When it comes to classifying companies, the first thing they do is break them down by sector.
William R. Inman
private investor
And it’s the sector breakdown that investors look at first in fundamental analysis. We investors don’t control the course of the economy, but we can adapt to the economic ebbs and flows.
Understanding the mechanics of these sectors gives me several important opportunities. With it, I can:
Diversify assets – that is, pick stocks from different sectors that loosely correlate with each other and thereby reduce portfolio risk.
Adjust for the current phase of the economic cycle.
Determine the size of the hedge share.
Cover certain industries or sectors through the purchase of exchange-traded funds.
In this article, I will discuss what sectors there are, how they are related, and why we need to know about them.
Sectors using the S&P 500 Index as an example
The S&P 500 is a stock index that includes the 500 largest-cap companies traded on U.S. exchanges.
What to do?
The companies in the index are divided into 11 sectors:
IT, information technology.
Health Care, health care.
Financials, financial sector.
Communication Services, communication services.
Consumer Discretionary, Secondary Goods.
Industrials, industrial sector.
Consumer Staples, Consumer Staples, Consumer Staples.
Utilities, Utilities, Power Utilities.
Real Estate, real estate.
Energy, energy, i.e. oil and gas sector.
Materials, raw materials sector.
The sectors perform differently, have different cyclicality, sensitivity to inflation and central bank key rates. Because of these differences, the weight of sectors in the index is constantly shifting. With the recent collapse in oil prices and the coronavirus pandemic, the Energy sector was the hardest hit – its capitalization collapsed by more than 50%.
But no matter what phase of the business cycle we look at, and no matter what fluctuations occur in the market, the general picture remains the same: the sectors with the highest capitalization are the most technologically advanced and closest to the end consumer. Below I will try to explain why.
To begin with, let’s take a general look at the key characteristics of the sectors. These characteristics determine how much of my portfolio I allocate to one sector or another.
SECTOR CHARACTERISTICS
Technology.
The list of 11 sectors completely covers the production chain, which can be divided into five stages:
Extraction and primary processing.
Production.
Transportation.
Storage.
Distribution and consumption.
Agriculture and animal husbandry in this scheme refer to extraction
In the capitalist model there is a rule: the closer in the production chain we are to the final consumer, the higher the profitability. That is, the farther we move away from extraction, the deeper the degree of processing of raw materials and the higher the added value.
This rule conventionally divides the world into two economic poles: the core and the periphery, that is, developed and developing countries, technological and raw materials. This division was especially evident in colonial times.
Not surprisingly, the richest country now is the United States, which is dominated by the ideology of consumption. It is here that the largest technology and entertainment companies are located.
And in peripheral economies there is a suppression of technological industries and domestic production. In addition, the extraction and export of raw materials is an activity with diminishing returns: further expansion of production gives less and less increase in income. Therefore, resource countries are often doomed to hang out on the periphery: the so-called resource curse.
Here are the conclusions an investor can draw from this.
One must understand the risks associated with investing in emerging markets. When the economy is struggling, the first hit comes to extractive companies and commodity sectors. Their margins are lower than those of technology companies, which means that in crisis conditions it is harder for them to maintain positive operating flows. So at the first signs of recession, capital tends to flow out of emerging markets.
How to measure investment risk
It makes sense to bet on advanced sectors if an investor is looking at the long term. The long term is decades. Right now, the advanced sectors that are shaping the new technological paradigm are biotechnology, renewable energy, artificial intelligence, and 3D-printing.
The technology sectors have been driving the entire index in recent decades. The most technologically advanced sectors right now are IT and Healthcare. Most stocks in these sectors are so-called growth stocks. These companies don’t spend a lot of money on dividends, but they direct the proceeds to new research and development and R&D.
And dividend papers are most often established businesses that have already carved out a niche. These companies do not have the potential for explosive growth, but they have flat revenues, which are distributed among shareholders. When building a stock portfolio, it is worth considering this aspect and clearly distinguish between growth and dividend securities.
It is also important to pay attention to the second key characteristic of sectors – cyclicality
.