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Sectors – winning vs. lagging, resilient vs. volatile

And the winner is..

Sector allocation is in focus of attention basically of every private and professional investor, regardless of whether it is passive (unless it is broad index investing) or active investing. Foreseeing uptrend in commodity market, many are switching now to the basic material sector, while technology is out of favor. In our previous article (link) we have discussed that this jumping around and trying to catch short-term wave does not lead to the decent results. We believe that on the micro and macrolevel, i.e. on the company and sector level, it is of the outmost importance to consider value generated by the sector, its competitiveness in the longer term. Ideally, the sector development is being supported by the global macrotrends such as climate change, population ageing or continuing digitalization.

The resulting outcome of the corporate internal quality and favourable global trends are to be reflected in the financial results. Within the scope of annual Corporate Excellence contest, which focuses on the financial quality of the companies evaluating historical corporate performance, we assess not only individual companies, but also end up with the global sector quality evaluation.

Figure 1: Sector representation in top 100 companies according to Corporate Excellence Award evaluation methodology

Source: Hérens Quality AM, Reuters

Clear leaders according to the quality status are Technology and Health care sectors, which have been gradually increasing their overwhelming presence among the best 100 companies according to their financial quality. They are much better represented in the top as compared to the broad market. Consumer Discretionary and Materials are the ones to face deterioration of their quality status – it becomes harder to find there truly good companies, being backed by excellent fundamentals. One hardly sees any top quality firm operating in the capital intensive energy or utilities sectors, as well as real estate.

Sector Quality

Further we analyzed several aspects of sector quality status, such as balance sheet robustness, competitive advantage proxied by margin level, management efficiency proxied by capital returns. Additionally, we have considered resilience of industries looking at financials’ volatility and zooming out the periods of business downcycles.

Figure 2. represents well the big picture of sectors’ fundamental strength and its resilience in the period of turbulence. In the last decade communications, utilities and energy were not able to deliver decent growth, while the latter sector is also distinguished by abnormal fundamentals’ volatility. These sectors are not looking well if one considers capital returns, too. Gross margin (GM) is the lowest among materials, energy and industrials, though the volatility is bearable, unlike GM volatility in the financial sector.

Figure 2: Sales growth and profitability of MSCI World AC sectors, 10Y average

Source: Hérens Quality AM, Reuters

The top positions judging by the ratios presented in Figures 2 and 3 are taken by the health care sector, which is often represented not only by big pharma, but also by medical equipment manufacturers, non-essential health service providers or biotechnological firms. The quality of IT sector is unquestionable as well – technology firms have their performance laurels well-deserved as they are able to generate high value added, delivering relatively high capital returns and operating with huge cash cushions at low debt amounts. Besides, the volatility of fundamentals has been low, supporting high quality standards.

The quality of sectors is also supported by the amount of R&D investments, which helps the company to sustain its competitive advantage by continuing to solve problems and adding value. Figure 2. clearly shows that Health Care and IT are the leaders in R&D investing, while real estate and utilities sectors are of low R&D intensity and, therefore, cannot build up distinct economic moat.

Figure 3: Balance sheet robustness and Altman Z-score of MSCI World AC sectors, 10Y avg

Source: Hérens Quality AM, Reuters

Sector Returns

Long-term fundamental performance is reflected in the 10Y sector total returns. IT sector rocked during the last decade, followed by health care sector. The bottom positions in the performance table are basically coinciding with the quality table based on Corporate Excellence evaluation: one sees energy and real estate in the bottom of the list.

Figure 4: Sectors’ total return, annualized, MSCI World AC

Mr. Market clearly recognizes the fundamental strength exhibited on macro level, which primarily relies not on the external short-term trends, but rather on the company’s and sector’s ability to solve fundamental problems, to generate high value added, and on top of that – to ride on the global long-term trends.

Will energy steal IT’s laurels?

That is what is happening right now, driven by the current environment: geopolitical unrest and supply chain disruption. This year energy and commodities outperform, while IT sector substantially underperforms diving into the deep value territory and seems to be traded with huge discounts while still being of high quality and able to grow at high rates. We see current situation as a short-term unsustainable phenomenon, and the reverse should happen immediately after the situation signals of becoming normal again and long-term trends will play the main roles again.

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