Examples of sector bias in passive indices is easily seen in this graphic from Janus Henderson, which shows the high technology weighting across various global equity indices: [Note:  The sector reclassification that took place last month means that technology’s weight, at least in the U.S., is much less than it was prior.  However, this is, in my opinion, merely a cosmetic transformation.]

In corresponding fashion, as technology shares have claimed the lion’s share of the index, traditionally defensive sectors and industries such as consumer staples and utilities have fallen, as Leuthold’s Jim Paulsen pointed out earlier this year (via the FT): [Note:  the MSCI USA index (cited above), and the S&P 500 index (cited below), are roughly similar, so the comparison works in this case.]

These are important developments for investors, especially index-only investors, because arguably sectors matter more than regions or countries in this globalized marketplace.  After roughly a decade of economic expansion and low inflation, not to mention a somewhat unprecedented bull market in technology stocks, passive investors may find themselves exposed to a surge in inflation, or an economic downturn.

Consider this table by S&P, which I have cited before, and which shows the different relationships across market sectors relative to macro factors such as inflation and unemployment:

Noting these relationships, we can see in the data that, for example, consumer staples, – basic products people tend to buy regardless of their economic situation, – have fared better than consumer discretionary stocks whenever jobless claims have risen.  In fact, roughly a third of the periodic outperformance of consumer staples relative to consumer discretionary stocks can be explained by trends in jobless claims alone:

Similarly, the last few years, while kind to technology shares, have not been kind to energy prices and commodities, with index exposure to both the energy sector and commodity-sensitive materials stocks dropping to very low market shares relative to history.  However, it is unlikely that these trends will last forever, and a heavy tech concentration at the expense of commodity exposure may cost passive investors if prices rise for natural resources:

In some ways, a continued heavy tech concentration relative to a sector like energy is an implicit bet on a strong dollar; around 25% of tech’s period outperformance relative to energy stocks can be explained by the dollar strengthening:

It is unlikely, of course, that the next cycle will be as favorable to dollar strength as the current cycle has been, if recent history is any guide.

The lesson here is that investors should take note of their sector exposures and make note of some of the implicit bets they may be making.  If, for example, they find they are overly concentrated in a few sectors that are heavily influenced by benign inflation and positive economic growth, they may want to consider bolstering their exposure to energy or defensive sectors, etc.  A key to successful long-term investing is surviving in the short-term, and investors would do well to remember that the best way to survive is by balancing their portfolios not just across regions but across sectors, ensuring that their sensitivities to changes in the macroeconomic environment are not overly large.

The post The Perils of Sector Bias appeared first on Fortune Financial Advisors.

For example, emerging markets appear to be the cheapest basket in the global equity market, but emerging market healthcare and consumer staples stocks are among the most expensive among their global peers.  Interestingly, this is also true for Japan, despite it being the world’s second cheapest market in aggregate.  In both EM and Japan, tech stocks appear to be bargains compared to their European and U.S. counterparts.

Now, it should be no surprise that industries such as telecommunications and utilities are more closely tied to the fortunes of their local economies; after all, they are largely immobile in their geographic footprint, and domestic sales account for close to 100% of their revenues.  For global industries such as technology and healthcare, however, investors should be aware that sometimes these foreign sectors trade very differently from market to market.

For example, investors intrigued by the apparent cheapness of both Japanese and emerging market tech stocks might think they are making a bet on cheap tech stocks poised to benefit from the global tech boom.  This has largely been the case in emerging markets, where tech stocks have traded more in-line with global technology shares than with the local equity markets:

In Japan, however, tech stocks have been tied more closely to the fortunes of the general Japanese market than to global technology shares:

In the healthcare space, both Europe and the U.S. trade at discounts to the global healthcare sector.  It is interesting to note that in each case, healthcare stocks were more closely aligned with global healthcare stocks than with the local markets:

When investors go abroad to look for bargains, it is important that they understand that relationships vary between regions, and even between regions and component sectors.  Unwary investors who, when placing their bets, fail to look past the veneer of aggregate valuations, and who fail to appreciate the different dynamics of various global markets, can end up with unintentional bets, and, of course, unpleasant surprises at times.

