The importance of sector bets 2 comments

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Bottom-up investors advocate starting the stock selection by analysing the financials of companies, and to concentrate your firepower on a few good picks. There is nothing wrong with that logic per se, and yet without the advantage of control of the company, the minority shareholder will always wonder whether he is having the raw end of the deal. Since there is a buyer (the individual), there must be a seller at the other end of the deal. What if the counterpart is the proverbial big boy or the company insider who knows more than you? That is always something that niggles at the end of the mind, and it is not seldom that we could buy and sell at the worst moments.

Diversification is not a dirty word. I have written on the case for diversification in an earlier article; the gist of the article was that you must know what you're trying to diversify. If you're bullish on the particular country's market in general, you diversify away sector and company risk by buying an index fund, for example. If you're bullish on the sector rather than the undervaluation of a particular company within that sector, it makes sense to diversify company risk by buying several companies within that sector. If it's the other way, then you concentrate your firepower and don't diversify. Those were my main points.

Today, I was examining the index trends for the Singapore market and the various sectors that I track on my Hotstocksnot blog. It has been a scintillating half-year and I am sure many have made a lot of money (I believe there's going to be an article tomorrow on some 30-year old Singaporean guy who has $200k in stocks). Also glaring at me from the figures was the fact that one could have made a lot of money by simply playing the hot sectors without painstaking company analysis. Take a look at the performance figures using 9 June (when I started tracking my personal sector indices) as the base:

Performance of various indices since 9 Jun 2006

Index	Last value	Change	% Change
STI	2865.14	527.70	(22.6%)
SESDAQ	132.73	41.49	(45.5%)
SGX Finance Index	2126.11	388.95	(22.4%)
SGX Property Index	1138.73	350.59	(44.5%)
SGX Hotels/Rest Index	948.79	152.60*	(19.2%)*
SGX Construction Index	423.71	140.91	(49.8%)
Plastics Index	94.22	-5.78	(-5.8%)
Env/Water Index	108.28	8.28	(8.3%)
Energy Index	125.27	25.27	(25.3%)
China Index	133.65	33.65	(33.7%)

* The Hotels/Restaurants index performance was adjusted due to certain aberrations in the index on 5 Oct; I believe it was due to removal of some key components that were not appropriately adjusted in the index. Presented above are my adjusted performance figures.

(Note: The SGX Finance, Property, Hotels/Restaurants and Construction indices are incumbent indices produced by SGX).

The point from an assessment of these figures is that if one had picked the right sectors, he need not have spent too much effort to achieve quite a phenomenal return. If he had picked property, construction and even China-themed stocks and diversified extensively within the chosen sectors, he'd have grown his assets by a magnificent 30-50% within half a year. He won't have done too shabbily in energy or finance either (~20%). On the other hand, if he'd chosen the plastics sector on the basis of bottom-picking the sector, the returns would have been totally unsatisfactory.

Hence my point that it may be possible to take the middle road (sector, and not market(top-down) or company (bottom-up)) and take appropriate diversification action to hedge away all non-related, specific risks. A sector, if I may argue, is easier to monitor than a company because various information sources (TV, newspapers, Internet) now offer us tremendous access to industry developments, if we care to look. Companies per se firstly can be quite opaque, and secondly might not react in the expected manner to a certain sector development (eg. a tyre distributor might be impacted adversely rather than benignly by tyre shortages because their allocations might be reduced). The fact that risks are diversified in a sector bet is obvious; however the evidence that performance can still be stellar should not be understated.

To be sure, even if one had chosen to put his money on the broad market, he would still have been able to do extremely well --- >20% for the blue-chip STI, and >40% if he took the position on small-caps (represented by SESDAQ) as a diversified market bet. If anybody can claim himself as a bottom-up investor and have much better performance figures than these indices thus proving that the bottom-up company analysis/concentrated bets approach is better, please feel free to comment.