Meeker.
Mary Meeker was the undisputed queen of internet equity analysis. So, a meeting with her compared to a meeting with me, the bond person? Not my lucky day.
The head of the committee literally said “bonds, yuck” and stuck her tongue out while she faked gagging.
“Why should we put any money in bonds? We should invest all our pension assets in equities”
My response, which unfortunately sounded quite self-serving but ended up being prescient: “because you could lose all of your money in equities. Companies do fail.”
It was a short meeting.
I trudged home through Times Square thinking: “Well, that was one of the worst meetings I have ever had. Was she really gagging over the thought of bonds? Very unprofessional from a member of the pension committee. At least the other people in the room seemed embarrassed by her behavior.
Was she seriously thinking they should invest all of their pension assets in technology stocks?”
Uh, yeah, she was.
That was the power of Mary Meeker proclaiming there was no bubble in internet stocks.
Returning to sectors, below are the primary categories:
- Communication Services
- Health Care
- Financials
- Consumer Discretionary
- Communications Services
- Industrials
- Consumer Staples
- Energy
- Utilities
- Real Estate
- Materials
We know that growth in our economy is heavily dependent on consumers. What products or services do we spend money on?
As the economy moves through different cycles, we can see how consumers shift the sectors they invest in.
Two sectors that I find particularly interesting are Consumer Staples and Consumer Discretionary.
Consumer Staples tend to be the things that people always buy, regardless of the economic environment.
If the economy is starting to slow, stocks in the consumer staples sector tend to do better than stocks in the Consumer Discretionary sector
For example, in Consumer Staples a few of the sub sectors are food, beverages, medical supplies; distillers and vintners; household products; packaged foods and meats; soft drinks, and personal products.
Consumer Discretionary stocks include apparel and luxury goods, hotels, restaurants and automobiles, home improvement and home building.
Companies in the Consumer Discretionary sector may not fare well during a recession as consumers choose to postpone expensive purchases.
The Consumer Discretionary sector does better when the economy is in a growth cycle.
If you are beginning to invest, it might be more fun to choose a sector by “backing into it”.
Choose a sector that interests you. It doesn’t matter what sector. What matters is your curiosity about a product and knowing more about the company that sells the product.
I am going to use Costco and Home Depot as examples of companies in different sectors *(see legal disclaimer)
Costco
- Sector: Consumer Staples
- Sub Sector: Hypermarkets and Supercenters
Home Depot
- Sector: Consumer Discretionary
- Sub Sector: Home Improvement Retail
The reason I picked Costco and Home Depot is because they are next to each other at a local shopping mall. Simple as that.
I was a little surprised. I didn’t think of Home Depot as Consumer Discretionary, but it makes sense.
When you look at Home Depot’s core business it is homebuilding and home improvement. Homebuilding is a key indicator when assessing the state of the economy.
If new home sales are trending down, the suppliers of lumber to new home builders may experience a slowdown in sales.
A slowdown in sales will impact the price of the stock.
Sector diversification, in a way, tells you what to expect. Remember, you are not trying to “time” the market.
The value of diversifying across sectors is that we know not every stock is going to go up or down at the same time.
Use the link below to see the companies in the S & P 500, by sector.
https://en.wikipedia.org/wiki/List_of_S%26P_500_companies
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