Note:  All returns are in USD

Links to Ed Yardeni’s source materials:

S&P 500

MSCI Japan

MSCI Europe

MSCI EM 

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“I’m always on the lookout for great companies in lousy industries…As a place to invest, I’ll take a lousy industry over a great industry anytime.  In a lousy industry, one that’s growing slowly if at all, the weak drop out and the survivors get a bigger share of the market.  A company that can capture an ever-increasing share of a stagnant market is a lot better off than one that has to struggle to protect a dwindling share of an exciting market.”

It goes without saying that many of the ‘blossoms’ that Mr. Lynch described in his book are perhaps no longer applicable as examples of ‘great companies in lousy industries’ as a lot has changed in the quarter-century since Mr. Lynch’s book was published.  The goal of this article, then, is identify a few current ‘blossoms in the desert’ with the purpose of updating Mr. Lynch’s thesis a bit.

The first order of business is to identify the lousy industries that Mr. Lynch describes.  To do this, I took a few of the industries that find themselves on the losing end of what McKinsey calls the “Industry Power Curve“:

The three lousy industries I chose to look at are airlines, building materials, and metal & glass containers.  To demonstrate just how lousy these industries have been, I charted their multi-decade performance versus the S&P 500.  Each underperformed the market by a fairly wide margin:

Yet, just as Mr. Lynch stated, there were ‘blossoms’ in each of these industries that handsomely rewarded investors brave enough to look past the industry factor.  Consider the cases of Southwest Airlines, A.O. Smith (building products), and Ball Corp. (metal & glass containers).  In each instance, the shares of these ‘blossoms in the desert’ not only crushed their industry peers, but also the wider market:

So what exactly made these companies so great despite being players in weak industries?

The performance of Southwest Airlines is well-documented; Mr. Lynch wrote about it at length in Beating the Street, and Professor Jeremy Siegel also dedicates a good portion of his book, The Future for Investors, to the remarkable airline.  In fact, Professor Siegel points out that Southwest Airlines is the only company to have bested the returns of Warren Buffett’s Berkshire Hathaway since 1972.  Some of the reasons Mr. Lynch and Professor Siegel list as catalysts for Southwest’s success is the measured pace of its growth, its reliance on one model of airliner (Boeing 737) and the efficiencies and savings from that, as well as its great relationship with both its employees and passengers.  Building on the corporate culture that is a legacy of its legendary former chairman, Herb Kelleher, Southwest Airlines has become not just a great company in a lousy industry, but one of the best-run companies in the world.

Ball Corporation, which no longer makes the famous mason jars that still bear its name (the brand has since been acquired by Newell Brands), is the world’s largest producer of metal cans, which make up the lion’s share of Ball’s revenues (Ball also has some exposure to the aerospace industry).  Even though the can industry is one of little growth and small margins, Ball has succeeded by expanding its global operations at a measured pace, always with an eye on profitability.  In addition, it is worth noting, as Morningstar does in a recent research note, that 10% of Ball’s shares are owned by its employees, which creates a powerful incentive for them to ensure the success of the company.  This has no doubt been a factor in the company’s success.

A.O. Smith is a leading manufacturer of water heaters and boilers for both commercial and residential use.  The company has grown from a small manufacturer in Milwaukee to one with a global footprint; in fact, A.O. Smith reports that now 43% of its 2017 sales originated outside the U.S.  The company has focused on high-efficiency products, and, in addition to its traditional distribution channels, A.O. Smith has adeptly leveraged online retail platforms to market its products.  A.O. Smith has proven itself to be nimble in navigating a competitive global marketplace, all the while steadily growing and maximizing shareholder value.

For these companies to have succeeded in tough markets as they have, each has had to adapt to changes in globalization, technologies, and survived some periods of very tough economic circumstances.  That each has done so well is a testament to the skilled management, corporate culture, and adaptability that seem to set them apart from their peers.  Their success serves as validation of the Lynch philosophy.

Note:  The author owns shares of A.O. Smith.  Clients of Fortune Financial own shares of Southwest Airlines.

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