Drawbacks of sector rotation

Here is a diagram showing the composition of the market, as represented by the Standard & Poor's (S&P) 500 companies, and divided into the ten sectors categorized by S&P's Global Industry Classification Standards (GICS).

The sectors are shown in their relative size, by the combined market capitalization of the companies which make up each sector. For example, at current market prices, companies in the Energy sector make up 14% of the market capitalization of all the companies in the S&P 500 index. Companies in the Financial sector make up 15%.

The way you often hear sectors discussed is via speculation as to which sector or sectors are about to do better, relative to the other sectors, and which sector or sectors are about to do relatively worse. Much of the "mass-managed money" world of big mutual funds manages money through the same approach, "overweighting" one sector and "underweighting" another, based on their assessment of various macroeconomic and other criteria.

We have previously made the observation that this is essentially "timing" sectors, such as in this post from March, 2008. It underscores the distinction between ownership of businesses and ownership of markets -- or in this case, slices of the market. There are several reasons why we believe that ownership of businesses is superior to ownership of markets.

First, the analysis of businesses is a mature field with a long history and a well-established body of knowledge. Financial statement analysis has been going on for decades. You can find out real, concrete evidence about a company through its balance sheet, income statements, cash flow statements, filings with the SEC and other real measurements, as well as through visits with the management teams and employees of the companies themselves.

However, the same body of knowledge for the evaluation of one sector versus another is nowhere near as well-developed. How do you compare the management teams of all the companies in the Utility sector versus the management teams of all the companies in the Energy sector? It simply cannot be done. Consequently, when someone is saying "It's time to move out of utilities and into financials," it is hard to justify as anything more than an opinion.

Secondly, as a close examination of the sectors themselves reveals, assigning a company to a sector is sometimes clear-cut, but in many cases the decision is ambiguous. For example, there are companies which could easily be classified as either Information Technology or Telecommunications, because their technology is critical to telecommunications infrastructure or because they are operating in the convergence of those two sectors. More and more sectors are converging as we move forward.

Perhaps the most important reason we do not follow an investment process that is based on sector rotation, however, is the fact that ultimately wealth is made and grown through the ownership of great businesses, not through the ownership of sectors. We would rather own great businesses in the Industrials sector, such as II-VI or MSC Industrial*, than own the Industrial sector itself. Where the Industrials sector is down over 13% year-to-date, shares of II-VI and MSC Industrial are up over 53% and 25%, respectively.

Neither of these companies are actually members of the S&P 500, but they are included in many industrial sector index funds. The point is that ownership of II-VI or MSC Industrial is ownership of shares in a business, rather than ownership of something vague, like a sector. Some might argue that ownership of a sector is actually ownership of a large number of individual businesses, and that is true, but the argument we are making is that the approach to owning a sector is an approach that is much more based upon owning the market or a sector of the market, not owning a business.

We discussed the distinction between owning companies and owning markets (or slices of the market) in our previous discussions contra indexing, such as this one and this one. Although most of the arguments used by proponents of indexing have to do with "just owning the market," in practice investors who index usually end up being sector rotators.

Investors should consider building their financial foundation on a discipline of owning businesses, rather than on a system of rotating through sectors.

* The principals of Taylor Frigon Capital Management own shares of II-VI (IIVI) and MSC Industrial (MSM).

For later blog posts dealing with this same subject, see also:

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